The primary and most tangible benefit of a 529 plan is the tax-deferred growth of the assets in the plan (growth is tax free to the extent the plan assets are used for tuition.) (See “529 Basics,” p. 55.) But this benefit must be weighed against the 529 plan's associated costs. The cost easiest to quantify is the administration fee that, along with other incidental charges like custody fees, vary, sometimes widely, by state. How the use of a 529 plan compares to saving for higher education outside of such a plan depends, at least in part, on the assumptions made about the investment performance, taxation of the assets outside of the 529 plan and the 529 plan administration fees.
We crunched the numbers, comparing saving for the costs of college (1) using a 529 plan, when the investment grows free of income tax but subject to plan administrative fees, and (2) outside of a 529 plan, when the investment is subject to current taxation (but, obviously, is free of the 529 plan administration fee). We found that whether a 529 plan makes economic sense depends on assumptions about things like tax rates, turnover and 529 plan fees — all of which are hard to predict. The 529 plan does enjoy an advantage over taxable accounts. But that edge is eroded when 529 plan fees are high and turnover outside of a 529 plan is low. Adding estate planning into the mix is a complex exercise without a clear answer, although the availability of the Internal Revenue Code Section 2503(e) exclusion for educational expenses is a factor militating against use of the 529 plan. Ignoring estate planning, however, the outperformance of 529 plans is reasonably consistent due to the income tax advantages of such accounts. That, coupled with the intangible benefits likely to be enjoyed by both the donor (for example, paying for a loved one's tuition) and the beneficiary (for example, knowing such tuition will be paid), may make use of a 529 plan attractive.
But let's see how we arrived at these conclusions.
There is an annual exclusion from the gift tax for gifts in 2006 of a present interest of $12,000 per donee. This amount can be doubled in the case of married donors who elect to split gifts (by properly filing a gift tax return). For simplicity, we therefore assume gifts of $24,000 are made at the beginning of the year for five years both inside a 529 plan and outside of a 529 plan (to the “taxable account”).1 The term of the analysis is 18 years. Within the 529 plan, the assets grow at 8 percent per year, but are subject to a plan administration fee, which is a percentage of the assets in the plan.2 Outside of the 529 plan in the taxable account, the assets also grow at 8 percent but are subject to tax on all realized gains.3 We assume there is turnover in the portfolio, which we define as the portion of the return subject to tax each year. Gains are taxed at the rate of 25 percent. For consistency, we assume the cost of managing the investments within the 529 plan and the taxable account would be the same so we ignore them in the comparison.4 We also did not factor in any state income tax savings for a gift to the 529 plan where the donor is resident. If we did by, say, creating a side account also subject to current taxation, the 529 plan's performance would improve. But we didn't because not all states offer such income tax deductions.
Tuition is assumed to be $30,000 per year in today's dollars, growing at the rate of 5 percent per year. At the end of an 18-year term we subtract from the 529 plan the future value of the cost of tuition for four years. Assets remaining in the 529 plan are reduced by income taxes of 35 percent and the 10 percent penalty (taking into account the return of the donor's contributions which is not subject to tax or penalty). We assume the taxable account is liquidated with all gains taxed at a rate of 25 percent and the tuition is subtracted from the balance. The ending values are then compared.
Because the analysis is very sensitive to the key assumptions, we looked at various combinations of turnover (which impacts the taxable account) and 529 plan fees. We assumed turnover of 100 percent, 80 percent, 60 percent, 40 percent and 20 percent per year and 529 plan fees of 0.20 percent, 0.40 percent, 0.60 percent, 0.80 percent and 1 percent. Of the 25 possible combinations, one example would be when turnover is 100 percent and 529 plan fees are 0.20 percent per year. In such a case all gains in the taxable account will be subject to current taxation (because turnover is 100 percent) and with a tax rate of 25 percent, the annual after-tax rate of growth would be 6 percent per year (8 percent less 25 percent of 8 percent). The 529 plan would grow at 7.8 percent per year (8 percent less the 0.20 percent plan fee).
What are the results for this fact pattern? The 529 plan in all cases did better than the taxable account. As expected, when turnover was high and 529 plan fees were low, the 529 plan outperformed the taxable account to a greater degree than when turnover was low and 529 plan fees were high. For example, assuming turnover of 100 percent and 529 plan fees of 0.20 percent per year, the ending balance after tuition and applicable taxes (and penalty in the case of the 529 plan) of the 529 plan exceeded the taxable account by about $60,000. But, when 529 plan fees were increased to 1 percent per year and turnover was decreased to 20 percent per year, the 529 plan outperformed by only $3,000. (See “Base Case Scenario After 18 Years,” p. 56.)
With the data organized so that turnover in the taxable account decreases and fees in the 529 plan increase, we can see the outperformance of the 529 plan diminishes, as compared to the taxable alternatives. This is consistent with expectations. Performance of the taxable account improves as turnover decreases and more gains escape taxation for a longer period of time. At the same time, the performance of the 529 plan is hampered by the higher fees.
Turnover and 529 plan fees are key variables — but not the only ones that impact the analysis. So we changed other variables, one at a time, to evaluate their impact. First, we lowered the tax rate on gains realized in the taxable account from 25 percent to 20 percent. The 529 plan, for the most part, continued to outperform the taxable account — but by less-and actually underperformed the taxable account when 529 plan fees were high and turnover was low. (See “Changing Key Variables,” p. 56.)
For example, assuming the lower tax rate applies, when turnover is 100 percent and the 529 plan fees are 0.20 percent per year, the 529 plan outperforms the taxable account by roughly $40,000. Where turnover is 20 percent per year and the 529 plan fees are 1 percent per year, the taxable account outperforms the 529 plan by roughly $12,000. This highlights the improved performance of the taxable account attributable to the reduced tax drag.5
A change in the tuition had a surprisingly large impact. When we increased it from $30,000 per year to $32,500 per year (all else being equal), the performance of the 529 plan improved with respect to the taxable account. This highlights the other advantage of the 529 plan: the fact that tax-deferred growth of the plan assets becomes tax-free growth to the extent tuition payments are made. (See “Changing Key Variables,” p. 56.)
Lastly, we recognized that it was unrealistic to hold investment returns constant. We decided to introduce volatility into the equation and replaced the fixed rate of return with one based on historical returns. We allocated assets only to U.S. stocks and bonds, which, using historical returns from 1945 to 2005, had average returns of 13.15 percent and 6.03 percent, respectively. A blend of 30 percent U.S. stocks and 70 percent U.S. bonds produces an average of 8 percent return on investment. While in reality the asset allocation and investments selected would change over time, by choosing an asset allocation with the same expected return as the fixed return, we could isolate the impact of volatility of returns on the comparison. For each fee and turnover combination, we randomly drew a set of returns from one of the years (from 1945 to 2005) and applied it to each account (with the same tax rate assumptions) for the 18-year term of the analysis and compared the ending values. We repeated the process 9,999 more times for that fee and turnover combination and took the average of the differences for the 10,000 trials. We did the same for every other fee and turnover combination. (See “Volatile Returns,” p. 59.)
The results are similar to the base case with fixed returns. There seems to be one relatively minor difference: The taxable account suffers a bit less in down years because no taxes are paid while the 529 plan is still subject to fees.
How do these findings influence estate planning? Contributions to a 529 plan for the benefit of another person (such as a child or grandchild) are taxable gifts. But the gifts can be protected from the gift tax by the annual exclusion. Additionally, a special rule applicable only to gifts to 529 plans allows a donor to accelerate five years of annual exclusion gifts (or up to $120,000 in 2006 for married contributors: $12,000 multiplied by two and again by five) to a 529 plan. Generally, assets contributed to a 529 plan are not included in the donor's estate for estate-tax purposes (they would be included in the beneficiary's estate if he were to die with unused plan assets). But if the donor made a contribution to a 529 plan utilizing the five-year acceleration and died within the five-year period, the portion of the amount gifted that is allocable to the period after death would be included in the deceased donor's estate.
When comparing the 529 plan to a taxable account, the ability to frontload the 529 plan makes a big difference. We revised our analysis so that, with the 529 plan, five gifts of $24,000 were made up front while, with the taxable account, they were at the beginning of the year for five years (all else being equal). To avoid divining the “cost” of using part of the applicable credit amount, we did not frontload the gift to the taxable account. As one would expect, the performance of the 529 plan improved dramatically. (See “Frontloading Is Ideal,” p. 59.)
While there is clearly a potential income tax advantage to using a 529 plan, it costs something from an estate-planning standpoint: the use of the annual exclusion.
Some more background is needed to better understand the issue. Gifts to minors are usually made in the form of transfers to custodial accounts under the Uniform Transfers to Minors Act (UTMA), Crummey trusts (which give the beneficiary certain annual withdrawal rights) or minority trusts (which give the beneficiary access to trust principal upon attaining age 21) — all of which qualify for the annual exclusion. Funds set aside in this manner are generally not used for beneficiaries' education expenses, because there is an additional exclusion from the gift tax under IRC Section 2503(e) for payments of certain educational expenses on anyone's behalf if the payments are made directly to the educational institution. There is no limit on the amount of the educational expenses and such expenses do not count against the annual exclusion. In contrast to the definition of “qualified education expenses” for 529 plan purposes, the exclusion under IRC Section 2503(e) does not apply to books or room and board. So in our analysis, we focus only on the overlap: the tuition.
The availability of the exclusion allows for the transfer tax free payment of tuition without use of the annual exclusion. The IRC Section 2503(e) exclusion for educational expenses, however, is inapplicable to contributions to 529 plans and thus calls into question whether one should (1) use the annual exclusion to fund a 529 plan or (2) forgo the use of a 529 plan and make annual exclusion gifts to or for the beneficiary with the expectation of paying for the beneficiary's education directly using the IRC Section 2503(e) exclusion from the gift tax for education expenses. The issue, in essence, appears to be whether the potential income tax advantage of the 529 plan (taking into account the applicable taxes and fees) more than makes up for the increased exposure of one's assets to the transfer tax by failing to use the available IRC Section 2503(e) exclusion from the gift tax for education expenses.
In our frontloaded fact pattern, the 529 plan provides an advantage of roughly $35,000 to $100,000, depending on the assumptions made. One way to view the cost of not using the exclusion from the gift tax for the payment of tuition expenses is the increased exposure of one's estate to the gift or the estate tax. A longhand way of analyzing the problem is to compute the estate tax of a donor assuming he dies at the end of the 18-year period we've discussed, both having (1) used a 529 plan to pay for tuition (expending the annual exclusion) and (2) paid tuition out of pocket using the IRC Section 2503(e) exclusion and made annual exclusion gifts to the beneficiary.
Assume, for example, that the donor in our example has $10 million. In one scenario, he funds the 529 plan and in the other he makes annual exclusion gifts of $24,000 to a beneficiary for five years, then pays for the beneficiary's tuition out of pocket using the exclusion from the gift tax for qualified education expenses. All assets grow at 8 percent, but outside of the 529 plan turnover is 60 percent and gains are taxed at 25 percent. An annual fee of 0.60 percent applies to the 529 plan.5 At the end of 18 years, tuition is paid and then the donor dies, with all remaining assets subject to estate tax at the rate of 50 percent.
In the first scenario, the amount left in the 529 plan (after income taxes6 and penalty) would be roughly $98,000 and the donor would have an estate of $28.2 million netting his heirs almost $14.2 million (all of $98,000 and one-half of $28.2 million). In the second scenario, about $305,000 would, for instance, remain in the gift account, and the donor's estate would total a little less than $28 million because of the tuition payments, netting the heirs almost $14.3 million (all of the $305,000 and one-half of the almost $28 million). (See “An Estate-Planning Perspective,” p. 60.)
Essentially, the income tax advantage of the 529 plan did not make up for increased estate tax exposure from failing to use the tuition exclusion. A shorthand way of analyzing the problem would be to apply an estate tax rate to the expected tuition (50 percent of roughly $289,000 in the above example or $144,500) and consider it the transfer tax cost of using the 529 plan. You would weigh this against the potential income tax advantage of the 529 plan ($35,000 to $100,000 in our example).
Either way, however, bringing estate planning into the analysis of use of a 529 plan introduces additional layers of speculation (over and above tax rates, turnover rates, fees etc.). First, we assumed an estate tax rate of 50 percent. Of course, under current federal law, a credit protects transfers of up to $2 million from the estate tax from now through 2008 and the excess is taxed at rates as high as 46 percent in 2006, decreasing to 45 percent in 2007. In 2009, the credit will protect $3.5 million from the estate tax (with the excess taxed at rates as high as 45 percent). For 2010, the estate tax is repealed, but without further legislation the repeal sunsets or expires at the end of the year (Dec. 31, 2010) and comes back in its 2001 form in 2011. Because of the federal repeal of the credit for state estate taxes paid, states are all over the map (no pun intended): some have no estate tax, while others have rates as high as 16 percent (which can be deducted for federal purposes). For our analysis we measured the estate tax at the end of the 18-year term, but it is not known when or even if an estate tax will be assessed.
Which brings us to the last problem: If one's plan is to forgo the use of a 529 plan and later pay tuition out of pocket using the exclusion for qualified tuition expenses, mortality must be considered; because the exclusion from the gift tax for education expenses can only be taken advantage of if the donor is alive, there is no testamentary equivalent.7 Consequently, the ability to gift today to a 529 plan will be more attractive to older donors (for example, grandparents) than the arguably more efficient use by younger donors of the IRC Section 2503(e) tuition exclusion.
There are a variety of other issues to consider when choosing among different states' 529 plans or whether to use a 529 plan at all. States limit how often changes can be made to the investment framework selected (changes can generally be made only once per year). States also may change 529 plan investment alternatives and fee structures, forcing contributors to closely monitor the accounts for any such changes.8 Only cash contributions can be made to a 529 plan — precluding the use of low-value assets with high appreciation potential or assets subject to a valuation discount (this further undermines the use of the annual exclusion to fund a 529 plan, because a gift of such assets can be used to transfer substantial amounts of wealth). In some states, ownership of a 529 plan cannot be transferred to estate-planning entities such as trusts that may provide creditor protection, among other benefits, or, in the case of a revocable trust, that may permit the avoidance of probate. Lastly, and perhaps most importantly, without further legislation, certain of the provisions of IRC Section 529 sunset on Dec. 31, 2010. If that were to occur, 529 plan assets would continue to accumulate tax-free, but withdrawals for qualified education expenses would be taxed as ordinary income (again taking into account the donor's contributions which would not be taxed) and all other distributions would also be subject to the 10 percent penalty. That would, of course, eliminate a significant benefit of 529 plans over taxable accounts.
Ultimately, the results of any analysis that involves at least a half a dozen variables — including, but not limited to, future tax rates, turnover and investment returns — and extends for almost two decades must be taken with a grain of salt. That does not mean, however, that the trends and relationships observed should be ignored. On the one hand, we observed that 529 plans have an inherent advantage that, across a wide range of possibilities, is rarely overcome. On the other hand, a donor who can afford to make contributions to a 529 plan does so at the expense of his annual exclusion with respect to that donee. But despite that cost and putting aside all the speculation involved both with respect to the economics and transfer tax consequences, we have also observed that there is a certain satisfaction a donor feels when “paying for the tuition” of a grandchild or child. In addition, if the beneficiary is the donor's grandchild, a burden — heavy or light — is lifted from the shoulders of the beneficiary's parents. And (one hopes) the beneficiary will be grateful. These intangibles, and the tangible income tax benefits, may tip the scales for most people in favor of using the 529 plan, even those for whom the “wasted” annual exclusion could be relevant.
The authors thank for their assistance with this article their colleagues at Morgan Stanley and Co., Inc., Nicholas Altieri, Christopher Leung, Alexis DeSieno, Paul Stam and Ian Weinstock.
The views expressed in this article are the authors' and not Morgan Stanley's.
- We assume all transfers for the benefit of a grandchild are excluded from the generation skipping transfer (GST) tax and, accordingly, have ignored GST tax planning and vehicles such as health and education exclusion trusts (HEETs) for purposes of these analyses and this discussion.
- For simplicity, we reduce the rate of return on 529 plan investments by the plan administration fee.
- Hypothetical results are for illustrative purposes and not intended to represent the future performance of any particular investment. Principal value fluctuates with the market and may be worth more or less than original costs. Also, we assume the gifts are not made to a grantor trust. Even if they were, taxes would still need to be paid. This allows us to clearly isolate the potential tax advantage of the 529 plan.
- 529 plans are typically invested in mutual funds, which can at times be more expensive than other investments a donor may be able to access. An indirect way of considering this would be to focus on the 529 plan fees that are on the high side (that is to say closer to 1 percent than 0.20 percent). So-called “broker sold” 529 plans can be subject to additional fees and may be viewed the same way.
- We had no special reason for choosing this particular fee and turnover combination other than it being in the middle of the range for the combinations rather than one of the extremes.
- Assets remaining in the 529 plan are not includible in the donor's estate for estate-tax purposes.
- Again ignoring HEETs trusts.
- If an undesirable change were to occur, rollovers from one 529 plan to another are permissible if the new plan is for the same beneficiary or a member of the beneficiary's family (including a spouse) and if it is paid to the new plan within 60 days of distribution from the old plan. Only one rollover is permitted within 12 months of the distribution.
An Estate-Planning Perspective
Heirs may fair slightly better if a donor pays tuition directly and uses the tuition exclusion, rather than using a 529 plan
|Scenario 1: Gifting to 529 Plan||Scenario 2: Gifting to Taxable Account and Paying Tuition Directly|
|Net Amount After-Tax in 529 Plan||$97,784||Net Amount Gifted to Beneficiary||$305,878|
|Donor's Estate After Estate Taxes||$14,100,435||Donor's Estate After Estate Taxes||$13,974,360|
|Total Value Transferred to Beneficiary||$14,198,220||Total Value Transferred to Beneficiary||$14,280,238|
|*Assumes an estate of $10 million; asset growth of 8 percent; 60 percent turnover for assets outside the 529 plan; 25 percent capital gains tax; 529 plan fee of .60 percent; and estate tax rate of 50 percent.|
|Source: Vincent C. Travagliato and Michael T. Lippincott|
Summer Impressions: Claude Monet's 1907 “Nymphéas, temps gris,” was part of his water lily series. It sold for $11.216 million on May 2 at Christie's New York's “Impressionist and Modern Art” sale.
Know the federal and state law — and issues
Qualified tuition programs, commonly referred to as “529 plans” after the enabling section of the Internal Revenue Code, are income tax favored vehicles for saving for the costs of higher education. Contributions to such plans grow free of federal income tax and withdrawals are income tax free under current legislation if used to pay for the qualified education expenses of the beneficiary.
Federal Income Tax
Internal Revenue Code Section 529 provides that a state may establish and maintain programs (529 plans) that allow an individual to either prepay tuition1 or contribute to an account which can be used to pay for a student's “qualified education expenses.” Contributions to a 529 plan are not restricted based on the income of the contributor, so anyone can open a 529 plan. But there are limits on how much can be contributed to a beneficiary's 529 plan. The limits are set by each state based on the amount the state determines to be reasonably necessary to provide for the qualified education expenses of the beneficiary. Currently, most states' limits are between $250,000 and $325,000 Only cash can be contributed to a 529 plan.
If these and certain other statutory requirements are met, 529 plan assets will grow income tax free while they remain in the plan and distributions for qualified education expenses will be tax free. If assets are withdrawn from a 529 plan but not used for “qualifying educational expenses,” the amount of the distribution attributed to account earnings also will be taxed as ordinary income (at federal rates currently up to 35 percent) — plus a 10 percent penalty generally2 will apply.
“Qualified educational expenses” are expenses for tuition, fees, books, supplies and equipment required for enrollment or attendance at an “eligible educational institution” (including additional expenses for beneficiaries with special needs), and reasonable room and board if the beneficiary is at least a half-time student.3 Eligible educational institutions are any college, university, vocational school, or other postsecondary educational institution eligible for student aid programs under the U.S. Department of Education, which includes most (if not all) accredited (public, non-profit and private) postsecondary institutions. Eligible education institutions can be located in the United States or abroad, so long as they meet these criteria. The amount of room and board expenses eligible to be treated as qualified education expenses is limited to the greater of the institution's housing allowance or amount actually spent on student housing.
All states (and Washington) have put in place 529 plans. Generally, these plans are open to contributions from residents of any state. But states vary in their treatment of non-residents and generally treat non-residents less favorably than residents. Also, each state's income taxation of a resident's use of 529 plans varies. Some offer income tax deductions for a resident's contributions to the state's own 529 plan while others do not. Most follow the federal treatment and allow the 529 plan to grow state income tax free. Many (but not all) states parallel federal law by also exempting withdrawals for qualified education expenses. Some, however, fully tax the income (and some even tax the principal) portion of withdrawals.
When choosing between state plans, considerations include the state income tax ramifications (if any), the fees generally charged by the state to administer the plans, any applicable penalties for failure to comply with plan rules and the investment options. Investment options tend to be an array of mutual funds managed by professional investment advisors. The mutual funds may be broadly classified by a style like conservative, moderate or aggressive or be age-based (that is to say that the asset allocation shifts — generally becoming more conservative as the beneficiary approaches college age).
- Prepaid tuition plans are not discussed in this article.
- If, however, the need for the 529 plan assets is obviated by (among other facts), the beneficiary's receipt of a scholarship or financial aid, or the beneficiary's death or disability, the federal 10 percent penalty (but not the income tax) is waived. The return of the donor's contributions is not taxed.
- Half-time student means the student is carrying at least one-half the normal workload for the pursued course of study at the institution.