Monday, May 14, 2007

The Downsides of Saving for College Expenses

Just as a parent will wake up at 3:00 am to feed a hungry new born, a parent will save for the child's college expenses. Many commentators recommend that you first fund your retirement, and use any remaining money for college savings. The idea is that you don't want to be a burden on your kid(s) when you're old. Given the amount of money it takes to retire comfortably, most people would have little left for college expenses if they actually took care of retirement first. But the parental instinct to provide for the child--be it with food or with an education--extends beyond financial rationality. People will save for the educational expenses of their children, even at the cost of adequately funding their own retirements.

That being the case, they should be aware of some of the pitfalls and downsides of saving for college expenses. The 529 Plan and the Coverdell account are heavily promoted today, especially the 529 Plan. Both a 529 account and a Coverdell account offer tax advantages--the money you put into them isn't tax deductible, but the earnings are not taxed if they are used to pay college expenses. Coverdell accounts can also be used to pay primary school expenses. Some states offer deductions from state income taxes to their residents who open an account in a 529 Plan offered by that state.

However, there are the downsides, which you not hear much about. Each 529 Plan has only a limited number of investment options. The plan itself, and the investment options, may impose high costs and fees on your account (as much as 3% per year in some cases). That's a hefty burden. Even with the tax shelter offered by the 529 Plan, fees at that level seriously reduce your long term returns. If you compare an expensive 529 Plan against an inexpensive taxable account (one where you pay taxes on realized investment gains each year), the inexpensive taxable account can produce greater wealth.

Another problem with 529 Plans is that if the money in your 529 account isn't used for college expenses, you can retrieve it only after paying state and federal income taxes, and a 10% penalty on the earnings. So you have an exit strategy problem if Junior doesn't go to college; or does go, but doesn't graduate. Something like 1/3 to 1/2 of all college freshman do not graduate. If you save for college expenses in an inexpensive taxable account, you have no exit strategy problem and may even come out ahead.

A 529 Plan is a good idea if you can find one with low costs. You can search for low cost 529 Plans at Among the plans that appear to have low costs are the Utah Educational Savings Plan Trust, the Virginia Education Savings Trust, the South Carolina Future Scholar 529 College Savings Plan (Direct-sold), and the New York 529 College Savings Program--Direct Plan. Note that you don't need to be a resident of a state to participate in its 529 plans. Also, you have to contact each of these states directly to open an account--these plans are not sold by brokers (which probably accounts for much of their low costs, since no one gets a commission for selling you one).

Finding Coverdell accounts with low costs tends to be easier than it is for 529 Plans, since you can open a Coverdell with a wide array of financial institutions. One downside of the Coverdell account is that you can only contribute $2,000 a year (the 529 Plan's limit is $12,000--or $24,000 for a married couple--a year). Also, the Coverdell can only be used by people subject to certain income limits. The Coverdell has a severe exit strategy problem: if the account assets aren't used for educational purposes by the time the child who is the beneficiary of the account is 30, the child gets the remaining assets (subject to payment of state and federal income taxes and a 10% penalty on the earnings). You don't get any of the money back for your retirement or any other purpose.

Persons having incomes below $78,100 if they're single, or $124,700 if they're married filing jointly, may be able to avoid paying some or all of the taxes due on the interest income of U.S. Savings Bonds that is used for college expenses. So U.S. Savings Bonds actually provide a tax shelter for college savings for persons meeting the income requirements. Since Savings Bonds can also be used to fund your retirement, they don't have an exit strategy problem. They're also simpler than 529 Plans and Coverdell accounts.

The tax sheltered plans--529 and Coverdell--also require extra work at tax time, especially when your taking money out to pay for educational expenses. If you're concerned about the downsides of 529 Plans and Coverdells, just save for college expenses in low cost taxable investments like well-diversified mutual funds or U.S. Savings Bonds.

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