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7 reasons why mutual funds don't work so well for college
College-savings traditionalists may argue that a college-savings strategy using tax-efficient mutual funds can generate higher returns than a 529 savings plan. Their reasoning: the extra costs of using a 529 plan may cancel out the tax benefits.
But here are seven reasons why 529s will almost always beat taxable investments—even index funds and other so-called tax-efficient funds—provided the money is eventually used for college.
No tax (529s) is better than some tax (mutual funds). Mutual funds investing in stocks usually make year-end capital gains distributions, whether you want them or not. And when you liquidate the fund to pay college expenses, the appreciation is taxed.
- Tax rates.
Rates on most long-term capital gains are at an historic low, only 5% for taxpayers in the 10% or 15% ordinary income brackets, and 15% for everyone else. But capital gains brackets are scheduled to rise in 2011, to 10% and 20%. The rates on dividends increase even more. Will your child be through college before 2011?
- Kiddie tax.
You may have been taught to make gifts of money or investments to your child to take advantage of his or her low tax bracket. But any child subject to the kiddie tax will have their investment income above $1,800 taxed at the parent's rate. Have you heard: starting this year (2008) the kiddie tax is imposed on many college students as old as 23?
- Risk adjustments.
Most financial planners suggest you ratchet down the equity exposure in your college savings portfolio as your child closes in on college. The "age-based" investment option available in most 529 plans does this for you automatically. Or you can do it yourself with no tax consequence by switching between static options in 529 plans as often as once per calendar year. But with taxable mutual funds, a transfer between funds to achieve a more appropriate asset allocation as your child ages will trigger tax on the built-up gains. In other words, you are locked in to your current fund unless you are willing to pay the tax when you switch.
- Financial aid.
The income that shows up on your Form 1040, including capital gains, can have a big impact on financial aid eligibility for the following year. If you need to tap your appreciated investments to pay for college, you may be eliminating any chance of your child qualifying for need-based aid. With a 529 plan there is no income to report on your Form 1040 when the distributions come out tax-free, and financial aid eligibility is preserved.
- 529 plan expenses.
Plan manager fees have been coming down, thanks in large part to the intense competition by investment firms to win state bids for management contracts. Also, many 529 plans have added low-cost index funds as investment options, reducing costs even further. Savingforcollege.com has performed extensive modeling to determine if 529 tax benefits are outweighed by the additional expenses and found it to occur only in rare instances where plan expenses are still relatively high and the investor is in the lowest income tax brackets.
- Investment management.
Many mutual funds, including all "tax-managed" funds, make investment decisions with tax consequences in mind. 529 plans don't have to do this, and investment decisions can be based entirely on investment considerations.
Taxable investments may still be attractive to investors seeking certain high-risk investment strategies generally not found in 529 plans. And, of course, if the 529 plan is ultimately used for something other than college, the tax and penalty cost of a non-qualified distribution dramatically alters the comparison.
But most families are not seeking high-risk investments for their college funds. And few are worrying about having too much money stashed away for college. For the majority of American families, 529 plans offer the best solution.
Posted March 7, 2008
Joe Hurley is the founder of SavingforCollege.com, and a certified public accountant.