529 College Savings Plans Are a Family Disaster Waiting To Happen

BF: Okay folks let’s get started. I sent a note out to everyone last week. We are going to talk about the 529 college savings plans specifically but we can also get to the Florida prepaid tuition plan or any state tuition plan. I thought this would be appropriate for today’s call simply because, at least for the state of Florida, the open enrollment for the state tuition prepaid plan ends January 31. So if you are thinking about the prepaid plans you only have a couple of weeks left to make a decision or commit money.

But I want to spend a few minutes speaking about the 529 Savings Plans. As you might have gathered from the note I sent out, I am not a big fan. The folks we talk with, we haven’t seen a huge success and personally I don’t think this plans have lived up to all the hype and part of that is there are a lot of financial institutions out there that have a significant financial interest in encouraging the 529 plans because they make tons of money promoting the plan.

A little background on the 529 plan if you are not familiar with them. It’s a plan where you put money in no tax deduction for the money going in. The money coming out, if it’s used for higher education, voc tech and so forth, are tax free and the contribution has already been taxed. So that’s the benefit. Then depending on the state plan, these things are administer by each individual state. As far as I know each state has their own 529 plan . If you are in a state that has income tax and you invest in your state’s 529 plan usually you avoid the state income tax as well. Doesn’t mean that you have to buy or invest in the plan issued by your state. So I’m here in Florida, if I wanted to invest in the Kansas College Savings Plan, I certainly could. And for those of us in Florida, really it’s not that big of an issue tax wise because we don’t have a state income tax. So we aren’t losing anything if we invest in a 529 issued by a different state.

There are a couple of things you need to think about, and if you know folks that have the 529 college plans, please pass this information on to them. Here’s why I’m not that big of a fan of these plans. First, I’m not a big fan of government or big government run agencies. Every single 529 plan is administered or overseen by each individual state and heaven knows there’s not a lick of politics that goes into deciding the investment manager that manages or offers the investment options in these plans. And I’m being facetious there. Some states, and the last time I checked Florida is one of them, they could choose to self invest or create the investment options and invest themselves. The other option is states can hire professional money managers, mutual fund companies, brokerage firms and let them serve as the investment managers. We’ve looked at a number of state plans. The fees and expenses are all over the place. Some states have gone the route of low cost index funds. Think Vanguard or TIAA CREFF. And other states have gone the route of so called professionally managed funds with very high fees and expenses. Coincidentally, those companies tend to be significant political campaign contributors. I’m sure it’s just a coincident, but something to be aware of. And then the other is, you do your homework today, you find a 529 plan you like whether it’s in the state of Florida or any other state in the country, predominately based on who that money manager is, well guess what, the state can change who they hire for the money manager. This year you have a good money manager and next year they make a change and you’ve got a bad money manager or at least that is your opinion, and you can’t do anything about it. Well, you can transfer from one plan to another but talk about adding hassle and complexity to your life. And I mentioned a minute ago fees. There are at least two layers of fees with the 529 plans. The state, the administrator, the 529 administrator and of course the mutual fund company with their fee and expenses and again they get very high if they are packaged and sold by commissioned oriented types of firms. And then the other draw back of the 529 plan is you have a limited range of investment choices unlike a self-directed IRA where you can pretty much invest in anything you want, the 529 plan you have to live with the choices of that plan and know the choices could change because the state or the administrator decides to make a change.

Most plans, you might want to check this out, how often can you make a change in your investment. Most plans, the state doesn’t want to get too administrative oriented and burdened with a lot of activity. So, a lot of these plans limit changing your investment choice to only once a year. Think about back in 2008 with all the craziness going on in the stock market and you didn’t even have the ability to make a change mid year. Is that something that’s really going to work for you now and in the future?

There are some advantages to the 529 plan. Well, let me take that back because this year there isn’t an estate tax. Any other year if there were an estate tax and you had a taxable estate and you wanted to give money away to reduce your taxable estate, one why to do that is to give money to a 529 plan. You could make the equivalent of five years worth of gifts all at once without it triggering a gift tax. Of course you’re going to be limited to the gifts you can make in the following years for gift tax purposes, but that ‘s one way to significantly reduce your taxable estate. But of course hopefully no one has to worry about that at least for this year.

The 529 plan you are in control or the adult who opens the account is in control. So you can change beneficiaries. You can take the money back if things don’t work out. Now if the money comes back out and it’s not used for higher education expenses, then the earnings are taxed and there also is a penalty tax.

The other thing that makes me question the 529 plans, when it comes to financial aid. The money saved in a 529 plan counts against you when the colleges calculate the family’s expected financial contribution.

And finally what we are noticing today, especially after the market performance in 2008, not uncommon that a lot of the 529 plans we’ve seen are under water. In other words, they are worth less than the money that was contributed to the plan. Well, with a regular investment again, an option would be to sell the investment and create a tax loss you can use either now or into the future for capital gains. You don’t have that ability with the 529 plan because technically it’s a tax deferred account. So investment losses will not be any benefit to you.

So a lot of people have gone into the 529 plan thinking it’s a wonderful tax break, when in reality today I question whether it’s much of a tax break if any at all in light of the market performance. And then you are saddled with minimal limited flexibility both when you can change your investment mix and when you can use or access your funds. So please think about it before your jump into one of these 529 plans.

The other thing, we always tell our clients, before you pay for college, make sure you’ve paid for your retirement. We believe as individuals, your responsibility is first to never be a burden to your family especially in latter live, retirement and beyond. So be sure to have your retirement situation taken care of first and then worry about college for the kids or grandkids. There are other ways to pay for college. Heaven forbid we think about part-time jobs or student loans or a combination of both.

Where do we go and what do you do if a 529 plan doesn’t seem as attractive as you once thought. I’m going to give you a couple of ideas. The first is, what about a Roth IRA for you? If you are eligible, and I’m not talking about converting an IRA, I mean you have income to fund a Roth IRA. You can’t make too much income to be eligible for a Roth IRA. But if you have earned income and can fund a Roth IRA, keep that Roth IRA in your name, the money grows tax deferred, you don’t get a tax deduction for putting money in. (So far it sounds like a 529 plan) When the money comes out, if it’s used for higher education, the IRA provision allows for a wavier of the early withdrawal penalty. You wouldn’t pay income tax if you follow the Roth IRA rules. So the Roth IRA might be a more attractive benefit or vehicle to use rather than the 529 plans mostly because you control the account. You can use a self-directed brokerage firm. A discount brokerage firm invests in just about anything under the sun when it comes to investment freedom and flexibility. The other option would be if the child or the grandchild has earned income. You can put money into a Roth IRA for them in their name. You just have to be sure that the contribution does not exceed what their earned income is. So, you know, a lot of kids’ part time work may not add up to the maximum Roth contribution amount. So you just don’t want to exceed that. And then finally the third option is to think about a uniform gift to minor account or a uniform transfer to minor account. That’s an account that you can be or the parent can be the custodian of the account. The child’s social security number is used to report on tax purposes. Earnings are, once the child exceeds age 14, earnings are taxed at the parent’s tax rate but kids under 14, the first $1400 is not taxed at all. So you have some very attractive features with the uniform gift to minor account. The big drawback that everybody thinks of is when the child turns 18, legally, technically, that account is their money. So you do want to look at the account balance, or what you think the account balance might be when the child turns 18. You want to make sure that it’s not too large of a sum of money so if they do something not wise, or prudent, it’s not going to be catastrophic financially speaking.

So that’s kinda’ my view. I’d rather see folks in most cases use either a Roth IRA or a uniform gift to minor account to accumulate money for children or grandchildren. A number of our clients with grandchildren want to set up separate college funds for the grandkids. Often times we just tell folks, “You know what? Just keep the money in your account. Let it compound. Don’t make life any more complicated or convoluted during your lifetime. If you want to help out your grandchildren, just help them out. And you’re in control and you can tell them you’ve been planning and setting money aside. No need, necessarily to create separate accounts from an overall strategic point of view. And then, if you want to make provisions in your estate documents to make sure that money goes to your grandchildren for college, you certainly can do that. Or you can just have a conversation with your children as to how you’d like them to use some of your money, their inheritance for your grandchildren’s education.” And with that we’ve seen an increase in a number of folks terminating their 529 plans simply because of performance. It’s not gonna’ trigger any taxable event in doing so because they’re under water on the account and they’re moving the money over to a Roth IRA or a uniform gift to minor account.
Those are my thoughts on the 529 plan. We’re going to open the lines up in just a minute for a questions. Whether you got a question along these lines or any other financial question. We got about 15 minutes or so left. We’ll be happy to answer any question you may have. As a reminder, when we open the lines up, it is a party line that Tony was telling you about. So anything that’s going on in your background, we’re going to hear that. If you want to yell at the dog and you don’t want us to hear that, then on your phone you just press *6 and then when you want to ask your question, you just hit *6 again and that unmutes your line and we’ll go from there.

One last reminder, we’re always curious just as to your thoughts. Topics for future calls, just call us or send us an email. Let us know if you got specific questions or topics that you’d like to see us cover and we’ll be happy to cover those in future calls.

So with that, Tony is there any other instructions we need to give folks?

(Tony)
Not really. I think you’ve basically covered it all. Just a reminder for the folks who may have joined us late, that we do record and archive these calls onto the website, www.brianfricke.com. I think it’s under the resources tab, yes?

(Brian)
Yes

(Tony)
So for those of you who joined us late and didn’t get to hear the whole thing you can certainly go out there within the next day or two and hear the call in its entirety minus the questions and answers, correct?

(Brian)
No, I think we even have the Q&A on there too.

(Tony)
Oh, we do have the Q&A on there, ok. So yeah, that’s just the only other announcement. I’m going to go ahead and unmute the lines and open it up for questions.

(Brian)
Alright, if you got a question just speak up, say your first name, you don’t have to reveal your full identity if you want to remain anonymous. That’s fine.

(Duane)
Say Brian, this is Duane. Got a question regarding closing 529 accounts and then taking the money and putting it, using it to pay down a pre-paid, like a Florida pre-paid college plan.

(Brian)
Yes. Great idea. In general I like that idea a bunch. The 529 plan, it just depends on where the plan is. If it’s under water so to speak, if it’s worth less money than what was originally contributed, there would not be a taxable event. There might be a termination fee but that might be modest from the plan administrator. And then, if there’s a existing, pre-paid tuition plan, check with the administrator of the pre-paid tuition plan and see if you can pre-pay part or all or whatever funds you’ve got to work with.

(Duane)
Ok

(Ron)
Hey Brian, this is Ron. Got a couple questions. The first point is on the Florida pre-paid plan, I know it comes up on the 31st, is guess that is our deadline to start at these rates.

(Brian)
Yes

(Ron)
Do you recommend like a single payment plan, a monthly payment plan or the 5-year plan that they have to offer. And they also have different plan types. I don’t know if your familiar with them but the 4-year university, they have a $15,000 fee and then they go to tuition differential plan. I guess that’s to get into Florida Universities?

(Brian)
Yeah, it’s

(Ron)
Yeah at another $17,000, that’s $32,000 at a single payment or the got a monthly payments or payments plan. What do you recommend?

(Brian)
Dependent on your situation, either way could be appropriate. See, the one thing I forgot to mention that I did want to cover with the pre-paid tuition plan. Those are issued by the states guaranteed by the states so you want to make sure your comfortable with the financial solvency of the state you’re considering. Florida, I believe, we’re not aware of any financial issues or concerns today. But if we’re talking about funds that are gonna’ be needed 10, 15, 18 years from now, you want to give that some thought or be aware of it. Alternatively, you know if I’m in California and I’m thinking about putting money in to a California pre-paid tuition plan, I’m not sure how comfortable I am about doing that at this point just given what California is going through.
As far as, “do I make a lump sum payment, or payments over time”, I think that is just you gotta’ crunch the numbers for your own individual situation. Yeah, you get a discount, the discount’s bigger by doing the lump sum compared to the monthly payment. You just want to make sure that it’s not going to jeopardize any other financial goals and objectives that you’re trying to reach. Especially if some of these other goals are going to happen at or before college years.

(Ron)
Ok, Second question is, to piggy back off of that. My son is going in first grade right now, so we got time, I think to do the other investments like the Roth. I like that idea. But how did you encourage your boys to save and invest?

(Brian)
Oh, my boys, yes. So I’ll tell you what I did with my boys and then I’ll tell you how I would improve upon it. You know, lessons learned. So, with my boys, I wanted them to learn and understand the core value, philosophy of being responsible and saving and investing their own money. So each of my boys has a custodial account, a uniform gift to minor account. And then what I told them, and we did this back when they were, I don’t know, 12’ish. And they’re now 17 and 19. But when they opened the accounts, I got them thinking, “Hey, this could be money that you could accumulate for a car.” Because when you’re 16 and want a car, Dad’s not buying you a car. So if you want a car, you’re going to have to buy one yourself. And that’s just my philosophy. What I told them is when it comes time for them to buy their car, whatever money they’ve accumulated, I’ll match. Kinda’ like a 401-Dad, or whatever. So if they’ve saved up $5,000 in their investment account then I’ll match it with another $5,000 to go towards their car. And the only criteria for the car is that it can’t be named after an animal. That’s my insurance person that said, “Don’t let them buy something that’s named after an animal. For insurance purposes that’s like Cobra, Mustang.” And then, you gotta’ buy a used car and you gotta’ pay cash. No financing.

What I would change, looking back is, I would change the match to a yearly match and maybe even quarterly. Instead of, at the very end, when they’re looking to make a major purpose, I think that would have been a better approach just to do the match. So show me what you’ve set aside in your investment accounts every year and I’ll throw in the same amount of money. And grandparents can do the same thing with grandchildren. It doesn’t have to be a one-for-one match. I t could be $.50 on the dollar, you know, whatever you want to do. Be creative and have a little bit of fun with it as well.

And then that creates teaching opportunities along the way that the kids bring up. Justin, my oldest son, he just turned 16, he went out and immediately got a speeding ticket. 45 in a 25 zone or something like that. You know I think the ticket was around $250 so he came to me wanting the pull money out of his investment account and I immediately said, “No, the investment account is for long term goals, not short term stupidity.” So you’ve got to figure out another way to pay your ticket, which he did. And that caused some short-term distress on his part because they didn’t have money to go out to the movies or on dates or whatever for a period of time. But he also learned the value of not dipping into long-term savings for short-term needs. So hopefully that one stuck with him. It sure made an impact at the moment.
Alright, any other questions?

(Ron)
As far as setting up that uniform gift to minor account. Is there any restriction, is there a certain age limit. How do you go about setting that up?

(Brian)
There’s not any age restriction other than the child needs to have a social security number. You set that up. Whatever financial institution you’re doing business with should be able to open up a custodial account. So a brokerage firm, bank, mutual fund company, whatever the case might be. The only other age issue to be aware of is legally, when the child reaches the age of “majority”, so when in their state, they are recognized as an adult, (in Florida, that’s 18) and other states, it could be 20. Some states are still 21. Legally, technically the account is still the child’s at that point. And I say legally, and technically and then you an exert suggest and perhaps the influence perhaps but maybe it’d be wise for you or their parents to still be on the account with them, maybe as a joint owner. They’ll provide some guidance and oversight.
I think we may have time for 1 maybe 2 more questions. If anybody has a question?

(Max)
Hey Brian, this is Max

(Brian)
Hey, Max!

(Max)
I have four 529 plans for my four grandchildren, and they vary in amounts and at this moment two of the four are at about break even and the other two are up just a little over a 7 year period. So what would you do in a situation like that?

(Brian)
Certainly the ones that are break-even or a little bit under water, I’d be inclined to close those accounts and then either open a Roth IRA or a custodial account.

(Max)
Now on a Roth, of course, you’re limited to your earnings. You can’t put in more than you’re making. And being a realtor, you know I’m not setting the world on fire.

(Brian)
Well your other option is to fund a Roth IRA for one of your children; they then would control the account, not you. If you’re comfortable with that. We’re talking about grandchildren here so you’ve got children that perhaps have got earned income that could fund their own IRA if you’re ok with the kids having access and control of the money and you just let them know what your desires and intentions are. The other option is a uniform gift to minor account, a custodial account.

(Max)
Yeah, Ok, thank you.

(Brian)
One last question. We got time.

(Brian Cheek)
Hey Brian, Brian Cheek here, how are you.

(Brian)
Hey

(Brian Cheek)
Within the uniform gift or uniform transfer accounts, what do you, if you can, simply, what are you recommending given, you know, historical sort of CD’s and conservative investments aren’t paying anything and some of the tax free annuities might be of more concern than their worth getting, you know, the tax free benefits from right now?

(Brian)
So in big picture, if the money’s gonna’ be needed within the next five years, or you think it might be needed in the next five years, I’m not a big fan of putting the money at risk in the stock market per se. So, I’d be looking at fixed income, fixed rate investment whether its CD’s, bonds, government bonds, municipal bonds. One of our favorite areas has been what are now called taxable municipal bonds, also the Build America bonds. And those things soon… We were getting yields in the 6-7% range and we don’t have serious concerns about the credit quality or the financial stability. We’re not buying community bonds from the Detroit area or California, you have to be careful about that. But there’s still attractive options out there.

(Brian Cheek)
OK, we’re outside of that window so we … longer term investment. What’s the minimum purchase on the Build America bonds?

(Brian)
Off hand I don’t know. Tony, do you have any idea?

(Tony)
I don’t know. We’d have to check with BT on that.

(Brian)
It’s part of our luxury I guess, we can buy a huge block of bonds and divide it amongst multiple client accounts.

(Brian Cheek)
I’ll call you later.

(Brian)
All right everyone, we are out of time. I promised you I’d keep these calls right at 30 minutes. And we are right up against that mark so if you have additional questions that you’d like answers to, just shoot us an email or gives a call at the office later today. We’re happy to help you out in any way possible. With that, I’m gonna’ let you get on with the rest of your day. Have a great week and we’ll see you right here next week, different time, different topic. Thanks everybody. Bye now.

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