Marvin Appel, M.D., PhD, and Brian Hufford, CPA
When the tax code was changed in 2001, families with college-bound children received an outstanding tax break - the opportunity to use investment earnings for college expenses without paying any income tax.
Now, almost four years later, the original benefit remains in place ... at least for another five years. However, the 529 Plan landscape has become much more cluttered and is now fraught with traps for the unwary. When will you start paying for college? If you use investment gains from 529 accounts to pay for college expenses before Dec. 1, 2010, you will not owe federal income tax on those gains. This means if you have a child who will need that college-expense money before this deadline, 529 Plans should be very beneficial to you, regardless of the investment portfolio you are using.
However, withdrawals from 529 Plans in 2011 or later are subject to income tax at the student’s ordinary income tax rate. As a result, if your oldest child will not begin college until 2011 or later, the decision to invest in a 529 Plan becomes complicated. As a general rule, for withdrawals beginning in 2011, 529 Plans will likely benefit bond investors, but may be of no benefit to equity investors.
Why are 529 Plans problematic for stock investors?
Two reasons. First, without exception, 529 Plans are more expensive than low-cost stock investments, such as Vanguard’s or Fidelity’s S&P 500 Index Funds which charge under 1/5 percent per year. These index funds also give you more flexibility in deciding when to reallocate your investments and when to make withdrawals.
Second, when you hold stocks or equity mutual funds for the long term, any investment gains and dividends receive favorable tax treatment. The current top federal tax rate is 15 percent. In contrast, withdrawals from 529 Plans will be taxed at the beneficiary’s ordinary income tax rate. Depending on how much you need to spend each year for college - and on the student’s other sources of income - the tax burden from the 529 might not differ from the taxes owed on your own investments.
Rule of thumb: 529 Plans could increase your after-tax equity fund returns compared to a low-cost index fund, if your 529 equity investments meet three conditions:
Investments must compound inside the plan for at least eight years.
The total expenses of the plan and its stock funds must be 1 percent or less per year.
The average investment return will need to be at least 8 percent per year.
How about bond investments? Here, 529 Plans make a lot of sense ... potentially. No tax benefits are available for taxable interest income, so all else being equal, the tax deferral of 529 Plans would add to your bottom line. The caveat is that 529 Plan bond offerings are often more expensive than certain mutual funds, such as the Vanguard Total Bond Market Index Fund (VBMFX), which charges less than 1/4 percent per year in overhead.
Recommendation: Do not place assets in a 529 Plan bond fund if the total expenses (fund expenses plus sales charges, if any) exceed 0.75 percent per year. Use the Vanguard Total Bond Market Index Fund or the Vanguard Intermediate Term Tax-Exempt Bond Fund instead.
TIAA-CREF manages 529 Plans in 12 states. They are California, Connecticut, Georgia, Michigan, Minnesota, Missouri, Oklahoma, Vermont, Tennessee, Mississippi, Kentucky, and Idaho. These states’ plans offer guaranteed income accounts currently paying 3 percent per year. In contrast to bond mutual funds, guaranteed income accounts will not lose principal if interest rates rise. Even better, if rates rise, so, too, could the interest you receive. The 3 percent per year is net of all expenses. The only risk is you must trust the creditworthiness of TIAA-CREF.
Recommendation: If you live in a state offering a guaranteed income account in its 529 Plan, use it!
One final bit of advice. The higher the investment return and the longer it compounds tax-deferred, the more valuable a 529 Plan could be for you. In particular, if interest rates do move higher by more than 1 percent, a 529 Plan bond fund might be more attractive than it is at current interest rates. However, in the current investment environment, look for the most economical alternatives.
Two excellent online resources will help you find the best 529 Plans. They are www.clarkhoward.com/topics/529_guide.html and www.collegesavings.org. Howard’s site lists the most cost-effective plans and the second site provides links to each state’s 529 Plan Web site.
Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his M.D. in 1991. He is co-author of Systems and Forecasts. Contact him at (516) 487-7146 or [email protected]. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.
