Forget 529 and Pay Uncle Sam

Nothing on earth makes people more bitter than paying taxes. But if you love your kids, read this blog about why 529 plans aren’t really the best possible way to send them to college. Here are the three reasons why I would rather have clients forgo the tax benefit, pay Uncle Sam, and invest elsewhere.

Many well-intending Gen Xers many resort to the popular 529 plans as a means of saving for their children’s college education. Although these vehicles have tax advantages, in many ways they are a less than adequate choice. There are better options available that parents should consider.

The first reason that 529 plans are not ideal is that you’re locked in to a college education. If for some reason your child decides not to pursue a college education, you pay a penalty on the earnings. With the cost of tuition skyrocketing and our country on the brink of a student loan crisis, attending a private four year university hasn’t been as practical as in the past. It’s likely that families will opt for alternatives such as pursuing a trade. If you’ve been saving for years and your child decides to join the military, you pay for changing your minds.

Secondly, these plans are a Christmas tree of fees. Many plans charge for enrollment, plan maintenance, and program management. In addition you get hit for the expenses that the underlying funds you invest. Also, you probably would buy these through a broker which would mean you pay a sales charge. Tired of the fees yet?

Thirdly, and most importantly, I’m unimpressed by the crummy investment options that I see in 529 plans. Whoever puts these plans together doesn’t want to get sued by including sophisticated vehicles that people may misunderstand, so they dumb down the menu. As a result, it’s hard to truly diversify, or to pursue a sophisticated strategy. For example, there are few international investment options. The ones I’ve seen focus on developed, as opposed to emerging, markets. This is a drawback because frontier markets, the most up and coming within the emerging world, are likely to be the engine of growth in years to come. Moreover, with credit fundamentals improving in emerging markets and deteriorating in developed markets, the lack of emerging market debt funds in these programs makes people choose bond funds that are less than optimal. With inflation likely due to the monetary injections, lack of commodity options such as gold or commodity funds is also a downfall.

The marketing pitch for these plans includes the jingle that you can choose a plan from a different state if you don’t like the one where you live. As far as I’ve seen, all the states are bad. The more honest marketing pitch would be that you can choose between bad and very bad.

The way the asset allocation adjusts over time is likely to leave money on the table. Many age-based 529 plans automatically move into fixed income as the child approaches college age. Remember that a child goes to college for four years. Moving into fixed income a year before college starts means that the money intended to fund years two, three, and four grows at a slower rate, possibly even a negative real rate of return (if invested in certain types of bonds). Given there are a few years to recover, it seems overly cautious to reduce risk so drastically because you’re sacrificing the potential for higher return. Moreover, given that short term bonds are yielding practically nothing right now, selling down into short bonds would garner negative real rates of return for these years.

The main advantage of investing in a 529 plan is exemption from tax. In my view, favorable tax treatment doesn’t outweigh all the lousy characteristics. Investing in something because you lose less money in taxes is akin to playing the game not to lose as opposed to playing it to win. I’d rather have a solid set of investments and a cogent investment strategy that may incur higher taxes but have higher growth potential.

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