529 College Savings Plans Are Best in Class

By Jim Krapfel, CFA, CFP
January 3, 2021

The full cost to send a newborn to college in 18 years could easily top $150,000, and that is for just four years at an in-state institution. Thinking a private university could be in the cards? That could run nearly $400,000. These are daunting figures for most families that multiply with more than one child. For those who have the desire and means to fund their loved one’s education, it is imperative to plan early in the child’s life. This article will guide you on what kind of education plan to utilize and how much to contribute to the plan each year.

529 Plans
Contributing to a 529 plan is the best option for most families. Created in 1996 when Congress passed the Small Business Job Protection Act, a 529 plan is a tax-advantaged savings plan designed to help pay for education. They are legally known as “qualified tuition plans” and are sponsored by all 50 states and the District of Columbia. There are two types of 529 plans: college savings plans and prepaid tuition plans. We will focus our discussion on the more commonly used and typically better-suited college savings plans.

Contributions can be made by parents, grandparents, single people with no dependents, and trusts. Unlike other college savings programs like Coverdell ESAs, UGMAs, and UTMAs, there is no income limit with 529s. An individual can contribute up to $15,000 annually per child without triggering gift taxes, and $30,000 for married couples. A special election may be made that entails contributing five years’ worth of contributions in one year, or $75,000 from an individual or $150,000 from a married couple, and no contribution the following four years. Contributions are not deductible for federal tax purposes, but some states give a tax deduction, such as my home state of Illinois.

Owners of 529 plans, who are the contributors and not the beneficiary, can typically choose among a range of mutual funds, exchange-traded funds (ETFs), and fixed income portfolios. Just like a 401(k) or IRA, accounts grow tax free. Withdrawals are also tax-free when used to pay for qualified education expenses such as tuition, mandatory fees, books and supplies, computers, and room and board during one’s undergraduate and graduate years. As a result of Trump’s Tax Cut and Jobs Act, tax-free withdrawals up to $10,000 per year are also now allowed for K-12 tuition. This inclusion largely eliminates the benefit of enrolling in a Coverdell ESA.

If the 529 plan has unspent funds in it, perhaps due to overfunding or the person does not enroll in college, the beneficiary can be changed to a family member of the original beneficiary, such as a parent, sibling, or first cousin. If 529 withdrawals are not used for qualified education expenses, they will be subject to federal and state income taxes and an additional 10% federal tax penalty on earnings. Another potential downside of 529 plans is that they typically impact a student’s eligibility to receive need-based financial aid.

Figure 1: Pros and Cons of 529 Plans

It is important to choose the right state plan to participate in because of their nuances and state income tax breaks in some states. It would take quite a bit of research to pour through every state’s plan offering. Thankfully, research firm Morningstar has done the heavy lifting for us. They awarded their highest “Gold” rating to three state plans in 2020 – Illinois’ Bright Start, Michigan’s Education Savings Program, and Utah’s my529. Ratings are based on having investment options they expect to outperform and exhibit some combination of the following features: a well-researched asset-allocation approach, a robust process for selecting underlying investments, and appropriate set of options to meet investor needs, strong oversight from the state and investment manager, and low fees. Check to see if your home state has state income tax breaks before choosing an out-of-state plan.

A Word on Prepaid Tuition Plans
Prepaid tuition plans are the second, less frequently used type of 529 plan. Although 22 states used to offer them, just 11 do as of 2020 – FL, IL, MA, MD, MI, MS, NV, PA, TX, VA, WA – and IL and VA are no longer accepting new enrollees. They are similar to aforementioned college savings plans in many respects except that they lock in future college tuition costs at today’s rates by your handing money over to the state today and letting the state invest the money to pay for future costs. A parent comes out ahead with this option if tuition increases exceed what their 529 plan would have earned under the college savings plan.

They also differ in that in order to receive the full benefit, one must enroll in an in-state institution. There are other restrictions with prepaid tuition plans, such as a lack of coverage for graduate school tuition and undergraduate room & board in most states. This plan option is only suitable for highly risk-averse investors living in one of the nine states that are accepting new enrollments who are confident their child will attend an in-state college. Worth noting is that there is a private prepaid tuition plan that allows for locking in tuition at around 300 private colleges in over 30 states. 

How Much to Contribute
Now that we have determined that 529 college savings plans are the best means to save for college for most people, it is helpful to determine how much to set aside each year. We want to maximize the odds that we accomplish our college funding goals without overcontributing so we do not get hit with taxes and penalties if some funds must be reclaimed. Proper budgeting is subject to a host of assumptions we make in the below exercise, including the type of institution attended, years of attendance, cost inflation, scholarship/grant amounts, desired funding level, and plan returns.

Let us start with college costs. As shown in Figure 2, the average total cost of tuition, required fees, books, and room & board for the 2020-21 academic year was $21,220 for 4-year in-state public schools, $38,339 for 4-year out-of-state public schools, and $48,801 for 4-year nonprofit private schools. All these costs can be borne by a 529 plan. Keep in mind that other necessary living expenses, such as transportation and entertainment, are not eligible.

Next, we project costs when the student is attending college. A helpful guide to future inflation is past inflation. According to data from educationdata.org, the cumulative average growth rate (CAGR) in four-year tuition over the past 10 years was 1.2% above inflation per year for public four-year universities and 2.1% above inflation per year for private four-year universities. This compares to the 4.9% and 1.5%, respectively, real (above inflation) CAGRs in the prior decade, from 2000-01 to 2010-11.

Figure 2: Distribution of College Costs at 4-Year Institutions

Source: educationdata.org
*Room & Board assumes average on-campus living costs

For our exercise let us assume that total tuition costs rise 4% annually, comprised of a 2% real (above inflation) increase and a 2% economy-wide inflation increase, for all school types. Let us also project books and room & board costs to rise with overall inflation of 2%. Compounding these inflation figures on average 2020-21 school costs for a newborn gets us to freshmen year college costs of $35,870 for public 4-year in-state, $70,550 for public 4-year out-of-state, and $91,093 for private 4-year.

Our remaining assumptions are (1) student receives no scholarships nor grants; (2) desire to cover 100% of undergraduate expenses, (3) constant contribution amount each year, (4) college entered at age 18 ½ with full annual tuition due upfront, and (5) 6% annual 529 plan return.

Under these assumptions the calculations work out such that a 529 plan should be annually funded as follows: $4,072 for a 4-year in-state public student, $8,009 for a 4-year out-of-state public student, and $10,341 for a 4-year private student. If we assume a more conservative 4% rate of return on plan assets, then our annual contribution level should be $5,177, $10,182, and $13,147, respectively. Of course, annual contributions can be raised or lowered if you are tracking above or below plan or if your financial circumstances change.

Figure 3: Estimated Annual Contributions to Fully Fund 4-Year College for a Newborn

Source: educationdata.org, my calculations

Bottom Line
Look no further than 529 College Savings Plans to fund your child or grandchild’s education. Illinois’ Bright Start 529 Plan is a great option, especially for Illinois residents. If you wish to send him or her on a full ride over four years, be prepared to contribute $4,000 to $13,000 annually to the plan depending on school choice and return assumptions.

Disclaimer

Advisory services are offered by Glass Lake Wealth Management LLC, a Registered Investment Advisor in the State of Illinois. Glass Lake is an investments-oriented boutique that offers a full spectrum of wealth management advice.

This article is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory, legal, or accounting services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein is based on or derived from information provided by independent third-party sources. Glass Lake Wealth Management believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions in which such information is based.