In the next few posts, I will walk through some key college saving options, namely 529 Savings Plan, 529 Prepaid Plan, Coverdell Education Saving Account (ESA) and Custodial Accounts (UGMA/UTMA). Actually, you don't necessarily need any of the above accounts to save for college, but these tools offer certain advantages specifically for college savings.
As 529 Plan is the most advertised college saving tool (for a reason), we will first take a look at it. 529 Plan includes two dramatically different options: 529 Savings Plan and 529 Prepaid Plan. We will first discuss 529 Savings Plans.
How It Works
529 Savings Plans are offered by states with the help of financial service companies. It allows people to grow a large amount of after-tax money on a tax-deferred basis using a number of investment tools prescribed by the plan. Withdrawals for qualified higher education expenses will be tax free.
While every state has one or more 529 Savings Plans available, you don't have to choose a plan from the state you live. Actually, you should always comparison shop.
- Scale: 529 Savings Plan allows you to invest a huge chunk of money. While contribution limit varies from plan to plan, you can contribution up to $230,000 in most plans (up to $300,000 in certain plans). You can almost invest the entire limit in one shot (if you are rich enough) -- you don't always have the opportunity to defer tax on this large amount of money; think about the $14,000/year limit for 401(k) and $4,000/year limit for Roth IRA in 2005.
- Favorable Financial Aid Treatment: Balance in 529 Savings Plan is treated as the asset of the account owner (in most cases, parents). Thus, it receives favorable treatment compared to assets under students' name.
- Donor Stays In Control: The named beneficiary usually has no access to the funds. In addition, donors can change beneficiary to other members in the immediate family, usually without income tax consequences.
- Investment Flexibility: 529 Savings Plan resembles 401(k) when it comes to investment options because you can only select from a handful of investment options offered by the plan. Wose, you are only allowed to change your investment options once every 12 months.
- Fees: Almost every 529 Savings Plan is supported by a single financial institution. This arrangement gives the institution the incentive to promote the plans as the financial institution can "lock in" the contribution and charge a higher-than-normal fee. (The dark side: states also receive some kickback.)
My Personal Take
The lack of investment flexibility almost turns me off immediately. The worst case will be: in the event of a market crash, you will need to wait close to 12 months to change your investments, and during these 12 months, watch your balance to dwindle every day. Associated fees also need to be watched, as some of the 529 Savings Plans are advisor sold with a high front load plus more than 2% annual expenses. (See Forbes' article An Expensive Education.) While the capability of putting a large amount of money to tax deferred account is certain attractive, it might not be a good bet unless you exhausted many other saving options like 401(k) and Roth IRA. (Recommended reading: A Lesson in Saving for College from BusinessWeek.)
Within this post, I cannot exhaust all the characteristics of 529 Savings Plans. A great resource is the 529 section at Savingforcollege.com. Especially, if you want to do your comparison shopping for 529 plans, its 5-Cap Ratings offers some hard-to-be-found objectivity in the world of 529 Plans.
529 Prepaid Tuition Plan is our next topic for discussion. Bearing the same "529" name, it actually offers many different things.
(This article is a component of the 10-part "Saving for College" series at PFBlog. If you want to read from the start, follow the links at this Table of Contents page.)