There’s something Dickensian — the best of accounts, the worst of accounts—about our college savings plans for our 14-year-old daughter Julia. Way back when, Grandpa Henry gave Julia $24,000 and we put it in an UTMA custodial account. That’s now grown to $64,000, but I loathe this account.
Why? Because we pay taxes on dividends and capital gains. Last year alone, the taxable income exceeded $6,000. So the account hasn’t really appreciated by $40,000. What’s the real number? Stop asking me questions I don’t want to answer.
But I am madly in love with our larger 529 account. First, contributions are at least partly deductible on your state tax bill in 34 states and the District of Columbia, which is a big deal in a high-tax state like New York where I reside. (High-tax California doesn’t let you do this, alas.) Second, your money grows tax-deferred and you owe no federal tax when you withdraw funds from the account. A 529 is like a Roth for college.
And the fine print aggravations aren’t so bad. To avoid federal tax, you have to use the money for qualified educational expenses. That includes tuition, room and board, books, computers and internet access. What about Netflix? (Pushy, aren’t we?) Well, paying for education is the point, after all, and this is only a problem if your kid takes 26 consecutive gap years. Your mutual fund options are a bit skimpy, but that’s not a deal-breaker. And you can only make changes to your 529 portfolio twice a year. Finally, contribution limits vary by state. Once the account hits a certain level — $235,000 to $500,000 — you can’t put in any more money.
One of the biggest caveats is almost funny. Planners warn against overfunding your 529, which could lead you to someday say, “Son, I’m sorry, but you have to go to grad school, preferably a six-year program. Or else, tax-wise, we’re screwed.” More seriously, you should start saving for retirement before you fund college. You can always borrow to pay for college. You can’t borrow to pay for retirement.
Also, beware of fees. All 50 states offer a plan, but expenses range from next to nothing to 2.0 percent per year for some adviser-sold plans. (Dickens again.)
Luckily (??), you can use any state’s plan regardless of where you live. To avoid being driven bonkers by variety, go to savingforcollege.com to cull the field and do some quick comparisons. Going with an out-of-state plan could gum up your state-tax deduction, so tread carefully.
Anyone, regardless of income, can contribute $14,000 a year to a plan ($28,000 for married couples). An individual can also contribute as much as $70,000 all at once every five years. And doting grandparents can contribute the same amounts. (“Hey, Mom, I was just thinking about you. And Julia. And Princeton.”)
You can be in charge of asset allocation, making your mix less aggressive as college nears. Or you can pick a target allocation option that changes the portfolio automatically based on your child’s age. My complaint about this option is that it’s usually not aggressive enough for a very young child. There’s no reason to have bonds or cash in a 1-year-old’s college account.
Unless cash is exactly what you want. Some plans let you put all the money in CDs or similar risk-free instruments. Not my choice, but it might be yours.
And you have another option that is, allegedly, risk-free. Seventeen states offer prepaid 529 plans. Your money is guaranteed to grow at the tuition inflation rate in your state. So if you contribute enough, you can be sure that Jack will be able to afford going to, say, the University of Virginia. What if Jack wants to go out of state? All or most of the money is portable but the guarantee of full tuition coverage is not if he chooses a more expensive school.
Prepaid plans penalize you when it comes to financial aid. They reduce aid by 100 percent of the amount in the plan. The standard 529, on the other hand, only dings your financial aid eligibility by 5.64 percent of the sum you’ve saved. And that UTMA I hate? A UTMA or UGMA messes you up here, too, as it reduces financial aid by 50 percent of the total you’ve amassed.
What if you’ve taken the plunge into a 529 but have belatedly discovered that your choice is too expensive or doesn’t offer an investment option you want? Once a year you’re allowed to roll over to another plan.
Finally, you can help fund your plan while you spend with a credit card from Upromise (five percent cash back, no annual fee) or Fidelity (two percent cash back, no annual fee, assets must reside at Fidelity). Hey, the more I spend, the richer I get. What a concept.
Andrew Feinberg is a writer and money manager. He is the author or co-author of five books on investing and personal finance, including Downsize Your Debt. His work has appeared in the New York Times Magazine, GQ, Barron’s, The New York Times, Playboy and The Wall Street Journal, among other publications.