Paying off debt versus a 529 plan



Dear Joe, I have a question regarding starting a 529 account for our daughter. Instead of starting a separate college account, we paid off all our credit cards, maxed out 401(k), maxed out our IRA and are currently paying extra on our mortgage to pay the house off by the time she is 13 and having 6 months cash in the money market account. Would you advise if this strategy is correct compared to putting the money in a separate college fund? We thought this way we will have house paid for and have a savings cushion if we ever need to finance her college. -- Alex


Dear Alex,

What you are describing is a viable college savings strategy. If everything plays out as you hope, you'll be in a comfortable position when your daughter turns 13, and with the mortgage paid off, the extra cash flow can then be directed into a 529 plan or other appropriate investment. Once your daughter gets to college, you can use a home equity loan to help fund that education, along with your savings and possibly some student loans.

The added benefit of home equity as a source of college funding is that your home value will not be counted in determining your daughter's eligibility for federal financial aid. (Your retirement accounts will not count against her either, but be careful about taking any distributions from retirement accounts as they are included in "base year income" and will reduce eligibility in the next year.)

In spite of all that, I would argue that you are probably better off maintaining your regular mortgage payments and putting at least some of the extra cash into a 529 plan or Coverdell Education Savings Account. Let's assume the interest rate on your current mortgage is 6 percent. If you are in the 25-percent tax bracket and can itemize your deductions, the after-tax cost of that interest is only 4 percent.

Can you achieve greater than a 4 percent annual return in a 529 plan or ESA? Most likely you can, but you might have to keep some of your portfolio in stocks to do so, which presents some market risk. The savings from prepaying your mortgage is essentially risk-free.

Or is it? When it comes time for you to take out a home equity loan to pay college costs, the interest-rate environment might not be as favorable as it is right now, and you could end up with a higher interest cost. Also consider that the income-tax deduction for home-equity interest is subject to a $100,000 loan cap. To the extent you can claim the interest deduction, you are increasing your chances of being stuck with the alternative minimum tax.

Another reason to start a separate college savings plan, even if only for a small amount of money, is that it instills budget discipline. You sound like a fairly disciplined person, but for many families the practice of making regular contributions to a college savings plan increases the odds the money will be there once the tuition bills begin to roll in.

Popular Questions


Two kids, two 529 plans?

Dear Big Bill,
While it's possible to maintain a 529 plan in just one child's name, even when you intend to send more than one child to college, I generally recommend that families open a separate 529 account for each child.

That's assuming there is no additional cost to maintaining multiple accounts. If your 529 plan charges an annual or quarterly account maintenance fee, check to see if you can avoid the fee by signing up for automatic contributions through payroll deduction or electronic funds transfer)

With a separate 529 plan for each child, it becomes easier for you to tailor the mix of stocks, bonds and stable-principal investments (e.g., stable value, guaranteed principal and money market funds) to the particular ages of your children. When your older child is nearing high school graduation, you may want to ratchet down the level of market risk in her 529 plan. At the same time, you could keep a more-aggressive asset allocation in your younger child's 529 plan, accepting more risk for a potentially higher return. Many 529 plans offer "age-based" investment options that automatically make these adjustments as the beneficiary ages.

Separate accounts for your children also offer more gift-tax leeway. Since your 529 contributions are treated as gifts from you to the account beneficiary, your $15,000 (in 2018) annual gift exclusion will go twice as far with two accounts -- one for each child -- than with just one account.

Financial aid is another reason to recommend maintaining separate accounts. You wouldn't want the investments reserved for your younger child's future college expenses to count against your older child's financial aid eligibility. Be warned: The rules here are rather murky, and the impact of a sibling's 529 account may depend on the college's own policies as well on as the type of aid -- federal or institutional -- being sought.

Finally, I believe that separate 529 accounts allow for better family bookkeeping. There will never be any doubt as to your intention to help send all of your children to college. You'll avoid the uncomfortable position of being asked to explain to a curious 8th-grader why account statements are showing up in the mail with only a brother or sister's name on them. And in the event of your death or divorce, no matter how unlikely, your legal representatives and other family members will have less reason to question your actions in setting up and funding the 529 plans.

Even with separate accounts, you'll continue to have the flexibility to shift the money around in the future. You simply need to make sure that whenever funds are withdrawn from the 529 plan to pay for college they are coming from an account in the name of the child incurring the costs. It's a simple matter to change the beneficiary designation among family members at any time, transfer 529 funds between different family members' accounts or split one 529 account into two. The ability to move assets around the family is a key advantage of 529 plans when comparing other college-savings alternatives, such as Uniform Transfers to Minors Act, or UTMA, accounts.

Original Post: 2005-10-13
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Coverdell ESA vs. 529 Plan: Which to choose? (Script)

The Coverdell ESA and the 529 plan are both excellent college savings vehicles because they are both tax-free when used for college. But many families face a choice: do they use a 529 plan for all of their child's college savings, or do they use a Coverdell for the maximum amount of $2,000 each year and put any any extra savings above $2,000 into a 529 plan? In spite of its low annual contribution cap, Coverdell's are now attracting quite a few families. There are two major reasons for that. One is that only the Coverdell allows you to self-direct your investments, just like you might self-direct the investments in your IRA. The other is that in addition to college expenses, Coverdells can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition. This feature is appreciated most in families planning to send their children to private grade schools, which may include additional costs such as room and board or uniforms. A 529 plan, on the other hand, does not impose age limits or income limits like the Coverdell does and so overall we see a lot more money going into 529 plans than into Coverdells. Plus many savers are happy with the investment choices offered by the 529 plans and don't necessarily want to self-direct their investments. And don’t forget this: your state may be giving you a state tax deduction for using a 529 plan, but there are no states offering a state tax deduction for investing with a Coverdell ESA.

Learn more about Coverdell ESAs.

Original post date 2013-07-15
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Top 529 Plan Withdrawal Tips. (Script)

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Top 529 Plan Withdrawal Tips. (Video)

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