529 college saving account - does it make sense?

Are there any other options?  

My friend asked me how am I saving for college for my child. I have one child, she has three. This question is important for both of us.

Most people go to college to get a certain degree. I heard that few go to college specifically for a "Mrs". degree.
I have a daughter... Looks like a college, one way or another, is in the stars... 

I didn't have college loans and it is very nice to start professional life without negative number for your financial worth. My husband on the other hand had to pay off his student loans. 

College expenses are also not really your expenses but your child's.
It would make sense to apply the oxygen mask rule used on a airplane: First help yourself.
Make sure that you have enough for your own retirement first. No one knows what can happen. If you hope that you will receive financial support in your retirement age from your child, it may not always work out for various reasons.


How much money will be needed?
It depends on the college, on time, on lifestyle, on inflation.... 
College costs are difficult to predict but it is possible to use at least one factor to estimate them in the future - inflation. With adding any other unknowns, chances are the costs will be higher.

Let say the college costs today are $60,000 (for private colleges it will be more, for public it might be less). With 3% inflation in 12 years $60,000 will become $85,545 according to the inflation calculator. (I am taking 12 years for my calculation example because my child is 7 years old now.)

What are the options?

There are very few options: basically only 529 plan and custodial brokerage account. There is also Coverdell but it is very restricted.  
Of course there are still regular savings accounts and space under mattress, but they would not be the first choice.

Option 1: 529 plans

Those are state-sponsored investment accounts with purpose to save for college expenses. The account us usually set up in parent's name, not child's name.


1. Tax
You contribute to this account with after tax money. 
The account grows tax-free (all gains and dividends grow tax-free and are not taxed every year as in a regular savings account).

Withdrawals are tax-free and penalty free as long the expenses are qualified (books, room and board (up to a certain limit), tuition and other education related expenses including computer. There is an official list which I would check close to the time for expenses, since qualifying items may change).

Some states offer partial or full tax credit or deductions for contributions to their states plan. Some states allow to deduct contributions to any plan. 
If you leave in a state without state income tax like Tennessee, there will be no deductions but the money will still grow tax-free.

Starting 2018 distributions up to $10,000 are allowed for elementary and high school tuition.    


2. Financial aid eligibility
Assets in 529 plan are considered parental assets and 5.64% of parental assets are factored into the calculations of the number that determines the child's eligibility (Expected Family Contribution, EFC). It is different with child's assets - 20% of them are considered for that calculation. You can find calculators online. I plugged in the data and my child will not qualify, definitely no expectations for any financial aid there. 


3. Contribution limits
The contribution limits are different and vary from state to state ($300,000 or more). In 2018 the limits were significantly increased. Anyone (not just parents) can contribute a tax-free lump sum of up to $70,000 per individual ($140,000 for couples) by treating the sum as a gift as though it were spread evenly over 5 tax years. 

If you plan to contribute close to the college start time, the lump sum contribution close to the college start may only make sense if you leave in the state with state income tax and you can deduct those contributions from your taxes. There will be no time for tax-free growth over time.

If you live in a state without income tax, you can't deduct the contributions. A large sum will only make sense if contributed early to have enough time to grow tax-free.


4. Flexibility
If a child elects not to go to college or receives a full scholarship, it is possible to change beneficiary to another immediate family member (child or adult - siblings, step siblings, parents and others (there is a very detailed official list of qualifying relatives. The question is if you would like to transfer that sum of money outside of your close family).

For example my friend with three children can transfer the money down from her first to second and then to her third child. I only have one child, I will not go to college myself anymore and I don't have any college age relatives in the US. I have no one to transfer to even if I wanted to do it.


5. Withdrawals
There is a penalty on non-qualified withdrawals. The earnings will be taxed at your income tax bracket plus 10% penalty on the gains unless  the beneficiary dies, becomes disabled or becomes one of the qualifying grants.

I made some calculations to estimate the savings and to see what I would have to pay in case of non-qualified withdrawal:

Using a simple savings calculator, if I save $450 every month for 12 years with 5% conservative growth rate (my child is 7 years old now) in 12 years I will have approximately $88,000 saved. With more optimistic 7% growth rate it will be approximately $101,000.

In both examples $64,800 of that sum is post-tax contribution money only. 
At 5% yearly growth $23,200 are the gains. At 7% growth $36,200 are the gains.

If you have to take that money out with penalty, your contribution stay unchanged but the gains ($23,200 or $36,200 in the examples) will be taxed at your tax bracket (presumed 39.6%, you can adjust it for your own bracket) plus 10% penalty.

For 5% growth example you will lose $9,187 (39.6% on $23,200 gains) + $2,320 (10% on $23,200 gains)=$11,507 (total). The $23,200 of gains will be reduced by $11,507 - about a half.
The second example at 7% growth ($36,200 gain) will show following: $14,335 (39.6%) +$3,620 (10%)=$17,955 (total). Also reduced by about a half. (Actually in both examples the amount is reduced by 49.6% (39.6% variable depending on your tax bracket plus 10% penalty independent of the tax bracket).

To comfort myself after such reduction I basically can say that the money was growing not at 5% and 7% but at approximately 2.5% and 3.5%.
This is actually comparable to an insurance product like whole life insurance (but has less constrains than such an insurance product). If I decide to keep it for myself and not use for college expenses, I can withdraw it while in retirement when the tax bracket will be lower.

However, statistically the most likely scenario is that the child will go to college and you will use the money in 529 plan for your child's college expenses.

529 plans only allow rebalancing 2 times a year. It doesn't appear flexible, but it will not matter for most people because most will allocate the money to index funds with the least expenses and just leave it there to grow. At this time there are no options to invest in stocks directly.

Saving in 529 plan is not the same as saving in a regular savings account because the interest offered by regular savings accounts  is at approximately 1% at this moment and the money doesn't grow tax-free. In regular savings account you pay taxes every year on accumulated interest (in many states both, federal and state tax).
   

Option 2: Custodial brokerage account

Custodial account is an account in your child's name. A parent sets it up and manages it until child is 18 or 21 years old ("age of majority" depends on the state).

1. Tax
Starting in 2018 "kiddie tax" on unearned income is not charged at parent's tax rates.
The accounts will be taxed by rules that apply to trusts and estates. 
All investment earnings above $2,100 will be taxed at following rates:
Up to $2,550 - 10%
$2,550 - $9,150 - 24%
$9,150-$12,500 - 35%
over $12,500 - 37%

Money in the custodial account is an irrevocable gift and once the child riches his "age of majority" the money is his.


2. Financial aid eligibility
The money is considered child's assets and will be calculated at 20%. 


3. Contribution limits
There are no contribution limits.
As with 529 plan you can contribute up to $14,000 ($28,000 per couple) per year to a custodial account without incurring gift tax. 


4. Flexibility
While managing the account you can make any withdrawals at any time without any penalty, as long as the money benefits beneficiary. 
There are some guidelines I could find on tax related pages what qualifies as expense that benefits the beneficiary (such things like paying for child's tax return with the money from his custodial account will qualify). In case you plan to withdraw you might need to research that more detailed. 

I tried to do the same calculations examples with this type of account. It is not easy, because only part of the money is not taxed. At the same growth rate as estimated in 529 plan example, the final amount will be less due to yearly taxation, but more than in your non-custodial brokerage account because every year the first $2,100 and taxed less then the rest. 
Another flexibility related issue: the money definitely doesn't belong to you and you can't just decide to pay penalty and use it for your own needs like you could with 529 plan.



Option 3: Coverdell Education Savings Account ( Education Savings Account or ESA)

This is a tax advantaged investment account for education expenses. The difference here is that the money can be used also for elementary, secondary education, not just for college. 
The account us usually set up in parent's name, not child's name.
If you earn above certain amount, you may not be able to contribute to this type of account. This will depend on your MAGI (modified adjusted gross income). For single filers MAGI should be less than $95,000, for joint it is $190,000. For partial contributions the limits are $110,000 and $220,000.


1. Tax

The contributions are post-tax and are not deductible. Money grows tax-deferred and can be withdrawn tax-free for qualified expenses.

 2. Financial aid eligibility
Like with 529 plan, the money is considered parental assets and 5.64% of parental assets are factored into the calculations of the number that determines the child's eligibility (EFC).

3. Contribution limits
The contribution limits are low: $2,000 per child per year.

 
4. Flexibility
This is different from both 529 plan and custodial accounts.
There are age limits. The contributions are only allowed until age of 18 and the balances have to be used up by age 30. The money can be transferred to another family member who is younger than 30.   Another difference to 529 account is that more investment options are available including stocks.

5. Withdrawals
There is a penalty on non-qualified withdrawals. The earnings will be taxed at your income tax bracket plus 10% penalty. 

 


Summary

Overall, it appears to me that it would make sense to go with 529 plan with the knowledge that I have no state deduction (because I live in a state without state income tax). 
The only benefit would be the tax-free growth. If I will not use the money for college expenses, I know that all gains will be cut significantly (ordinary income tax rate and penalties). 
But in retirement taxes are expected to be lower and if there is no urgency to take money out of this account, I can wait till my taxes decrease. Taking out money at 15% or 25% tax rate instead at 39.6% will help. 

What about a custodial account?
My custodial account is with a bank that has an option to invest in stocks as well as in funds.

If I use the same settings of $450 per month for 12 years but with 10% growth rate (invested into REIT stocks and reinvesting the dividends), that will amount to approximately $120,000 (excluding tax).
The amount you contributed will be the same $64,800. The total interest is approximately $56,800. 

Another option to get to approximately the same amount of savings is to put a lump sum of $30,000 (divided over 3 years to prevent gift tax) and just let it grow with the same REIT stocks for the same 12 years. That will amount to approximately $94,000 (again excluding  tax).

All the numbers are very approximate. The growth with mutual funds in 529 plan as well as with REIT stocks or other stocks will always vary. Dividends may change, the markets will go up and down. Saving with both options will not be a straight line.

I will use both, a 529 plan and a custodial account.

The custodial account I might actually use as savings for my daughter's wedding. I was told that in the US the bride's parents are usually on the hook for the wedding costs.
If I put a lump sum of $12,000 and let it grow for 15 years (till she is 25 years old), this will grow to approximately $50,000. That will equal $77,000 in today's money it there is 3% inflation. Clearly $77,000 or even just $50,000 is too much for a regular wedding. But if you think, the investment is actually only $12,000 and then it just grows with time and luck. $12,000 is probably OK to pay for a "Mrs. degree".   





Update 03/2019:
Use of 529 plan funds abroad: 
The expenses would be eligible for tax-free distribututions if the educational institution abroad is in the list of those listed on the Free Application for Federal Student Aid form (FAFSA). Find out the school code and check here if it is qualified.  

 <img src="http://www.siteindexed.com/index/crawler.png" />