If you're thinking about saving for your children's or grandchildren's education, which we all should be, the available options can seem daunting: education savings accounts, 529 plans, custodial accounts, trusts, etc. The question is, which is best for you and your family and, most importantly, which will provide the greatest stability and growth? My wife and I recently had our son and were confronted with this question.
I think for many people 529 plans are the default education savings and investment option, probably due to their wide availability and the lack of ongoing attention they require. However, Oregon's 529 plan and many others like it are subpar investments. As of December 2011, the annual return on Oregon's 529 plan was roughly 3% to 5% depending on an investor's risk tolerance and other options selected. However, Oregon investors are not confined to the Oregon 529 plan, they may invest in other states' 529 plans as well. In Utah for example the returns are higher, but so is the risk. Depending on an investor's risk tolerance, age group, and other factors the annual return in the Utah 529 plan ranged from 1% to 8%, roughly. While the high-end return of Utah's 529 plan far outstrips Oregon's 529 plan performance, so too does the risk. If an investor were to put their money in a simple mutual fund however, such as the Vanguard Wellesley Income Fund (Symbol: VWINX) which I myself own, the annual return would be 10.12% since the fund first started, 12.07% over the last 3 years, and 6.03% over the last 5 years (including 2008 when markets collapsed); all with only moderate risk.
Hold on, some might say, that's not the full picture. You are ignoring the tax benefits of the 529 plans. True, there are tax benefits to 529 plans. However, even when accounted for, they do not offset the investment underperformance of many 529 plans. In addition to the fact that 529 plans grow tax-free, meaning that their increase in value is not taxed when funds are withdrawn, Oregonians, like many residents of other states, can get an offsetting state tax deduction on contributions of up to $4,180 if they invest in Oregon's 529 plan. Assuming the taxpayer itemizes deductions, the actual benefit this translates into for a married couple making $95,000 per year is $282. Is that worth such significant investment underperformance? Clearly not.
[SIDE NOTE: I can't really critique Oregon's 529 plan without talking about the Oppenheimer fiasco. Several years ago when the economy crashed in 2008, Oregon's 529 plan manager, Oppenheimer, was basically fired and sued for their extreme investment underperformance. The settlement won Oregonians $20 million, which may sound like a lot but is minimal compared to what was lost. Now Oregon's 529 plan is under new management, which has performed more closely to market standards since 2010. Since we all know that past performance is no indicator of future performance (right?), the Oregon 529 plan under new management may turn out to be a much better investment vehicle than it has historically been.]
Fine, Oregon's 529 plan may not be the best option, but what is? For most people, trusts are not cost effective, custodial accounts must be turned over to the child at a certain age (typically before they are financially competent), and Education Savings Accounts offer few benefits. But what about an IRA? A Roth IRA has the same benefit of growing tax free as a 529 plan and contributions to a Traditional IRA provide a current federal tax deduction, which is more valuable than the state deduction offered by some 529 plans. Furthermore, while 529 plan distributions may be made only for education without incurring a 10% penalty in addition to taxes, an IRA may be withdrawn not only for the individual account holder's, their children's or grandchildren's education, but also for a down payment on a house or medical expenses. And with Roth IRAs the original principal deposited can even be withdrawn for any reason with no taxes or penalties.
To compare: with 529 plans money can only be taken out for education expenses forever, without incurring taxes and penalties; with IRAs on the other hand, in addition to the benefits I mentioned above, you can always get the money out penalty-free once you reach age 59.5 for any purpose. I dont know about you, but I put a premium on that kind of control. In any event, if you do open a 529 plan make sure you don't put more money into it then you will need for education expenses.
Finally, and I know some may see this as a drawback but I do not, an IRA provides control over your investments. 529 plans on the other hand are usually contracted out to investment firms whose performance is monitored by uninterested government officials. An IRA provides much more freedom and flexibility than a 529 plan and, even if invested in basic mutual funds, most likely better performance. For those of you who find the prospect of managing your own financial investments too intimidating, or are otherwise committed to opening a 529 plan, there is no question that 529 plans are good just, in my opinion, not best. If the choice is between opening a 529 plan or not saving for your children's education at all, go with the 529 plan; it is easy to administer and does provide tax benefits.
Now, there is a big drawback to an IRA. You can only contribute up to $10,000 a year if you are married and if you are making those contributions for your children it means you can't make them for your own retirement. Let's be honest though, how many of us are maximizing our own IRA contributions? I know I'm not. Also, once a child has any earned income, even from babysitting or mowing lawns, IRA contributions may be made in their name; although then they technically own the account so it is best not to tell them about it until they're older.
What if you are maximizing your IRA contributions or just want to set aside more money for your children than is permitted by most tax-favored accounts? There are other options. While my wife and I are currently putting education savings for our son in an IRA in my name, this is not our long term plan. Based on our future expectations of salary growth and disposable income, we hope to be able to set aside much more for our children than any tax-favored account would allow. So what then? I like 2503(c) trusts, but that is a discussion for another post.
Regardless of which option you feel is best for you and your family, I believe it is important to get others who care about your children's future involved in your planning. Once you have an account setup, whether it be a 529 plan, trust, or IRA, get grandparents, aunts and uncles, friends, and other relatives involved in helping you and your children achieve their education savings goals. Let them know that you would like, perhaps in lieu of cheaply made toys with a short shelf-life, a small $5 or $10 contribution to your children's education fund (this may be a request more easily made among close family and friends and, hopefully, one that could be reciprocal). As for grandparents, or anyone else for that matter, you don't have to wait for such a request, you can setup a 529 plan or trust for your grandchildren, or even an IRA in your own name and make contributions without being asked.
So... what are you waiting for?
