Monthly top tips

So Says the 529 Guru

No. 12
Joe Hurley
Sunday, March 28th 2004

Question: I understand that 529 savings plans charge extra fees. Does the 529 tax advantage outweigh the additional expense? I’m particularly interested to know if it is more advantageous to invest in index funds as part of a 529 plan or simply to buy them directly.

Answer: Your question is very timely, Daniel, considering that just earlier this month, the Securities and Exchange Commission formed a task force to study 529 fees and expenses. The SEC also wants to find out if 529 plans are fully disclosing the extra expenses in their enrollment materials.

The “task force” at has been studying these concerns for quite some time, and we’re happy to report that for most 529 participants the tax advantages of 529 plans outweigh the extra fees by a wide margin. The quality of program disclosures has also improved considerably over the years, although there’s still some room for improvement.

The tax advantages in a 529 plan—tax-deferred growth and potentially tax-free withdrawals—are particularly powerful when you want at least part of your portfolio invested in fixed-income funds or principal-plus-interest options. But you’ve asked specifically about index funds. Stock index funds are already tax-efficient, so why incur the extra fees to invest in them through a 529 plan? To answer this question, we’ve developed a fairly sophisticated calculator that compares the after-tax returns of different investment choices.

Let’s assume you are a moderate-income parent putting away $5,000 per year for your newborn child’s future college expenses. In one scenario, you invest directly in an S&P 500 index fund growing at the hypothetical rate of 8% per year (6% appreciation plus 2% reinvested dividends). In the second scenario, you make contributions to a 529 plan investing exclusively in that same index fund. The 529 plan charges an annual program management fee of 0.25% plus an annual account maintenance fee of $25.

Under these assumptions, the 529 plan wins. It provides 8.4% more for four years of college than the index mutual fund. These calculations assume the federal tax breaks enacted in 2001 and 2003 are allowed to “sunset” in 2010 and 2008, respectively. If Congress makes those breaks permanent, the 529 advantage increases to 11.3%.

It gets even better if you are allowed to deduct your 529 contributions against your state income tax. If your state tax rate is 5% and you itemize on your federal return, the 529 plan produces a result that is at least 12.5% better than a direct investment in the index fund.

Assuming sunset of tax breaks:
$ for four years of college beginning at age 18
No state tax deduction5% state tax deduction
529 plan$203,808 $211,487
Index fund$188,011$188,011
Difference$15,797 (8.4%)$23,476 (12.5%)

Assuming permanent tax breaks:
$ for four years of college beginning at age 18
No state tax deduction5% state tax deduction
529 plan$219,979$228,270
Index fund$197,630$197,630
Difference$22,349 (11.3%)$30,640 (15.5%)

It’s important for you to understand that we can construct some scenarios producing a better result with a direct investment in the mutual fund. If you can reduce your federal tax rate to the lowest bracket by first gifting the money to your child, you receive no state tax deductions, and the 529 plan management fee jumps from 0.25% to 0.40%, then the 529 plan produces $200,341 while the index mutual fund gives you $204,620.

However, I would be somewhat hesitant to put that kind of money in my child’s name for the sake of tax planning. For one thing, taxable investments are treated more harshly than 529 plans in determining the student’s federal financial aid eligibility, and placing the assets with the child only exacerbates the problem. For another, your child might get some crazy ideas about using “his” or “her” money for something other than college. Cancun, anyone?

Question: I am the president of a small corporation and want to know if I can set up a 529 plan where my business would make the contributions? If so, what are the guidelines?

Answer: Helping your employees with future college costs is an admirable goal, and I commend you for your intentions. An increasing number of companies are bringing 529 plans into the workplace by establishing automatic contribution programs for their employees through payroll deduction or periodic transfers from bank accounts. In many situations, these “employer-sponsored” 529 plans offer lower expenses along with college planning seminars and other educational materials.

However, not many companies are making matching contributions or other direct contributions to employee 529 accounts. One reason is that employees remain subject to tax. The contributions would be treated as compensation to your employee, even when the employee’s child is named as beneficiary, and all payroll tax and withholding rules would still apply. Another reason is that you would have no control over the employee who receives a contribution of company funds into his or her 529 account and then decides to pull the money out of the account the next day for a non-educational purpose.

A possible alternative is for your company to establish and “own” the 529 account. Many states now permit business entities to establish accounts in their 529 plans. However, I strongly recommend that you seek out professional legal and tax advice before doing this. There are a number of very tricky issues relating to the tax rules surrounding deferred compensation, ERISA requirements, and gift tax. The cost and tax risk associated with this effort is probably not worth it for a small company like yours.

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