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This is a two-part guest post written by Dr. Anne Champeaux, MD. Dr Champeaux is well versed with 529 accounts and has often shared her knowledge on social media groups. I asked her to write a post on it and she graciously obliged. We have no financial relationship.

Geez College is Expensive….

For physicians, the expectation our children will also attend and graduate from college is high. With this looming expectation, planning how to pay for this exorbitant expense may be quite anxiety provoking in the face of own expenses and student debt.

There are many ways parents and students can pay for college expenses, but let’s talk about the 529 plan. 

I am not a financial advisor nor a financial expert. I am a parent and a physician. My husband and I started a 529 plan for our son in the year 2001, shortly after the account inception in 1996. Our son is currently a junior in an out-of-state public school with a scholarship and I am using our 529 plan for expenses.  I have experience in opening, contributing, investing into, and using the 529 plan. 

What is a 529 plan? How do I get one?

A 529 plan is an IRS regulated state-sponsored plan which allows the account owner, usually a parent, to save money for qualified educational expenses. 

There are two types of 529 plans, pre-paid tuition plans and individual owned 529 plans which can be further classified as direct-sold or financial advisor-sold. 

For all intents and purposes there is ZERO reason to have a financial advisor sell and manage these plans for the owner. These plans were set up to be very simple, do-it-yourself, and hands off to allow families of all walks of income and investing experience to use these plans. 

Plans sold to parents by financial advisors are often ridden with commissions, higher fees and filled with high cost loaded funds for investment.

A worthy [Ed: and scrupulous] financial advisor will point parents to the state website of a plan for parents to open on their own. Accomplish this task yourself. It’s simple.

The actual account is owned by the parent. There is only one owner.  The account owner then names a beneficiary.

The beneficiary is usually the child who the owner is targeting the savings for. A beneficiary could also be a nephew, niece, spouse, other qualified relative or the owner can name him/herself as the beneficiary. My husband is the owner of the 529 account and our son is the beneficiary. 

Why save in a 529 plan? 

Tax-free growth of money. Bottom line.  I’ll demonstrate a couple examples. I’m terrible at math, but you get the idea….

Mary and her husband have a combined income of $200,000.  They save every month into the 529 plan they opened when their son was born contributing a total of $40,000 over 18 years. The money is invested in a low-cost index fund and the total amount in the 529 when their son graduates high school is $81,000. There is $41,000 of gains in the account that Mary and her husband will never pay taxes on when used to pay for their son’s college expenses.  The entire $81000 is used for qualified college expenses. (Qualified expenses include tuition and fees, required books, room and board, electronic needs).

Cindy and her husband also have a combined income of $200,000.  They were skeptical of a 529 plan and opted to save their money in a savings account.  They also saved $40,000 and the money grew to $54,000 (interest rate 3%).  Each year they paid ordinary income tax (32%) on the interest. Over the years they accrued $14,000 in interest.  After taxes this left a return of $49520 to pay for school.  Meh.

Karen and her husband also have a combined income of $200,000.  They were skeptical of a 529 plan and opted to save money in their own brokerage account.  They also saved $40,000 in a low-cost index fund and the money grew to $81000 just like Mary and her husband.  But Karen’s money is subject to capital gains taxes at 15% when they sell the index fund to pay for tuition. This leaves $74850 to pay for college.  (I left out calculating annual dividends and taxation, but you get the point). Meh.

Bottom line. 529 plan allows tax-free growth when the money is used for qualified higher educational expenses.  This optimizes the savings as there is no tax drag on earnings.  

One thing to realize is the amount the account grows is subject to the owner’s investment style and risk; but risk can be mitigated with adjusting the asset allocation for age of the child. 

I opted to use an age-based fund. These funds are very hands-off as the fund automatically adjusts the allocation of investments based on the age of the child. There are even different types of age-based funds based on risk such as high, moderate or low risk target funds. They all function under the same premise with the money gradually invested into lower risk assets as the child approaches college entry. 

Account owners can surely choose to self-manage their accounts and buy, sell and rebalance funds to fit their investment risk and needs.  

I am a fan of age-based “set and forget” type of investing for a 529 plan. I set an automatic $200 contribution each month into an age-based fund.  By the time my son entered college, I had invested approximately $43,000 and the account was worth over $125,000. The entire $82,000 of gains is tax-free money.

Why are parents skeptical of 529 plans?

The statistic is staggering, but in 2018 less than 18% of children had access to a 529 plan. This is mostly due to lack of knowledge of existence of the plans and unfamiliarity (approximately 1/3 of adults are unaware of 529 plans).

Here are a few other reasons in my experience discussing these plans with others:

“I don’t have the means to save into a 529 plan”

This is a reality for many families, but most physicians can budget college savings and use a 529 plan if they are planning to save. Some physicians may need to offset college savings while their own debts are paid. Some families may choose not to assist with financing college for their children. 

“The use of the account is too restricted” 

I find this to be largely untrue.  Even most scholarships do not cover 100% of all expenses.  For instance, my son’s scholarship covers food, but not rent. It covers books, but not a computer. No one is saying a family needs to put 100% of their expected expenses into a 529 plan, but whenever an expense is covered by the plan, the cost is offset by using the gains in the account. 

“What if I lose money?”

Yes, there is risk. If these plans are started early, the risk is mitigated by time in the market. Families can also invest in lower risk assets. 

“What if college is free in the future?”

No one has a crystal ball.  Maybe it will be free for some families. Maybe funds in 529 accounts will be allowed to be rolled over into a Roth or traditional IRA as to not penalize families who saved. No one knows, but I wouldn’t stop saving based on speculation.  

“The 529 plan savings will impact financial aid”

This is low on the reasons for the average physician. Physician income alone will preclude most need-based aid. It won’t affect merit-based aid and/or scholarships. Speaking of scholarships….

What if my child gets a scholarship?  

AWESOME! No frets.  What are the options?

• Account owner can take out the equivalent amount of the scholarship without penalty. Taxes still are paid on growth, so this may be an “ouch” for physicians who are in high tax brackets when their children enter college
• Change the beneficiary on the account.  Use the money for another child, yourself, a grandchild. 
• Do nothing. Maybe your child will go to graduate school 5-6 years later. Just continue to let the money grow. There is no urgency to do anything with it.
• There are probably plenty of qualified expenses not covered by the scholarship. Make sure you take advantage of paying for qualified items from the 529 plan.
• When all else fails, you can take money out and use for anything at 10% penalty plus taxes on any gains. 

We will continue the rest of the post next week. Hope you have found it useful so far. Stay tuned!