Smart Investing


March 30, 2012


529 plan tax benefits don't outweigh poor investment performance

My objective is to help people grow their wealth personally, or for their business, by investing in public companies at a low price and then selling them at a higher price.

This has worked out well for my portfolio and my clients' portfolios as well, both of which are managed side by side. It is easy for me to manage my client assets in their retirement and regular investment accounts.

However, every once in a while, I do run across what are known as 529 plans. If you’re not familiar with 529 plans, they are a way for people to save for their children’s college education. The number 529 comes from a section in the Internal Revenue Code, much in the same way 401(k) is a section in the Internal Revenue Code.

Some tax advisers might think 529s are great investments because of the tax benefits. Others, like myself, will admit that the tax benefits are good, but not so much for the investment options that are out there. I read an article last week stating that 85 percent of registered investment advisers do not actually like 529 plans.

I prefer not to use 529 plans, myself, but rather invest the money properly, and pay the tax on the gain. One comes out ahead by having a very good investment over a tax advantage plan with a poor earning investment. So while the tax benefit is one reason many tax advisers like 529s, they may not understand the poor investment performance. For years I have said to never look at the tax benefits of a poor investment — remember the leveraged partnerships years ago with the great tax benefits.

The tax benefits of a 529 include tax-free growth of the investment if the proceeds are used for college expenses, which include tuition, books, room and board, and more recently, the cost of a computer along with Internet connection costs. If the student lives off campus, the expenses cannot exceed what the costs would have been if the student were living on campus.

Contribution limits are $370,000, but one should be aware that all that money along with the hopeful earnings must be used for education. What if the student wants to go to San Diego State University, where yearly tuition is around $7,000? Add in room and board, books and a computer, and you may get to $120,000 for a five-year degree. What do you do with the other $250,000?

One option is naming another beneficiary who could be a child, grandchild, niece or nephew — the choice is yours. If you don’t want to go that route, you can withdraw the money with a 10 percent tax penalty and pay the income tax due. If you’re going to use 529 plans, I suggest underfunding them instead of overfunding them.

Another concern on the 529s that people may not think about is the gift tax provision. Currently, gift tax allows $13,000 for a single filer, and $26,000 for joint filers. Over a five-year time span, the total amount would be $130,000 invested in the 529 plan. Contribute more than that and you have entered into problems with the lifetime gift exclusion. Be sure to consult an estate planning attorney or a qualified tax professional if you have exceeded the annual gift limits.

Be careful to know which plan you are using: a prepaid plan or a savings plan. A prepaid plan allows one to purchase tuition credits at today’s rates to be used in the future. This plan can be restrictive on what colleges the student attends.

The more popular option would be the savings plan, in which the growth is achieved by investments into various portfolios, typically a set type of mutual fund. This is where a good investment adviser should be helpful on how to invest the funds.

Two big downsides with these plans: First, don’t fall for the age-based plan. The age-based plans will invest more in bonds. For example, if the child is 16-18 years old, 75 percent of the money could be invested in bonds, which is a terrible place to be for the next two or three years. Having more money in stocks would be better, but the age-based plan won’t allow it.

The other downside to 529 saving plans is that you are only allowed one exchange per year. While I’m not a trader, and would not plan to go in and out often, it would be possible to adjust the portfolio in January and need to do so again in September or October. Yet I would be forced to wait until January. I don't like to have my hands tied when managing money.

I have found a couple of 529 plans that are OK that we manage and add some value to if someone already has a 529 with a gain on it and they don’t want to pay the tax. But my feeling is that if you haven’t started a 529 plan, don’t.

Wilsey is president of Wilsey Asset Management and can be heard every Saturday at 8 a.m. on KFMB AM760. Information is provided by Reuters.


March 30, 2012