529’s and the Power of Compound Interest


Costs of a College Education
It has been said that the only thing more expensive than going to college is not going to college.  Some may view this with skepticism, when the annual cost of an out-of-state public university tops $40,000, and elite private institutions run significantly higher.  Yet the majority of those without a college degree lag behind in terms of wages and opportunities, and this disparity is expected to widen.  According to the Financial Times, the U.S. will probably create 15 million jobs in the decade leading up to 2020, and 65% of these positions will require post-secondary education and training beyond high school.

Assistance Available
The need for an advanced education to be successful in the workforce contrasts alarmingly with a steady fall in college enrollment since 2013, as reported by the National Student Clearinghouse Research Center.  This decline is due in part to the skyrocketing costs of college.  Financial assistance, however, is plentiful, and too many families fail to pursue or are not cognizant of the $257 billion in grants, scholarships and loans available.  Barry Fox, a Long Island –based Financial Aid consultant, wrote that in 2015 the Federal Government estimated that $18 billion was not distributed because either financial aid forms were filed incorrectly or no one asked for it.

What is a 529 Account?
In additional to being unaware of readily accessible aid, many do not fully perceive the tremendous advantages of a college savings vehicle called the 529 Plan.  A study sponsored by Fidelity Investments determined that only 32% of people could correctly identify a 529 Plan as an option for saving for college expenses.  A 529 Plan provides tax deferred growth and tax free withdrawals for qualified expenses such as tuition, room and board and supplies.  Moreover, 33 states, including New York, give residents a tax break if they invest in that state’s sponsored 529 Plan.  529 Plans are also assessed at a favorable rate when calculating financial aid.  Finally, 529 Plans are portable in the sense that while established with a designated beneficiary, the account owner can replace him with another beneficiary when circumstances dictate.    These features combine to make the 529 the best way to save for college.

Advantages: Ability to Change Beneficiaries
One of the concerns of building a savings account for a specific person to go to college is the risk that said person will not go.   While a 529 Plan will only benefit from favorable tax treatment if used for the beneficiary’s education, that beneficiary no has control of the account.  The account owner is the only party authorized to make withdrawals, and the account owner has the right to change to a new beneficiary with no tax ramifications or penalties if the current receives a scholarship or decides not to attend college.    The new beneficiary must be chosen from the immediate family, which includes siblings, nieces, nephews, even the parent himself.   Since 529 accounts have no age restrictions or time limits, a parent can name himself as a beneficiary until another suitable beneficiary becomes available.  Thus a parent expecting a child can establish a 529 with himself as beneficiary and then change when the child is born.   Although income taxes will not be due if a 529 is transferred to another qualified beneficiary, there may be estate tax consequences if the new beneficiary belongs to a younger generation.  The original is considered to me a making a gift to the new beneficiary, and if the gift exceeds $15,000, it has to be factored into the donor’s exemption of $5.6 million on federal estate tax.

Advantages: Lower Assessment for Financial Aid Purposes
Determining eligibility for financial aid begins when a family completes a FAFSA for the student applying for assistance.  The federal government and colleges examine a family’s income and assets detailed in the FAFSA to discern how much that family can afford to contribute towards the cost before receiving aid.  Some family assets are excluded altogether in the calculation, such as the family’s primary residence and life insurance.  Other assets are assessed at either a rate of 5.64% or 20%.  A higher assessment on an asset results in less aid.   Let’s say a child has $10,000 in a bank account.  That $10,000 asset will reduce financial aid by $2000.  That same $10,000 held in a bank account registered to the parent lowers aid by $564.  As far as the Federal government is concerned, the primary function of a child’s assets or income is to pay for college, while the parent’s assets/income satisfy a variety of family needs.    529 Plans owned by students or their parents are assessed at the lower rate of 5.64%.    529 Plans owned by non-custodial parties (such as grandparents) are excluded when tabulating family assets.  However, withdrawals from such an account will count as income of the student and be assessed at a much higher rate of 50%.  A 529 account owned by a grandparent is, therefore, best used for the beneficiary’s last year of college after the final FAFSA has been submitted.

Advantages: The Power of Compound Interest
Time is the most important variable an investor controls, and the power of compound interest is what allows a person of average means to save a healthy sum for college.  The following example will demonstrate this phenomenon.  Michael sets up a 529 Plan when his son is born and puts away $2000 on his birthday for the next 5 years, for a total of $10,000.  He then stops saving, but leaves the money in an account where it continues to accrue interest at 7% per year.  On the son’s 18th birthday, the account is worth $29,656.   Jennifer held off contributing to a 529 until her son’s 10th birthday, but likewise deposited $2000 per year into an account earning 7% per year and stopped after 5 years.  On her son’s 18th birthday, the 529 was worth $15,071.      Why the substantial difference in value when the principal ($10,000) was the same for both parties?  Most of the power of compound interest comes at the very end, so the additional 10 years Michael invested, the extra decade of interest on interest, gives him a huge boost.   The key to building wealth is to make regular deposits into an investment whose objective is growth while tolerating inevitable fluctuations and maintaining a long term outlook.

529 Plans are in no way the perfect funding vehicle.  They are included as an asset for financial aid purposes.  For withdrawals to be tax free, the money must be used for specific purposes.  Investment options are limited to what the state sponsor makes available, and principal could be lost if the investments perform poorly. Simply saving, however, is not enough.  To keep pace with escalating college expenses, money must be invested so it will grow, unencumbered by taxation.  Driven by the power of tax deferred compound interest, 529 Plans remain the best way to save for college.




Author: Daniel Mazzola

Daniel G. Mazzola, CFA, CPA is his clients’ first call when seeking financial advice and to get things done. For parents concerned about educational expenses, he can be relied upon for pertinent tax law, money saving strategies and prudent financing.