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.
This is neither an offer to sell nor the solicitation of an offer to purchase any interest in GIM or any other investments discussed. This publication is for informational purposes only; it is not intended to be a solicitation, offering, or recommendation by Grillo Investment Management, LLC of any product, security, transaction, or service. It should not in any way be interpreted as investment, financial, tax, or legal advice.
An investment in any security discussed herein may be speculative, and may involve a high degree of risk. An investor in securities could lose all or a substantial amount of his or her investment. Investors should conduct thorough analysis on their own before investing in any investment vehicle. The risks of investing in international markets include currency fluctuations and political instabilities.
This presentation and its contents are proprietary information of GIM and may not be reproduced or otherwise disseminated in whole or in part without GIM’s consent. All data herein was obtained from publicly available information and/or sources, internally developed data, and other sources believed to be reliable. Except as otherwise stated, GIM has not sought to independently verify information obtained from public or third party sources and makes no representations or warranties of any kind, express or implied, regarding the accuracy, completeness, or reliability of such information.
Hypothetical and forward looking statements should not be taken as an indication or guarantee of any future performance, analysis, forecast, or prediction. Past, pro forma, hypothetical, projected, or suggested performance of any investment or portfolio of investments is not necessarily indicative of future performance. Dividend rates are not guaranteed payments, nor can they guarantee a rate of return.
The S&P 500 Index consists of 500 selected stocks, all of which are listed on the exchange, the NYSE or NASDAQ, and spans over 24 separate industry groups. It tracks the performance of the US large cap equity market. Indexes are unmanaged and investors are not able to invest directly into any index. Dividend rates are not guaranteed payments, nor can they guarantee a rate of return.