Many of us are watching children or grandchildren climb onto big yellow school buses this week. Whether college is years away or looming in the very near future, it’s not too late or too early to focus on college savings. In honor of this exciting end of summer, Ambassador Advisors would like to share a few tips from Forbes on getting more from your 529 college savings plan.
Bonanzas and booby traps: Plenty of both await you in the complex world of 529s.
Needlessly complex, since the concept is simple. You set aside savings for college costs, and the earnings (per section 529 of the tax code) escape tax. But the execution is messy because 48 states plus the District of Columbia compete nationally for the business of overseeing the accounts. They have created a crazy quilt of investment choices and tax rules.
Two-thirds of states operating 529 plans offer tax deductions or other subsidies for contributions to college accounts, and the deal is usually available only to participants who patronize the home-state plan. What should you do if your state has a lucrative deduction but runs a crappy plan? The aim of this article is to answer that question and to offer guidance on other ways to extract the most from your account.
Strategic Insight, which tracks the money management industry, counts $230 billion in 529 assets, not including tuition prepayment plans. The money is driven into place not only by the tax exemption, both federal and state, on earnings, but also by the state deductions for contributions (there’s no federal deduction). A wealthy New Yorker can pocket state and city 529 tax breaks cumulatively worth $20,000 (assuming $10,000 in 529 contributions a year for 20 years and a 10% combined state/local rate).
The optimum 529 investment strategy depends on where you live, how much you’re putting in and for how long. But three rules apply no matter what.
One rule is that you should do your retirement saving first, college saving second. That is because retirement assets are for the most part ignored on financial aid forms, while college assets are fair game. A core principle of aid administrators is that people who have saved for college are undeserving.
Here’s how that principle is put into action. A 529 account whose “owner” (that’s the person who controls disbursements) is the student’s parent will get nicked 5% to 6% a year in the aid formula. In other words, $100,000 contained in a 529 will, over four years, reduce aid by a cumulative $20,000 or so. The same wealth stashed in a 401(k) won’t do that.
The next rule is one that applies to all tax-sheltered investing: Get the cheapest investment option on the menu. That will probably be a stock or bond index fund.
Resist the lure of actively managed funds with seemingly terrific records–records, in case you didn’t know, being close to useless in predicting future results. If you want to chase performance, do it in a taxable account, where at least you can take a capital loss for your mistakes.
The last general rule is to pace your withdrawals. If you or the student might be able to claim the American Opportunity Tax Credit, don’t pay your entire college bill with 529 money. This federal credit hands you $2,500 toward the first $4,000 of tuition that isn’t covered by a 529 distribution.
Parents with adjusted gross income below $160,000 can get the full college credit. Alternatively, a student who is not claimed as a dependent on the parent’s return can grab the credit.
Now let’s delve into geography. Some states, like Michigan and New York, have terrific deals for their citizens: low-cost funds and valuable deductions for contributions. Some, like California and Connecticut, have one of these two good features.
Other states seem to be in the 529 business for the sole purpose of picking savers’ pockets. Neither Texas nor Hawaii offers a tax benefit for contributions. They both operate fee-gouging plans.
The map above highlights the best and the worst states. Here, we assume you’re a high-bracket, joint-return filer putting aside $10,000 for a newborn. The net cost shown is the cumulative fee outlay (over 18 years) on the home-state plan, minus the value of any tax benefit for tossing the money in.
Green: Invest locally. Red: Send your money to one of the two states with the best plans. California has the cheapest stock index fund in the business, at 10 basis points ($10 a year per $10,000 invested). New York has the cheapest bond index fund, at 16 basis points.
If you live in a yellow state you might be able to come out ahead by opting for the home plan. To know for sure, you could calculate the net cost by figuring your tax savings off your tax return and your investment cost off the plan documents. If that’s too much of a headache, just send your money to California or New York.
What if you are investing a lot more than $10,000? Or investing for a shorter period? Or you are the grandparent of the future student? Then the optimization game gets more nuanced. We have seven 529 strategies to help you.
Potential investors of 529 plans may get more favorable tax benefits from 529 plans sponsored by their own state. Consult your tax professional for how 529 tax treatments would apply to your particular situation. To determine which college saving option is right for you, please consult your tax and accounting advisors. Neither APFS nor its affiliates or financial professionals provide tax, legal or accounting advice. Please carefully consider investment objectives, risks, charges, and expenses before investing. For this and other information about municipal fund securities, please obtain an offering statement and read it carefully before you invest. Investments in 529 college savings plans are neither FDIC insured nor guaranteed and may lose value.
Ambassador Advisors is a Registered Investment Advisor. Securities offered through American Portfolios Financial Services, Inc. of Holbrook, NY, 631-439-4600 (APFS), member FINRA, SIPC. Investment Advisory Services offered through Ambassador Advisors, LLC. Ambassador Advisors is not owned or operated by APFS.
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