Even if you are a Harvard professor, an economist and an authority on financing a college education, finding the right college savings program is still a nettlesome process.
Susan Dynarski, an assistant professor of public policy at Harvard’s Kennedy School of Government, not only knows how tough it is for parents to choose the best program, she also needs to make financially savvy choices for her two children, age four years and five months.
Picking the right college plan involves finding one that offers a combination of the highest after-tax and after-expense benefits while allowing you to qualify for as much financial aid as possible. That’s not easy.
“If academics and highly paid financial advisers are not figuring it out, then it’s a sure bet parents and students aren’t figuring it out,” says Dynarski, who has done research and written several papers on college savings plans and financial aid. She holds a PhD in economics from the Massachusetts Institute of Technology and a master’s degree in public policy from Harvard.
Thanks to Dynarski’s research, there are a number of guidelines to help you pick the right 529 college savings plan, a state-sponsored program that offers a choice of mutual funds which permit compounding and withdrawal of assets tax free (in most states) for higher education. First you need to weigh how expenses can pare the multiple tax benefits of 529s.
High plan expenses — what you pay in annual asset management and other fees on 529’s — can reduce their overall tax benefits. So you need to compare 529 expenses with and without state tax breaks to taxable mutual funds to see if you would be better off outside of a 529 plan. This is what Dynarski found:
– Say your household income is $100,000 and your state offers a 529 deduction. A regular mutual fund is a better deal than the 529 if its total expenses are low enough to offset the loss of the tax benefits.
In this example, a regular fund makes more financial sense if expenses are 1.6 percentage points lower than the 529 plan; 1.25 percentage points if no state write off is offered.
“For example, if a 529 has annual asset-based expenses of 2.6 percent, then a mutual fund with expenses lower than 1 percent is a better choice,” Dynarksi said.
– If your household income is $150,000 and your state offers a 529 write off, then a regular mutual fund may be better if the total expenses are 1.65 percentage points below that of the 529. Without a state break, the fees should be 1.30 points lower.
– If you make $335,000 or more, a conventional fund beats the 529 plan with the state-tax write off if its expenses are 1.8 percentage points below the 529; 1.45 points without the deduction.
For the purposes of these examples, Dynarski uses married couples filing jointly investing $1,000 in pretax income at the birth of a child; a mixed portfolio of stocks and bonds; 9 percent annual return for stocks and 4 percent for bonds; and typical state tax rates.
Your Best Option
All other things being equal, low expenses and state tax breaks combined with tax-free compounding maximize your net return.
Like most tax-advantaged investments, the higher your income, the greater the potential after-tax returns, depending upon your marginal tax rate.
“The 529 with an upfront (state) deduction yields a return 26 to 91 percent higher than a non-tax-advantaged account in the parent’s name,” Dynarski discovered, “with the highest returns for those in the top tax bracket.”
Even without the state tax break, assets held in 529s or Coverdells net after-tax returns of 17 percent to 70 percent higher than the taxable (non-college saving) accounts, Dynarski said.
Coverdells, also known as education savings accounts, are similar to 529s because they offer tax-free compounding and withdrawal for education expenses, only they restrict annual contributions to $2,000 per child.
What About Aid?
Once you’ve found the right combination of tax incentives and low 529 costs, you’ll also need to abandon the idea that you may not be eligible for financial aid.
“In a high-tuition school, you can still qualify for aid,” she says. “It’s not something you can ignore, even if you’re in a high-income bracket. You may have more than one child in school at a time. It’s always a function of the school cost to your ability to pay.”
To ensure that you qualify for every possible dollar of aid, Dynarski says the best situation under the current federal aid formula is to ensure that as little money as possible is in the child’s name.
That throws out of favor custodial accounts that go by the acronyms UTMAs or UGMAs, which hold assets in childrens’ names. These accounts also give children legal access to the money, usually at age 18. College funds are better held — and controlled — in parents’ or even grandparents’ names through 529 plans.
The Right Decision
What choice did Dynarski make for her college financing plan? She set up 529s for her children through the Utah Educational Savings Plan. This program charges a maximum $25 annual fee plus up to 0.65 percent for asset-based charges, according to http://www.savingforcollege.com , a 529 site.
Investing in the Utah plan was made easier by her home state Massachusetts, which offers no state 529 deduction. If your state is similarly impaired, consider low-cost, commission-free 529s sold directly by Michigan (Education Savings), Nevada (Vanguard) and New York (Direct Plan).
If you need additional guidance, work with accountants or fee-only financial planners who are not receiving commissions to sell 529 plans.
At the very least, do the homework to narrow down a list of the lowest-cost, highest-returning programs. Like a college education, it will be a bountiful investment of your time.