Section 529 Plans

Section 529 Higher Education Savings Plans

An effective way to invest for college?

Jeffrey Altieri

Abstract

This paper is about the Section 529 higher education savings plans that allow family members to receive certain tax breaks while investing for a child’s higher education. The data used in this study is the historical rate of return on a Connecticut 529 plan versus the benchmark, the S&P 500. The time period covered was the inception of this plan starting in 2002 up to the start of research on this study, the end of September, 2004. The tests show that although this particular 529 plan offers tax benefits that could help in investing for higher education, that this particular plan failed to outperform the market during the period observed. Therefore it is my conclusion that there are better investment options on the market to invest in a child’s higher education than this Connecticut 529 savings plan. This study may lead to further observation of other Connecticut 529 plans as well as 529 plans managed nationwide to figure out if 529 plans are as effective as advertised.

“529” college plans have become greatly debated in recent years as a tool for investing for college. The plan, which takes its name for the provision of the tax code that sanctioned them, is a college savings account which allows parents or grandparents to give gifts to children that will be later used to obtain a college education. Although some 529 plans have been around since 1988, the Economic Growth and Tax Relief Reconciliation Act of 2001 made sweeping changes to Section 529, most of which became effective in 2002. These changes offer substantial tax benefits to families seeking to finance the cost of college expenses. 529 plans offer families, regardless of income, the opportunity to generate tax-free earnings on funds specially set aside for higher education. These plans, which are run by individual states, can be of great benefit to children by allowing their family members to give money to them in advance to save for college. It can also be detrimental to not only the people who invest but the children who are receiving these gifts. I became aware of these 529 plans by reading “A Random Walk Down Wall Street” by Burton Malkiel. My motivation was to see if these 529 college saving plans are as effective as advertised and to look at the upsides and downsides of investing in them. Since there are tax deductions from investing in such plans for the donors, as well as gains earned and used towards a college education are exempt from Federal taxes, it is definitely an attractive offer.

Such a plan allows an individual donor to contribute up to $55,000 to the account with couples allowed up to $110,000 without paying gift taxes and without reducing estate tax credits (Malkiel, 2003). But as we know, if it does not outgain the alternative, then it is not a worthwhile cause. Plans have a 10% penalty that is assessed on the income portion of any distribution in excess of qualified higher education expenses as well as a penalty for withdrawals not made for a qualified use. Such penalties are on top of the federal taxes that now must be paid to due to non-qualifying use (Auster, 2003). Therefore, there is a need to examine further just how well these 529 savings plans are performing and whether it is a way to beat the market.

I. Literature Review

There are many positive aspects of Section 529 college savings plans that are attractive to parents and grandparents. These plans are designed to encourage saving for college or post-graduate education of the younger generations. These plans let the family save for any eligible higher education institution in the United States. Qualified higher education expenses include tuition, fees, room and board, required books, supplies and equipment at an eligible institution.

There is no question of the growing popularity in these plans. Their assets had doubled by 2003 and could triple to approximately $50 billion by 2005 (Karp, 2003). Contributions to a 529 account grow in an income tax-deferred environment, and distributions for specified higher education expenses are free from federal income tax. There are two types of 529 plans: savings and prepaid tuition. Many states have both types of plans and their effectiveness differs for the individual. The savings plans allow a contributor to put funds in a state-sponsored, professionally managed investment account for the benefit of child at hand. Prepaid tuition plans typically permit a donor to purchase inflation-protected tuition credits for a specified individual, and are therefore more conservative investments (Pfefferkorn,