Section 529 Higher Education Savings Plans An effective way to invest for college? Jeffrey AltieriAbstract This paper is about the Section 529 higher education savings plans that allow family members to receive certain tax breaks while investing for a child’s higher education. The data used in this study is the historical rate of return on a Connecticut 529 plan versus the benchmark, the S&P 500. The time period covered was the inception of this plan starting in 2002 up to the start of research on this study, the end of September, 2004. The tests show that although this particular 529 plan offers tax benefits that could help in investing for higher education, that this particular plan failed to outperform the market during the period observed. Therefore it is my conclusion that there are better investment options on the market to invest in a child’s higher education than this Connecticut 529 savings plan. This study may lead to further observation of other Connecticut 529 plans as well as 529 plans managed nationwide to figure out if 529 plans are as effective as advertised.” 529″ college plans have become greatly debated in recent years as a tool for investing for college.
The plan, which takes its name for the provision of the tax code that sanctioned them, is a college savings account which allows parents or grandparents to give gifts to children that will be later used to obtain a college education. Although some 529 plans have been around since 1988, the Economic Growth and Tax Relief Reconciliation Act of 2001 made sweeping changes to Section 529, most of which became effective in 2002. These changes offer substantial tax benefits to families seeking to finance the cost of college expenses. 529 plans offer families, regardless of income, the opportunity to generate tax-free earnings on funds specially set aside for higher education. These plans, which are run by individual states, can be of great benefit to children by allowing their family members to give money to them in advance to save for college. It can also be detrimental to not only the people who invest but the children who are receiving these gifts.
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I became aware of these 529 plans by reading “A Random Walk Down Wall Street” by Burton Malkiel. My motivation was to see if these 529 college saving plans are as effective as advertised and to look at the upsides and downsides of investing in them. Since there are tax deductions from investing in such plans for the donors, as well as gains earned and used towards a college education are exempt from Federal taxes, it is definitely an attractive offer. Such a plan allows an individual donor to contribute up to $55, 000 to the account with couples allowed up to $110, 000 without paying gift taxes and without reducing estate tax credits (Malkiel, 2003).
But as we know, if it does not out gain the alternative, then it is not a worthwhile cause.
Plans have a 10% penalty that is assessed on the income portion of any distribution in excess of qualified higher education expenses as well as a penalty for withdrawals not made for a qualified use. Such penalties are on top of the federal taxes that now must be paid to due to non-qualifying use (Auster, 2003).
Therefore, there is a need to examine further just how well these 529 savings plans are performing and whether it is a way to beat the market. I.
Literature Review There are many positive aspects of Section 529 college savings plans that are attractive to parents and grandparents. These plans are designed to encourage saving for college or post-graduate education of the younger generations. These plans let the family save for any eligible higher education institution in the United States. Qualified higher education expenses include tuition, fees, room and board, required books, supplies and equipment at an eligible institution. There is no question of the growing popularity in these plans.
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Their assets had doubled by 2003 and could triple to approximately $50 billion by 2005 (Karp, 2003).
Contributions to a 529 account grow in an income tax-deferred environment, and distributions for specified higher education expenses are free from federal income tax. There are two types of 529 plans: savings and prepaid tuition. Many states have both types of plans and their effectiveness differs for the individual. The savings plans allow a contributor to put funds in a state-sponsored, professionally managed investment account for the benefit of child at hand. Prepaid tuition plans typically permit a donor to purchase inflation-protected tuition credits for a specified individual, and are therefore more conservative investments (Pfefferkorn, 2003).
Since the 529 savings plans are largely more popular, we will focus on these although most issues arising from Section 529 do apply to both types of plans. Section 529 plans exist in all 50 states, and most allow participation by nonresidents of the sponsoring state with no requirement that the benefiting individual attend college in that particular state. The federal tax laws create mandatory federal rules for states in creating these 529 plans, but states are free to create rules regarding their plan that are in addition to the federal statutory framework. One of the strengths of a 529 plan is the ability to contribute up to $55, 000 in one year and treat the amount as being gifted pro-rata over five years. Although the account owner maintains control, this qualifies the contribution and any earnings a separate from one’s personal estate after a period of five years. Individual donors are allowed to contribute as much as $55, 000 to a 529 plan without gift taxes and without reducing estate tax credits, with the amount doubling to $110, 000 for couples (Malkiel, 2003).
Section 529 plans give the account owner a substantial amount of control over the account. The owner has the unilateral right to take back the contribution or change the designated beneficiary to another family member at any time. This feature would allow the account owner to shift benefits or change the designated beneficiary to another member of the family. This would allow any unused benefits to be passed on to other siblings to help them afford a higher education institution without having to pay fees or penalties on the unused portion. Another good feature is that in most cases, the designated beneficiary does not have the right to access the funds in the account, even when enrolled at a college or university.
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Many states offer state income tax benefits for contributions to the state’s 529 plan by state residents as well as the Internal Revenue Code not imposing a ceiling on contributions to the 529 plans (although individual states might).
There is, however, an often-overlooked downside to Section 529 savings plans. There are a few but very costly penalties that a well-informed taxpayers should evaluate when determining if and how much to invest in a 529 plan. The first are Federal penalties.
Withdrawals that are not used to pay qualifying higher education costs (such as tuition, room and board, books, etc. ) are taxed to the account owner instead of the designated beneficiary. The earnings associated with the distributed monies will be taxed at the parent’s tax bracket and not the beneficiary’s tax bracket. In addition, non qualified withdrawals are subject to a 10% penalty, unless the withdrawal is due to the death or disability of the beneficiary. Example: Immediately prior to taking a $20, 000 distribution to buy a car, the plan balance was $90, 000, and total contributions to the plan were $60, 000. Since one-third of the account balance consists of earnings, one-third of $20, 000, or $6, 667, is gross income.
The penalty is 10% of gross income, or $667 (Auster, 2003).
There are also associated plan penalties, which can be very costly. Prior to 2002, to maintain its tax-exempt status, the plan itself had to levy a “more than de minimus” penalty for withdrawals not made for a qualified use. Some plans continue to assess a penalty on refunds. As far as a plan is concerned, if there is a disqualified use, such as using the funds for any purpose other than higher education, or a university outside the United States, the federal penalty does not apply, but the 529 plan’s penalty will (Auster, 2003).
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Roth IRAs look to be more attractive in this regard, since they can be invested in almost anything, and all distributions are nontaxable, regardless of use.
Like using any other firm to manage your investments, there are fees that go along with Section 529 plans. Such Fees can be very costly to account owners and end up hurting the earnings and the amount that can be designated to a child’s higher education. The typical annual management fee is from 1% to 1. 5%, of the account balance, while there are some no-load or index funds that charge. 5% or less. These fees included with the fact that there are limited investment choices because of typical plans allowing only a handful of mutual funds as options, make regular investments in mutual funds more attractive.
Another harsh drawback is the limited to nonexistent amount of protection Section 529 plans get from creditors. Currently, only about one-quarter of the states exempt Section 529 plans from the owner’s creditors. These states include Alaska, Colorado, Kentucky, Louisiana, Maine, Nebraska, Ohio, Pennsylvania, Tennessee, Virginia, and Wisconsin (Auster, 2003).
This is a major drawback to Section 529 plans and an important factor when deciding which financial tools to use.
Another major drawback to such plans are the effects it can have on the amount of financial assistance a child receives when applying for higher education institutions. Financial aid is likely to be reduced or eliminated because of parents’ and grandparents’ well-meant altruism. There is an almost na ” ive belief that 529 plans are not taken into account when determining financial aid. However, it is just that if a person thinks that a college does not look into any and every source of income when determining the amount of aid they will be giving students to attend their college or university. II.
Data andMethodA. Data The data used in this paper would need to be that of a current Section 529 offered by any state in the United States. Since any resident of any state can invest in any other state’s 529 plan, it is not relevant which state the account owner is from, only which state he chooses. Since the research is being done in Connecticut, we will choose a Connecticut 529 plan. B. The Sample For the sample, I chose the High Equity Option offered by TIAA-CREF as the Connecticut 529 plan that would be used for this research.
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TIAA-CREF, unlike other 529 plans, has low fees that are more comparable with index funds and would therefore make the fees a non-factor in arriving at a decision. This fund was taken from its inception in October of 2002, to the beginning of the school year when this research was started, ending with September of 2004. The historical price of this fund was taken monthly. The specific period that was covered by the data was chosen to select a more modern fund and one still in its infantile stages. C.
Research Design For this research, we will take the Connecticut – TIAA-CREF account and compare it to the benchmark (in this case, the S&P 500) throughout its existence. We will try to find if it is outperforming the market, while taking into account the tax benefits of distributing the funds at the liquidation of the account. A tax of 15% is assessed to the capital gains S&P 500 index while the amount gained from the 529 plan is excluded from Federal taxation. The rate of return on each individual mutual fund inside the High Equity Option was obtained and calculated to include the distribution of the money inside the fund. Here is the distribution for the High Equity Option: Institutional Growth & Income Fund Institutional International Equity Fund Institutional Bond Fund 70. 00% 10.
00% 20. 00%The hypothesis is formulated to test, whether or not the High Equity Option of a Connecticut 529 plan is a better alternative for parents and grandparents in investing for a child’s higher education. It is stated as follows: Hypothesis H 1: The Connecticut 529 plan is more beneficial to family members who are looking to invest for a child’s higher education and with tax benefits included, will outperform the benchmark. Rejection of this hypothesis would mean that the Connecticut 529 plan chosen would live up to expectations and is not necessarily a superior investing tool in regards to investing for a child’s higher education. III. Empirical Results After getting historical prices on each fund, the monthly rate of return was calculated as well as the rate of return on each mutual fund since its inception.
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The three funds are the three that make up the High Equity Option of Connecticut’s 529 plan. The first fund was the Institutional Growth & Income Fund as shown in Table I of the Appendix. Since the funds inception to the specified ending date, the fund earned about 22. 11%. The second fund, the Institutional International Equity Fund, was shown in Table 2.
This fund earned 41. 24% since inception. The last fund, the Institution Bond Fund, was shown in Table 3. This fund has returned -3. 11% since its start. Together, factoring in the amount distributed to each fund, the High Equity Option of the Connecticut 529 plan managed by TIAA-CREF earned 18.
98% (as shown in Table 3).
In the same time period, as shown in Table 4, the S&P 500 had a rate of return of 25. 83%. After calculating the tax on capital gains of 15%, the S&P 500 gained a total of 21. 96. Therefore, I would have to reject the hypothesis stated earlier that the Connecticut 529 plan is more beneficial.
The plan’s High Equity Option could not out gain the benchmark (S&P 500) and should not be viewed as a more worthwhile investment. IV. Summary and Conclusions The Connecticut 529 plan has the concept of becoming a great investment tool for parents and grandparents in investing in a family members’ higher education. Currently, however, it did not outperform the benchmark set forth. After considering all of the negative aspects in investing in such a plan it seems not to be worth the risk and does not seem like an investment that would be worthwhile. Even if one were to take into account the pre-investment tax considerations, it would take a large amount of money to make the investment worthwhile rather than choose better investment options currently available.
V. Future Research There is a lot more that can be done with the concept I have brought forth here. Every state has 529 plans and higher risk, higher return plans as well. With more time, one could look into all of these plans, since investors can put their money in any state’s plan they choose. Although the TIAA-CREF did not out gain its benchmark, the possibility that other funds around the country did is likely and those more established funds could be a good investment for those looking to earn money toward a loved one’s higher education. REFERENCES Auster, Rolf, June 2003, Qualified tuition programs: The often-overlooked downside, Practical Tax Strategies, Boston.
Vol. 70, Iss. 6, pg. 336. Chu, Kathy, September 3, 2003, Year End is Ideal Time for a 529 Gift, Wall Street Journal (Eastern edition), New York, N.
Y. , pg. D. 2.
Karp, Stephen, March/April 2003, Section 529 and deferred compensation plans, Compensation and Benefits Review, Saranac Lake, Vol. 35, Iss. 2, pg. 43. Malkiel, Burton G. , 2003, “A Random Walk Down Wall Street”, W.
W. Norton & Company, New York, NY, 2003, pg. 292-293. Paradis, Margaret, February 2004, As Section 529 Plans Grow Up: The Challenges, The Investment Lawyer, Englewood Cliffs, Vol. 11, Iss. 2, pg.
22. Pfefferkorn, David M. , The investment of Custodial funds in Section 529 qualified tuition programs, November, 2003, Estate Planning, New York, Vol. 30, Iss. 11, pg. 571.
APPENDIX Table 1 Ticker Symbol = TIGRX TIAA-CREF Institutional Growth & Income Date Open High Low Close 1-Sep-04 8. 13 8. 28 8. 07 8. 12 0. 00% 22.
11% x 70% of the funds assets = 0. 1547372-Aug-04 8. 11 8. 14 7. 81 8. 12 0.
62% 1-Jul-04 8. 27 8. 27 7. 95 8. 07 -3. 35% 1-Jun-04 8.
23 8. 41 8. 19 8. 35 1. 58% 3-May-04 8. 21 8.
25 7. 96 8. 22 0. 98% 1-Apr-04 8. 34 8. 49 8.
14 8. 14 -1. 81% 1-Mar-04 8. 5 8. 51 8. 03 8.
29 -1. 43% 2-Feb-04 8. 32 8. 51 8. 26 8. 41 1.
33% 2-Jan-04 8. 15 8. 42 8. 15 8.
3 1. 59% 1-Dec-03 7. 94 8. 17 7. 84 8. 17 4.
21% 3-Nov-03 7. 83 7. 85 7. 65 7.
84 0. 90% 1-Oct-03 7. 52 7. 77 7.
52 7. 77 5. 57% 2-Sep-03 7. 54 7. 71 7.
36 7. 36 -1. 08% 1-Aug-03 7. 22 7. 44 7.
11 7. 44 2. 06% 1-Jul-03 7. 22 7.
42 7. 22 7. 29 1. 67% 2-Jun-03 7. 13 7. 47 7.
13 7. 17 0. 84% 1-May-03 6. 83 7. 11 6.
82 7. 11 4. 25% 1-Apr-03 6. 38 6.
83 6. 38 6. 82 8. 43% 3-Mar-03 6.
27 6. 67 5. 99 6. 29 -0.
16% 3-Feb-03 6. 43 6. 43 6. 14 6. 3 -1. 56% 2-Jan-03 6.
77 6. 93 6. 32 6. 4 -2. 44% 2-Dec-02 7 7 6. 54 6.
56 -6. 55% 1-Nov-02 6. 75 7. 02 6.
57 7. 02 5. 56% 1-Oct-02 6. 38 6. 73 5. 85 6.
65 TABLE 2 Ticker Symbol = TCIEX TIAA-CREF Institutional International Equity Date Open High Low Close 1-Sep-04 13. 45 13. 73 13. 4 13. 7 2. 62% 41.
24% x 10% of the funds assets = 0. 0412372-Aug-04 13. 29 13. 39 13.
05 13. 35 0. 45% 1-Jul-04 13. 72 13. 73 13. 1 13.
29 -3. 20% 1-Jun-04 13. 4 13. 88 13. 37 13. 73 2.
39% 3-May-04 13. 4 13. 69 12. 63 13. 41 0. 22% 1-Apr-04 13.
86 13. 92 13. 38 13. 38 -2.
26% 1-Mar-04 13. 82 13. 84 13. 14 13.
69 0. 51% 2-Feb-04 13. 35 13. 92 13. 28 13. 62 2.
25% 2-Jan-04 13. 23 13. 73 13. 23 13. 32 1.
37% 1-Dec-03 12. 66 13. 3 12. 66 13. 14 5. 20% 3-Nov-03 12.
25 12. 49 12. 19 12. 49 1. 96% 1-Oct-03 11. 76 12.
41 11. 76 12. 25 6. 15% 2-Sep-03 11. 33 11. 9 11.
33 11. 54 3. 04% 1-Aug-03 10. 89 11.
27 10. 79 11. 2 2. 28% 1-Jul-03 10. 77 11.
12 10. 7 10. 95 2. 34% 2-Jun-03 10.
62 11. 19 10. 57 10. 7 2. 49% 1-May-03 9. 89 10.
49 9. 89 10. 44 6. 10% 1-Apr-03 9. 04 9. 84 9.
04 9. 84 9. 70% 3-Mar-03 9. 23 9. 32 8. 47 8.
97 -1. 86% 3-Feb-03 9. 49 9. 49 9. 01 9. 14 -2.
25% 2-Jan-03 9. 89 10. 11 9. 28 9. 35 -4. 20% 2-Dec-02 10.
11 10. 11 9. 57 9. 76 -2.
69% 1-Nov-02 9. 67 10. 1 9. 67 10.
03 3. 40% 3-Oct-02 9. 28 9. 7 8.
8 9. 7 TABLE 3 Ticker Symbol = TIB DX TIAA-CREF Institutional Bond Date Open High Low Close 1-Sep-04 10. 3 10. 37 10. 23 10.
29 -0. 10% -3. 11% x 20% of the funds assets = -0. 006212-Aug-04 10. 16 10. 3 10.
16 10. 3 1. 48% TIGRX total = 0. 1547371-Jul-04 10. 11 10. 21 10.
09 10. 15 0. 59% TCIEX total = 0. 0412371-Jun-04 10. 05 10. 1 9.
98 10. 09 0. 20% Rate of Return 3-May-04 10. 14 10. 14 9. 99 10.
07 -0. 69% For CT Section 1-Apr-04 10. 41 10. 41 10. 13 10.
14 -2. 78% 529 Savings Plan = 18. 98%1-Mar-04 10. 39 10. 51 10. 37 10.
43 0. 29% 2-Feb-04 10. 32 10. 4 10.
31 10. 4 0. 78% 2-Jan-04 10. 22 10. 41 10. 22 10.
32 0. 58% 1-Dec-03 10. 61 10. 78 10. 25 10. 26 -3.
57% 3-Nov-03 10. 64 10. 76 10. 6 10.
64 -0. 19% 1-Oct-03 10. 81 10. 81 10.
61 10. 66 -1. 39% 2-Sep-03 10. 48 10. 81 10. 48 10.
81 2. 46% 1-Aug-03 10. 51 10. 63 10. 5 10. 55 0.
38% 1-Jul-03 10. 93 10. 94 10. 51 10. 51 -3.
93% 2-Jun-03 10. 98 11. 11 10. 94 10. 94 -0. 91% 1-May-03 10.
81 11. 04 10. 8 11. 04 2. 13% 1-Apr-03 10. 76 10.
81 10. 7 10. 81 0. 56% 3-Mar-03 10. 82 10. 86 10.
67 10. 75 -0. 46% 3-Feb-03 10. 67 10. 81 10. 67 10.
8 1. 22% 2-Jan-03 10. 61 10. 71 10. 59 10. 67 -0.
09% 2-Dec-02 10. 57 10. 76 10. 57 10. 68 0. 95% 1-Nov-02 10.
6 10. 69 10. 58 10. 58 -0. 38% 1-Oct-02 10. 69 10.
7 10. 48 10. 62 TABLE 4 S&P 500 Date Open High Low Close 1-Sep-04 1102. 67 1131. 52 1099.
31 1114. 58 0. 94% Rate of Return for 2-Aug-04 1098 1109. 66 1060. 74 1104.
24 0. 23% S&P 500 = 25. 83% 1-Jul-04 1139. 41 1140. 84 1078.
85 1101. 72 -3. 43% 1-Jun-04 1117. 98 1146. 33 1113. 4 1140.
84 1. 80% Capital Gains Tax 3-May-04 1110. 45 1127. 65 1076. 39 1120. 68 1.
21% of 15% = 3. 87% 1-Apr-04 1128. 14 1150. 57 1107.
24 1107. 3 -1. 68% 1-Mar-04 1148. 93 1163. 09 1087.
48 1126. 21 -1. 64% Total = 21. 96% 2-Feb-04 1132. 58 1158. 99 1124.
45 1144. 94 1. 22% 2-Jan-04 1112. 61 1155.
37 1105. 02 1131. 13 1. 73% 1-Dec-03 1061. 89 1112.
52 1053. 52 1111. 92 5. 08% 3-Nov-03 1051. 75 1063.
65 1031. 24 1058. 2 0. 71% 1-Oct-03 997. 15 1053. 72 997.
15 1050. 71 5. 50% 2-Sep-03 1009. 14 1040. 18 990.
34 995. 97 -1. 19% 1-Aug-03 989. 88 1011. 04 960. 82 1008.
01 1. 79% 1-Jul-03 973. 99 1015. 44 962. 1 990. 31 1.
62% 2-Jun-03 965. 88 1015. 37 964. 46 974. 51 1.
13% 1-May-03 915. 78 965. 39 902. 82 963.
59 5. 09% 1-Apr-03 849. 17 924. 3 847.
81 916. 92 8. 10% 3-Mar-03 843. 82 895.
79 788. 9 848. 18 0. 84% 3-Feb-03 856.
53 864. 66 806. 31 841. 15 -1. 70% 2-Jan-03 881. 69 935.
11 840. 31 855. 7 -2. 74% 2-Dec-02 941. 55 954.
4 869. 42 879. 82 -6. 03% 1-Nov-02 885. 76 941. 85 872.
02 936. 31 5. 71% 1-Oct-02 816. 3 907. 49 768.
58 885. 77.
