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Thinking Beyound 529 College Plans

Sangita Joshi Rousseau

This question was asked by a reader in a September 2017 Wall Street Journal Investing Report.

“What’s the best type of account to use when saving for college – a “529,” a brokerage or savings account, or an UGMA?”

The recommendation, provided by a California financial advisor, was to use a 529 Plan, primarily for its tax advantages compared to the other options. But is it really “the best type of account?”

Whether deliberate or not, the framing of this question reflects a persuasion technique called “thinking past the sale.” In order to answer the question, you must assume that the three options listed are your only choices. That’s not true. And it neglects what is perhaps the most important factor in saving for college.

The 529 Plan: A Simple Concept, with Lots of Rules

A 529 Plan is a state-sponsored account regulated by the US Tax code that allows deposits to accumulate and be withdrawn taxfree, provided the funds are used for qualified education expenses by a designated beneficiary. 529 accounts are usually established with parents or grandparents as the owners and a child/grandchild as the beneficiary. Most plans offer a menu of passive investment choices, such as mutual funds.

These tax advantages are coupled with restrictions on how the funds may be used, and include penalties for improper distributions.
Among them:
• 529 Plan deposits are not deductible from federal income taxes, although some plans may qualify for a state income-tax deduction.
• For purposes of the Free Application for Federal Student Aid (FAFSA), accumulations in a 529 Plan are considered parental assets, and added to the Expected Family Contribution (EFC), which diminishes a student’s eligibility for federal grants and scholarships.
• Each 529 places a cap on how much can be deposited or accumulated, based on the estimated costs for five years of tuition, fees, and room and board at the state’s most expensive university. (In the state of New York, the maximum is currently $525,000. In North Dakota, the cap is $269,000.) Once an account balance reaches the cap, either through contributions or appreciation, no further deposits can be accepted.
• There is no annual limit on deposits, but amounts in excess of the gift tax exclusion (currently $14,000 per year per donor) may result in a tax for the depositors.
• Any funds not used by one beneficiary may be transferred to another 529 account, naming an approved relative (such as a sibling) as the new beneficiary.
• Distributions that are not used for qualified education expenses (each state has a list), become taxable income for the account owner, and trigger a 10% penalty as well.
• Student loan payments are not considered qualifying education expenses.

Reading this list might prompt a thought:

“Isn’t there another choice for college saving that doesn’t have as many restrictions as a 529?”

There is. It’s an option with…

• Tax-free accumulation
• Options for tax-free distributions
• No restrictions on how distributions are used (and thus no tax penalties for “non-qualified” expenses)
• An exemption that keeps accumulations from being included in the EFC calculation on the FAFSA.

What is this college saving option has that similar tax advantages without a 529’s restrictions or tax penalties? Life insurance cash values.

In a side-by-side comparison of features and restrictions, you could make a compelling argument that cash values as a college saving vehicle have distinct advantages over 529 plans. Which is why many parents and grandparents have used cash values for higher-education expenses in the past – even before 529 plans existed.

But using life insurance cash values for college funding requires some planning and integration with other aspects of your financial affairs. You can’t simply open an account, make a deposit and withdraw it at a later date.

Cash values can only exist inside a life insurance policy; someone must qualify for life insurance, and pay the insurance costs in order to accumulate cash values. There are “contribution” restrictions in that premiums (including the amounts apportioned to cash values) are tied to the size of the insurance benefit; large cash value accumulations must have proportionally equivalent insurance benefits. And the investment options within cash value accounts may or may not be as extensive as those offered by a state’s 529 plan.
So…“What’s really the best type of account to use when saving for college?”

Probably the one that nudges you to action. Economist Richard Thaler, a pioneer in behavioral economics, was recently awarded the Nobel Prize for research that showed people are often irrational in their financial decision-making, but can be “nudged” toward better outcomes through well-designed procedures and policies. A 529 plan is a classic example of two economic nudges to encourage saving for college.

The first nudge is specifically stating the account’s purpose. For parents and grandparents, an explicitly designated college savings fund is a tangible demonstration of their love for, and investment in their children. Every subsequent deposit affirms and reinforces those commitments.

Of course, the same psychological motivation and reinforcement could be achieved with any account – saving, brokerage, cash values, whatever – just by having the designation “College Savings Fund.” But a 529 Plan has a second nudge: The tax advantages that make it “official.” The government recognizes (and approves of) your intention to save for your children’s education by granting a tax advantage.

If you’re already motivated to save for your college, why not choose your own nudges? Just because 529 plans have government approval and are presented as the default solution, doesn’t mean they are your best choice. Guarantees, investment opportunities, funding limits and withdrawal restrictions should be evaluated in the context of your individual circumstances.

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