In honor of it being 5/29, I’m going to dedicate today’s blog post to covering college savings strategies in general, differences between different college savings vehicles, and then conduct a deeper dive on Arizona’s 529 plan.
Different ways of saving for college
Since minors are unable to hold assets directly in their own names, there are four broad ways of putting away money for a child or grandchild:
- Uniform Trust to Minors Act/Uniform Gift to Minors Act accounts. Sometimes referred to as UTMA/UGMA or custodial accounts, these accounts have no stipulations on how the money is used and the assets legally become property of the child once they reach the age of majority, which in most jurisdictions is at age 18. Gifts made to UTMA/UGMA accounts are irrevocable. These accounts have one adult custodian and one minor beneficiary. There doesn’t have to be any sort of familial relationship between the two parties. A formal trust does not need to be drawn up to open a UTMA/UGMA account. From a tax perspective, there are no tax breaks to use the money for educational purposes and any capital gains, dividends, or interest income is considered to be the child’s income and subject to ‘kiddie tax’ rules. Simplifying things greatly, the kiddie tax means that minor children will have to pay taxes at their parent’s rates if they have more than $1,900 of investment income in a year. Finally, from a financial aid standpoint, UTMA/UGMA accounts are considered to be an asset of the child, meaning that they will more adversely impact a child’s financial aid award than if the money was held in the name of a parent or dedicated education account.
- Trusts. Having been to law school and been trained as an attorney, I have a hard time describing trusts without using a lot of $20 words, but here it goes: A trust is written legal document where a separate legal ‘entity’ is established to hold assets for the benefit of someone else. I put ‘entity’ in quotation marks to signify that it is not a living, breathing human being but rather something created on paper solely for the purpose of holding assets. Typically trusts are set up when leaving an inheritance to a minor child and allow the person who died to have some control from beyond the grave. Unlike UTMA/UGMA accounts, an attorney does need to draft a trust document.
- Coverdell Educational Savings Accounts. Sometimes called ESAs, Education IRAs, or ‘Coverdells’ these accounts allow contributions of up to $2000 per child per year. The parent or guardian (not grandparents) has to be the custodian on these accounts; however anyone can make the contributions subject to some income limitations. The two big benefits to ESAs are 1) very broad investment options – you can invest in mutual funds as well as individual stocks, ETFs, and bonds; and 2) that monies can be used for qualified elementary and secondary education expenses in addition to qualified post-secondary expenses. With the low contribution rates, fewer companies are opening new ESAs making it difficult to find a custodian. Additionally, contributions can only be made until the beneficiary’s 18th birthday and all proceeds have to beliquidated by the beneficiary’s 30th birthday. However, an ESA can be rolled over to a 529 plan and thus the monies can be held indefinitely. While there are no tax deductions or credits for contributions into an ESA, distributions are tax free for qualified educational expenses including: tuition and fees; books, supplies, and equipment; room and board (with restrictions); and academic tutoring, uniforms, and transportation for elementary and secondary schools (all with some restrictions). An ESA is considered a parental asset for financial aid purposes which means less impact on financial aid.
- Qualified Tuition Programs. More commonly known as 529 Plans (after the section of the Internal Revenue Code which created them) or College Savings Plans these are now the most common way of saving for college. 529 plans come in two flavors: 1) Prepaid Tuition Plans where you buy chunks of the child’s college at current prices and the sponsoring state bears all investment and price inflation risks (which is analogous to a company pension plan); and 2) College Savings Plans where you put in money and assume all investment and price inflation risks (which is analogous to your 401k). As Arizona only offers College Savings Plans, I’ll focus my comments on that type of plan.
Benefits of 529 College Savings Plans
Like Coverdell ESAs, allow for tax free growth of assets as long as used for ‘qualified’ higher education expenses. Again, there are negative tax ramifications in most cases if money is pulled out and used for things other than educational expenses.
Unlike Coverdell ESAs, there are no income limits for making contributions.
High maximum investment amounts. While this varies from state to state it is typically between $300-400,000 and in Arizona it is currently $374,000. If the account balance reaches this amount, no further contributions are allowed. My experience in working with clients is that this limit is largely hypothetical as I see very few accounts even in the low six-figure range.
Allow for accelerated gifting to get assets out of wealthy relatives account if they are facing estate tax issues. Typically, only gifts up to $14,000 per year qualify for the annual gift tax exclusion but up to five years of gifts (or a total of $70,000) can be made in one year to a 529 plan without triggering the gift tax.
Possible state tax benefits. This varies from state to state but in Arizona a single or head of household tax filer can deduct up to $750 and married filing joint tax filers can deduct up to $1500 per year of contributions. For a married couple filing jointly with $100,000-300,000 of taxable income, a $1500 contribution would equal $63.60 in state tax savings. Also of note in Arizona is that ANY state’s 529 plan can be used to get the tax deduction!
Transferability. If you have a child that doesn’t attend college, you can transfer the 529 plan to a sibling or cousin with no tax ramifications. If you don’t transfer it to a child in the same generation, you can hold on the plan and give it to a grandchild but are limited by gift tax limits as to how much you can give to the grandchild without triggering the gift tax.
Simplified management. While it is possible to buy individual mutual funds, not every plan offers this choice and even those plans that allow individual mutual funds have a limited set of funds from which to choose from. Most 529s offer pre built mutual fund portfolios which are either constructed based on risk tolerance or are age-based options which automatically become more conservative as the beneficiary gets older. Additionally, all 529plans limit investment changes to once per calendar year or upon change of the named beneficiary.
Considered as a parental asset for financial aid calculations, resulting in a lower impact on financial aid awards.
Drawbacks of 529 College Savings Plans
While I believe that there is a time and a place for active management, the time and place is not inside of a 529 Plan as there are limited investment options and severe limits on changing your investment choices. As a result the best strategy is to invest in index-based options that are appropriate to your risk tolerance and focus on keeping your costs low!
Tying the 529 Plan into a specific state adds unnecessary confusion and complexity. While I don’t like this state of affairs, Congress has cast their lot with 529 Plans and is unlikely to change the status quo and make the simpler Coverdell ESA more potent.
Arizona 529 plans
Currently, Arizona sponsors 529 plans from three different companies:
- Ivy Funds InvestEd 529 Plan – This plan is sold by advisors, so you will have to pay an upfront sales commission of 2.5% to 5.75% in addition to the underlying mutual fund expense ratios and a .25% annual distribution (12b-1) fee. The total asset based fees range from .98% for the InvestEd Conservative Portfolio to 1.67% for the Ivy Real Estate Securities Fund. The Ivy Money Market Fund does not charge a sales load or 12b-1 fee and carries a .78% expense ratio. It offers 16 individual Ivy Mutual Funds as well as three age-based portfolios and three static risk-based portfolios. The 16 different mutual funds allow an investor to be more granular with their investment decisions; however the fees are some of the higher 529 plan fees that I’ve seen.
- Fidelity Arizona College Savings Plan – This plan is sold directly to participants so you will not have to pay any sales commissions. There are four main investment options: 1) Fidelity Funds – includes age based and risk tolerance based portfolios ranging from .56% to 1.01% in total annual fees; 2) Fidelity Index Funds – includes age based, risk tolerance based, and individual mutual fund investment options with annual fees ranging from .25% to .35%; 3) Multi-Firm Funds – includes age based portfolios with annual fees ranging from .94% to 1.40%; and 4) Bank Deposit Portfolio – fees range from .05% to .50% depending on the prevailing interest rates, as of 4/30/2013 the yield on the Bank Deposit Portfolio was .10% interest.
- Arizona Family College Savings Program – Sold by the College Savings Bank, this plan has four main investment options that are all FDIC insured as well as charge no fees: 1) Honors Savings Account – advertised as ‘one of the highest yielding FDIC-insured savings account within the 529 industry’ it is currently paying .65% interest; 2) CollegeSure CD – variable rate CD with the yield tied to the rise in college costs. Offers maturities from 1-22 years and pays interest annually on July 31st every year, maturity date of the CDs is also July 31st, regardless of when purchased. The interest rate isn’t clearly stated on the CD and I also looked at the terms and conditions and am still uncertain as to the interest rate paid. As far as I can tell on 7/31/2012 the College Inflation Rate was 4.25% and the margin for CD’s less than 3 years was 3.9%, meaning that the CD earned 0.35% interest; 3) InvestorSure CD – variable rate CD which offers 70% of the return of the Standard & Poors 500 stock market index over 5 years, with a guarantee that principal will be returned at maturity even if the market declines. The term of this CD is five years and while the future performance is uncertain, over the past 5 years the average APY was 1.21%, over the past 10 years the average APY was 1.03%, and over 20 years the average APY was 3.47%; 4) Fixed Rate CDs – they currently offer a 1 year CD at 0.40% interest and a 3 year CD at 0.68% interest.
Recommendations on for saving for college and using 529 college savings plans effectively
- Unless you are over the income limits for a Coverdell ESA or plan on contributing more than $2000 per child per year, your best bet is to start with a Coverdell ESA since its investment choices and investments both are more flexible than those found in a 529 plan.
- Since Arizona allows its residents to use any state’s 529 plan for the tax deduction be sure to pick a state which offers the best investment choices as well as the lowest fees. Listed below in the resources/links are some good sources on choosing a 529 plan.
Resources and Links
The official website for Arizona’s 529 plans is at: www.az529.gov. Here you will find the websites for all three 529 providers as well as information on the state tax breaks.
An in-depth website devoted to all things regarding college savings including in depth information on 529 plans for all 50 states is www.SavingForCollege.com
Morningstar also has information on 529 plans; however most of their best analysis and recommendations are available only to paid subscribers.http://529.morningstar.com/state-map.action
Allan Roth, a fee-only financial advisor in Colorado recently ranked his top five 529 college plans in this article. http://www.cbsnews.com/8301-505123_162-57578285/top-five-529-college-plans/
To get information straight from the source on all tax benefits regarding education expenses, check out IRS Publication 970 http://www.irs.gov/pub/irs-pdf/p970.pdf
Financial planning thought leader Michael Kitces wrote in greater depth earlier this month on Coverdell ESAs vs 529 Plans.http://www.kitces.com/blog/archives/496-Coverdell-Education-Savings-Accounts-Vs-529-Plans-For-College-Savings.html
On the Reuters news service yesterday there was an article about alternative ways to save for college other than 529 plan. (I also plan to address this in a later blog posting) http://www.reuters.com/article/2013/05/28/us-college-savings-529s-idUSBRE94R0FC20130528