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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.

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Howard 6:33pm April 12, 2012

5. Prepaid plans are routinely skipped by advisers, primarily because they won't make any money on them and/or they aren't aggressive enough to make a good story. You generally go straight to the state managing it. As far as restrictions on schools, people who write them off need to think for a moment about what a prepaid is providing them and what the benefit is. We began with our prepaid plan in 2003. People laughed at us when they were living it up during 2007 as their investments would go up daily. By 2009 and 2010, guess who was laughing? Today, the funds in our prepaid will provide 100% coverage for our child to go to one of 80 schools in the plan and graduate entirely debt free. Don't let anyone tell you prepaids are a waste. We've also supplemented with a 529 savings plan, as Fidelity gives us a full 2% of all our credit card purchases as cash into the 529 - which gets us an more than an additional $1000 a year.

Howard 6:31pm April 12, 2012

The author has his view, which he is entitled to, though I don't agree with most of it. 1. 529 savings plans are the best college savings vehicles for most families. 2. Many studies show index mutual funds not only outperform most other non-index mutual funds, but also well over 50% of advisers. 3. Most 529 plans offer plenty of funds enabling most any mix of investment objective and level of risk. What the funds will provide is diversification, owning individual stocks will not. 4. Students who are 16-18 should be in a stocks for an extremely small portion of their college portfolio, because should any losses take place in that period, it's gone, you're not going to make it back. How'd you like to be the parent of the 16 year old that was 75% or more in individual stocks in the spring of 2009? If you're concerned about bonds in an age-based portfolio, then move a big chunk to a cash, CD, or money market portfolio. You don't want risk at this time.

College Savings 7:18am April 12, 2012

While not an issue across the most of the industry, certain 529 plans such as Utah Educational Savings Plan (UESP) do not provide the level of transparency that they should and are therefore difficult to work with. Therefore investors should avoid the Utah Educational Savings Plan (UESP) and ratings firms should account for this issue accordingly.

Ed Clark 8:26pm April 9, 2012

It is unfortunate that the author strives to denigrate 529 plans in an effort to elevate himself. He speaks of poor investment performance but fails to note or doesn't understand 529 plans are like 401k plans or IRAs as they are not investments but a way to own investments. You can choose any type of 529 investment from the world's largest and most respected investment firms offering all types of options. It is more a matter of making the right type of investment choice at the right time. As a financial advisor he should be aware that while a few had poor performance many had returns far in excess of the S&P 500 and in several cases available options exceeded 8% over the past 5 years. You can change investments 1x per year or simply choose another option in another plan which you can also do anytime. They have & are helping millions of families across the nation. One can learn alot more about 529 plans on the web than you can following Wilsey.

Jamaal C. LaFrance 10:24am March 31, 2012

Brent - What is a good alternative to a 529? I see you mentioned: "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."