State-run 529 plans have been a staple of the college savings landscape for years. But a 529 account has never been as easy as ordinary investments to choose and manage. With the new tax rules passed about a year ago and the financial markets looking shaky, families may wonder if the venerable 529 is still worth the trouble.
Why jump through hoops if you could invest in an ordinary taxable account with greater flexibility and a universe of investing options?
The short answer: 529s are still a great deal. But investors who took a hands-off approach until their child was ready to start college should probably take a closer look at the risk they’re taking in today’s market. Here are few considerations they should weigh:
— Know that 529s still have tax benefits.
— Take a look at an age-based target portfolio.
— Assess if your allocations are safe.
Know That 529s Still Have Tax Benefits
“529s are still the best savings tool for college tuition,” says Jim White of J.H. White Financial in Pottstown and Malvern, Pennsylvania. “Any of the various alternatives frequently mentioned either have contribution limits or lack tax benefits.”
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529s are named for the statute that created them in 1996. Though features like tax treatment changed in the early years, many of the key elements remain the same after the Republican tax law passed late in 2017. Most important is that withdrawals for approved expenses, such as tuition, books and room and board, are free of federal income or capital gains tax.
Investors can contribute up to $15,000 a year from each donor to each beneficiary without incurring gift tax, but there is no tax deduction on contributions, as with other tax-favored accounts like 401(k)s and individual retirement accounts. Some states also offer tax breaks.
The downside hasn’t changed either. Shopping can be tricky, since the common investment-style plans are offered through state-sponsored programs. Investors can use plans from any state, not just their own, except when it comes to a subset called prepaid tuition plans. Because of its complexity, many investors use plans offered through brokers, which can increase expenses, though most plans have versions available for direct investment with no middleman.
The biggest change in the new law is to allow these funds to be used for private schools for K-12 education, says Ben Birken, financial advisor with Woodward Financial Advisors in Chapel Hill, North Carolina.
“For most people, this change doesn’t amount to much due to the high cost of private school and the limited amount of time that would be available for tax deferred/tax-free growth,” he says.
Most plans contain packages of stock and bond mutual funds that investors choose according to their views of the market, time to college and tolerance for risk — heavy on stocks for the bold, loaded with bonds for the cautious. Many plans also offer ever more popular target-date funds that start out emphasizing stocks for maximum growth and automatically shift to bonds and cash for safety as the college start date approaches.
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Take a Look at an Age-Based Target Portfolio
“While the (recent market) volatility has not changed my view on 529s, it has strengthened my opinion that monthly savings in age-based target portfolio is the way to go,” White says. “You cannot predict the future and trying to do so usually doesn’t end well. Dollar-cost averaging in an age-based portfolio that will slowly reduce risk as the student approaches college is simple and prudent and doesn’t require trying to remember to reallocate.”
Dollar-cost averaging means investing an equal sum at regular intervals, buying more shares when prices are down and fewer when they are up. That approach helps investors resist the urge to play the market’s ups and downs.
When money is needed for college, the wise choice is generally to have the fund send it directly to the institution to avoid paperwork and potentially taxes. A 10 percent penalty can be charged if it is channeled into an ordinary account first. Colleges and the fund companies that manage the plans for the states have become familiar with the process and experts say it generally works smoothly.
The plans are meant to be fire-and-forget investments that leave decisions to the pros, but investors can switch from one investment to another, either within a state’s program or to a different state’s 529, for instance.
Assess if Your Allocations are Safe
Birken suggests investors look closely at their accounts to see if they are still comfortable with the allocation between stocks and bonds. That means, for example, looking at how a target-date plan intends to change the allocation as the college years approach, as some leave more in stocks than others.
“Some 529 plans have more aggressive allocations than others, even as the account beneficiary approaches college age,” Birken says. “This worked great when markets only went up, like in 2017. But 2018 was a different story. If your allocation has been too aggressive, moving to cash after markets decline isn’t necessarily helpful. That’s like asking for an epidural after the baby is born.”
In a volatile market, it’s simply prudent to emphasize safety, says Katie Vercio, a wealth consultant at Evergreen Wealth Consultant with Evergreen Gavekal in Bellevue, Washington.
“If a child is in high school, I would recommend taking a conservative track, Vercio says. “If a child is starting school in fall 2019, it may be a good idea to switch to a cash or (a certificate of deposit) option.”
One of the trickiest questions is what happens if the beneficiary doesn’t go to college. Taxes or penalty are waived in some circumstances, such as if the child goes to a military academy. But if the child simply chooses another path, 529 proceeds can be subject to tax and penalty if simply withdrawn.
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But the beneficiary can be changed to another person without penalty. There is no age limit for beneficiaries and funds can be used for graduate school and private schools.
Emily S. Boothroyd, a private wealth advisor at Price Financial Group in Wilton, Connecticut, urges parents to keep the big picture in mind — the parents’ retirement needs as well as college costs, as young people have more time to pay off loans.
“For younger parents or those who are focused on their own financial planning, please use the oxygen mask analogy when thinking of your kids: Help yourself first, then them,” Boothroyd says. “If you have credit card debt, you probably should not be adding to a 529. If your retirement isn’t on track, you probably shouldn’t be adding to a 529.”
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How Investors Can Best Use a 529 Plan originally appeared on usnews.com
