529 Plans: The Party Starts Here

November 2, 2018

 

Planning for college has become a hot topic in recent years – rightfully so.  Over a 35-year period[1], inflation for educational expenses has averaged 4.9%[2].  Whereas, housing and “food and beverage” have averaged 2.8% and 2.7% respectively[3].  Even healthcare costs came in lower, averaging 4.8%[4]!  In order to combat the ever-increasing costs of higher education, in the Small Business Job Protection Act of 1996, the government established section 529 to the Internal Revenue Code solidifying the 529 plan vehicle[5].  As many know, a 529 plan is an excellent way to pay for education due to its tax advantages and wealth transfer capabilities.  However, what is often missed is how to go about choosing a 529 plan. In this month’s blog we will go through the necessary steps one should take in their evaluation of 529 plans.

 

Step One - choose the type of 529 plan

There are two types of 529 plans – prepaid tuition plans and education savings plans.  529 prepaid tuition plans allow “an account owner [to] purchase units or credits at participating colleges or universities for future tuition for the account beneficiary.”[6]  Whereas a 529 education savings plan allows “an account owner [to] open an investment account to save for the account beneficiary’s qualified higher education expenses or tuition for elementary or secondary public, private, or religious schools.”[7]

 

529 prepaid tuition plans are beneficial as the account owner is buying either units or credits of tuition in a certain school at today’s prices.  If the cost of tuition increases, the account owner will benefit as they locked in a price at a lower rate.  The con to such a plan are the numerous restrictions[8].  Participating in prepaid tuition plans means you are paying for tuition only.  Other costs such as books, room and board, and a computer would not be covered under this plan.  In addition, most states restrict participation to residents only.  Meaning, if an account owner lived in WI, but their daughter wanted to go to the University of Texas, they would be unable to participate in the Texas Tuition Promise Fund as they are not residents of Texas.

 

529 education savings plans are more liberal in nature and are more common.  Having the ability to spend 529 plan funds on what the IRS deems a “Qualified Expense”[9] creates flexibility for a student allowing them to attend any school of their choosing.  In addition, an individual could participate in another state’s 529 education savings plan without being a resident.  It may mean they don’t receive the residential benefits, but they can still participate in the fund.  The one potential downfall in comparison to a prepaid tuition plan is if tuition increases at a faster rate than the contributions and growth of the education savings plan account, the prepaid tuition plan could make more sense from a numbers’ stand point.

 

For most individuals it makes sense to choose the 529 education savings plan over the prepaid tuition plan.  That does not mean you can’t participate in both; the 529 education savings plan is just less restrictive.  With that said, going forward we are going to focus on 529 education savings plans (“529 Plan”) as it is less restrictive and more common place (if you are curious about 529 prepaid tuition plans, please don’t hesitate to reach out).

 

Step Two – direct-sold vs. advisor-sold

As mentioned above, most states operate their own 529 plans and there are two ways to access said funds: direct-sold or an advisor-sold plan.  For example, the state of WI has two different 529 plans Tomorrow’s Scholar and Edvest.  Tomorrow’s Scholar is an advisor-sold plan, while Edvest must be accessed directly by the consumer.  They are run by different organizations, meaning there are different investments to choose from, and both funds receive the same tax benefits.  The big kicker: if a WI resident goes through Tomorrow’s Scholar, then they are going to pay higher fees as they will need to pay the advisor for selling it to them.  That same resident could go directly to Edvest reducing their cost substantially.

 

The benefits of going through an advisor - they can help with investment selection and can perform ongoing monitoring.  However, 529 plans are quite restricted as it relates to investment selection.  Typically, a participant can choose from multiple pre-built investment options, ranging from target date to static asset allocation models – simply, it’s a passive style of investing.  With that said, in LBW’s opinion, an individual should not pay an advisor to sell them a 529 plan.  Instead they should work with an advisor who will educate them and assist them in locating and setting up a direct-sold 529 plan, as there is not much an advisor can do other than select the appropriate pre-set model.  As for ongoing, monitoring, the individual could provide statements on a semi or annual basis and ask their advisor if there is any need for rebalancing.  This method of choice as mentioned could reduce the participant cost significantly.

 

Step Three – residency/state income taxes

Now that we know which type of plan we want to select, and we understand the differences between direct-sold and advisor-sold plans, the next step is easy.  We need to ask where do we live/and or pay state income taxes?  Depending on the participant’s state of residence and/or where they pay state income tax, we can nail down which state plan they want to participate in.  For example, let’s say a resident of NV is looking to participate in a plan and part of their income is derived from rental real estate from houses they own in NM.  When looking to participate in a 529 plan they may not want to participate in NV’s plan as there is no state income tax deduction because NV doesn’t have state income taxes.  However, because income is being derived from NM, which means they are paying NM state income taxes, it may make sense to participate in their plan in order to get the state’s unlimited tax deduction[10][11] to potentially offset any state income tax they may receive from their rental properties[12]. 

 

Understating the rules and benefits provided by each state can help accelerate the process of choosing the optimal 529 plan.

 

Step Four – fees

By step four we should have whittled down which plans we want to participate in.  If we are residents of WI and want to receive a state income tax deduction, then we have two choices: Edvest and Tomorrow’s Scholar.  If we have gotten down to these two, it is now time to evaluate the fees.  There are a few ways a participant is charged in a 529 Plan: there will be administrative fees, management fees, expense ratios from the funds, and a commission or advisory fee if the advisory route is chosen.  It is best to evaluate what those fees would be and compare them.  At the end of the day, because investments are so restrictive and passive in nature, going with the institution with the lowest fees makes the most logical sense.  Now, if paying an advisor for their services is something a participant wants, they need to recognize they will be paying more for a similar product.  Furthermore, depending on the findings from step three it may make sense to pay slightly higher fees to receive a larger tax deduction.  For residents of Kansas, fees become a large part in the decision-making process as they have the ability to receive a tax deduction regardless of the state plan.  

 

Step Five – performance

Our last step in our process would be to evaluate the historical performance from each plan we are choosing from.  The interesting point to this exercise – most 529 plans are attempting to have lower overall fees and it drives them to create asset allocation models in a passive manner.  In other words, the way the states manage assets is to mirror a benchmark, such as the S&P 500, instead of beating it.  Due to this style of investing, it can be difficult for one state to outperform another as all states are trying to achieve a similar goal. 

 

With that said, it is always a good idea to compare performance.  In order to do so, it is important to compare apples to apples.  For example, if a WI resident is invested in Tomorrow’s Scholar’s Voya 529 Age 0-4 Option, they will want to compare it to Edvest’s Age-Based Option: Age Band 0-4.  If they compared it to Edvest’s Aggressive Age-Based Option: Age Band 0-4 it may not be an apple to apple’s comparison as the volatility of the aggressive fund may be more extreme then the supposed comparable Voya fund.

 

Performance is always a consideration; however, depending on other benefits such as tax deductions and fees, it may not be the driving force in the decision. 

 

Conclusion and resources

Choosing a 529 plan can be tedious and time consuming.  However, following the steps we’ve laid out should help smooth the process.  Below are a few resources that can help you get started.

  • General research and resource: https://www.savingforcollege.com/college-savings-201

  • IRS Publication 970: https://www.irs.gov/pub/irs-pdf/p970.pdf

  • WI Direct-Sold Plan – Edvest: https://www.edvest.com/

  • WI Advisor-Sold Plan – Tomorrow’s Scholar: https://529plans.investments.voya.com/Wisconsin/index.htm#.W9ultpNKiUk    

Thank you,

LBW

 

 

 

 

[1] 1982-2017

 

[2] JP Morgan Asset Management. “Guide to Retirement℠”. 2018 Edition. Slide 12. PowerPoint Presentation.

 

[3] JP Morgan Asset Management. “Guide to Retirement℠”. 2018 Edition. Slide 12. PowerPoint Presentation.

 

[4] JP Morgan Asset Management. “Guide to Retirement℠”. 2018 Edition. Slide 12. PowerPoint Presentation.

 

[5] https://www.gpo.gov/fdsys/pkg/PLAW-104publ188/pdf/PLAW-104publ188.pdf

 

[6] https://www.investor.gov/additional-resources/general-resources/glossary/prepaid-tuition-plans

 

[7] https://www.investor.gov/additional-resources/general-resources/glossary/education-savings-plan

 

[8] There are other restrictions not mentioned such as the transferability of tuition credits or units.  If the student decides not to attend the school the tuition credits or units were purchased for, depending on the state plan, there may be the ability to transfer said credits or units to the school of your choosing.

 

[9] To find definitions of qualified expenses follow this link - https://www.irs.gov/pub/irs-pdf/p970.pdf

 

[10] https://literature.theeducationplan.com/doc/The_Education_Plan_Plan_Description.pdf

 

[11] LBW is not a CPA and cannot provide tax advice.  If you are curious about certain taxable benefits, please contact your CPA professional.

 

[12] Another state example: a resident of Kansas can receive up to a $3,000 per beneficiary per year in state income tax deduction regardless of which state’s 529 plan they contribute to!

Please reload

6410 Enterprise Ln., Ste. 120

Madison, WI 53719

(608) 286-1321

tsbickmore@lbw-wealth.com

  • White LinkedIn Icon
  • White Facebook Icon
  • White YouTube Icon
Send Us a Message

Leach, Bickmore & Weiss Wealth Management is a registered trademark of Leach, Bickmore & Weiss Wealth Management, LLC

LBW Wealth Management is a registered trademark of Leach, Bickmore & Weiss Wealth Management, LLC

Photo Courtesy of John Swise, Rebecca Li and Katie Dunkel

Copyright © 2019 by Leach, Bickmore & Weiss Wealth Management, LLC.  All rights reserved.