529 plans are smart way to save for college

A recent column I wrote on 529 college savings plans did not sit well with one reader.

In case you don’t know — and many people don’t — there are two types of 529s. A prepaid plan allows you to pay a child’s tuition and fees in advance. The idea is to lock in today’s tuition prices. With the savings plan, you invest much as you would in a 401(k). Your earnings grow tax-deferred and are exempt from federal income tax as long as the money is used for qualified higher education expenses. In most cases, earnings are also free from state and local taxes.

But not everyone is sold on the benefits of 529 plans. In what I call my “Talk Back” feature, I occasionally allow people to respond to my columns. Here are some of the points made by the reader:

“The advantage of 529 accounts — their only advantage — is that gains are not taxed. But many stock investments lost money over the past 15 years.”

“Money in 529 accounts is counted in the college-aid formula. The more you save, the less your kid gets. Other investments, such as Roth IRAs, are specifically excluded from the aid formula. So any tax advantage on the income is more than offset by the reduction in financial aid.”

“The fees in most 529s are outrageously high.”

“If your kid decides not to go, or drops out, or gets a full ride academically or for sports, or you saved more than you need, you’re [out of luck]. You have to pay tax on all the returns, plus another 10 percent penalty.”

A smarter investment would be simply to move to “a better neighborhood” with better schools.

I asked two experts to address the reader’s arguments: Brian Boswell, vice president of savingforcollege.com, which provides advice on 529 plans; and Mark Kantrowitz, publisher of Cappex.com, a free website that connects students with colleges and scholarships. They offered the following rebuttals:

Returns can be good. “Depending on timing and the selected vehicle, as with any investment, the investor may have realized significant gains,” Boswell said.

A 529 does not significantly decrease financial aid.The value of the account set up by a parent or legal guardian is reported as an asset on the Free Application for Federal Student Aid, or FAFSA. But it only increases the student’s expected family contribution by a maximum of 5.64 percent of the account value, Boswell notes.

On the other hand, most assets in the student’s name are counted at 20 percent, he said. So when you take out money from a Roth to pay for college, it will be counted as student income on the following year’s FAFSA.

By the way, a lot of financial aid is offered in the form of loans anyway. Not saving now would only increase the amount your kid may borrow.

There are low-fee plans. You often have the option to open an account that is “direct-sold,” meaning you don’t go through an adviser. The fees on these plans “are not outrageously high,” Kantrowitz said. “Minimizing fees is the key to maximizing net returns.”

As an example, Boswell said that the fee for New York state’s 529 direct-sold plan is just 0.16 percent of a fund’s assets annually, and the plan offers the investor a wide range of Vanguard funds.

There is flexibility in the plans. As Kantrowitz points out, if a student ends up not needing the 529 plan funds because he or she wins a scholarship, the 10 percent tax penalty that the reader mentioned is waived on nonqualified distributions up to the amount of the scholarship. And although nonqualified distributions are still subject to ordinary income taxes, they are taxed at the beneficiary’s rate, not the parents’ rate, he said.

Better high schools don’t necessarily mean a lot of free money. There is a great deal of competition for limited scholarship dollars. So even if your child has great grades, the odds are not in your favor for significant financial aid.

On average, about one in eight students in bachelor’s degree programs has a private scholarship, according to Kantrowitz, and the average amount is $4,000. Throw in money from the school and government grants, and less than 1 percent of students in bachelor’s degree programs receive enough to cover the full cost of attendance.

“For most savers, 529 plans are an exceptionally good deal, and getting better all the time,” Boswell said.

The way I look at it, the risks of not investing in a 529 plan outweigh any downside. I’d rather err on the side of saving.