Important 529 Plan Features
August 30, 2019
Remy Blaire: Welcome to Asset TV. Back-to-school season is here. As the days get shorter and storefronts showcase dorm room gear, there's no denying that students are heading back to the class room.
Remy Blaire: The cost of a college education continues to ride, and US student debt has ballooned to over 1.5 trillion dollars. The cost of in-state tuition and fees at a public four-year college has tripled in the past three decades, when adjusted for inflation. Now more than ever, a saving plan for education has become an essential part of a comprehensive investment plan.
Remy Blaire: Today I'm joined by Michael Conrath, Head of Educational Savings at JP Morgan Asset Management; Thomas Rowley, Director of Retirement and Education Strategies at Invesco; and Doug Sue, Multi-Asset Strategist at QS Investors, an affiliate of Legg Mason Asset Management.
Remy Blaire: Gentlemen, thank you so much for joining me today. Well, first and foremost, it's that time of year when the days are getting shorter. Of course, we're all thinking about back-to-school, especially for those parents out there who's children are going off to school.
Remy Blaire: First and foremost, Tom, I want to start out with you. Everything, when it comes to savings, might seem obviously. But when it comes to 529 plans and saving for college, it's not so obviously. Can you tell me what happens when it comes to college kids and time?
Tom Rowley: I think that most advisors should be aware and should be promoting that, one, college is expensive. Two, your kids are going to grow up much faster than they think you are. Three, the time to start saving for college is now, and the amount to save is as much as you can.
Remy Blaire: Indeed, it does seem as though every year the cost of college tuition, whether we're looking at public or private universities, they continue to sky-rocket. There is no better time than the present to start investing. Now, Doug, can you outline what's covered by a 529 plan?
Doug Sue: Yeah, absolutely. I think we're all aware that when it comes to a 529 plan, typically what's covered is something that we refer to as qualified higher education expenses. Of course, I think most of us have a sense that this means the tuition, room, and board for a college or university experience.
Doug Sue: There are other things that 529 plans cover, as well. For example, they pay for a number of things, like the books, which can be very expensive for college; additional supplies; all types of fees. Even covering things like paying for a new computer and the internet service that comes along with using that computer, can be covered by a 529 plan expenses.
Doug Sue: Lastly, I think the point to make here, is that you actually don't need to limit yourself to an American university. These funds can be applied for higher education abroad, as well.
Remy Blaire: I think that's a very key point. There might be a misconception out there among some investors about how to apply a 529 plan. Indeed, if you look at the cost of textbooks nowadays, it's staggering, just as when we might have all been in an undergraduate or graduate school.
Doug Sue: Right.
Remy Blaire: Now Mike, can you tell me what makes a college savings plan successful?
Michael Conrath: Yeah. Well, first of all, it's important to have that plan in place. A lot of the research tells us that few families do actually have plan, so that's a great opportunity for advisors and clients to engage in that conversations.
Michael Conrath: At the simplest level, Remy, I think it involves three things. One is having a clear understanding of the costs. Tom talked a little bit about that, and we talked about rising tuition prices, so that is a moving target. That's number one.
Michael Conrath: Two is really having a healthy sense of a reality of financial aid. There's a lot of misconceptions around aid and what it is, versus what it actually isn't, and how that may impact a particular family. That's an important part of that plan.
Michael Conrath: Thirdly, don't just be a saver, but be an investor. When it comes to investing for college, 529 plans really have become the premiere way to invest. That's, again, Doug covered those key points there. Be an investor and consider 529 plans.
Remy Blaire: When it comes to the value proposition of these plans, Mike, many families may not be so familiar with the limits, in terms of contributions. Can you give us a little bit of insight into that?
Michael Conrath: Yeah. A lot of families think that you're limited to a state tax deduction amount. That's an important consideration. I'm sure we'll talk about that a bit.
Michael Conrath: Really, the limit is per plan per state. There are no federal limits on 529 plans, per se. Every state or every plan has its own limit per beneficiary.
Michael Conrath: That said, you do want to be cognizant of the federal gift tax rules, which do encompass the 529 rules, as well. If you consider the annual gift tax exclusion is $15 thousand a year, currently, per individual. If you leverage a 529 plan, you can actually front load five years’ worth of gifts in a lump sum.
Michael Conrath: Instead of being limited to $15 thousand, you can actually max out at $75 thousand per beneficiary. That's your $15 thousand times five. Or as a couple, grandma and grandpa, for example, can double down, do gift splitting. They can do $75 thousand each, which brings them to $150 thousand per child, per grandchild.
Michael Conrath: So you do have generous limits, and sometimes that is necessary, given where tuition prices have been and where they might be headed.
Remy Blaire: So Tom, 529 college savings plans are a tax advantaged investment vehicle. They are designed to encourage parents to save for higher education expenses. Can you tell me a little bit more about the structure, as well as the contributions?
Tom Rowley: Sure. Structure of a 529 is easy to explain. There is an owner and a beneficiary. The beneficiary is the student. The owner is generally the parent, or it could be a grandparent. It could be an aunt, an uncle.
Tom Rowley: Generally, the owner has a control over the plan. The owner can change beneficiary whenever they want. The owner can contribute funds and withdraw those funds if they want. They have the ultimate control over the 529 plan.
Tom Rowley: Then the 529 plan gives you flexibility. It allows you to change the beneficiary, as I said. It has the flexibility to say that I can use the 529 plan in Rhode Island and be from Illinois and send my child to a Texas school.
Tom Rowley: It's got control and flexibility and tax advantages. The money goes in after tax, grows tax deferred, and provided that you use the distributions for qualified expenses, it comes out tax free.
Remy Blaire: Tom, before I move away from you, I understand that you've seen how college savings plans have evolved over the years. Could you give us a little bit of an overview, in terms of changes you've seen in the industry?
Tom Rowley: Sure. 529s came out about 1996. I've seen the changes because I've got three kids, and now all three of my kids are out of college. I used a 529 to pay for all the colleges. Before 529s, what would happen is you would save your money in an account. Then the car would break, and you would spend that money.
Tom Rowley: One of the nicest things about a 529 is if clients put money in a 529, they generally won't take it out. Why? Because there's a 10% penalty if you're using the distributions for non-qualified purposes. So, you tend to put that money away, now it's earmarked for college.
Tom Rowley: The 529 has gotten better, and better, and over the years, in terms of the benefits and the features. In fact, the last Tax and Job Acts of 2017 changed the rules that you could use 529 for tuition for K-12. It's not only for college anymore. It's for education.
Tom Rowley: You could use it for tuition for K-12. You could use it for college. You could use it for graduate school. You could use it at an international cooking school, like Cordon Bleu, golf schools in Florida. There's a lot of flexibility and opportunity with 529.
Remy Blaire: I think you just highlighted the array and varieties of education institutions where these plans can be applied to. Indeed, given the rise in tuition costs, we know that many families can use a lot of help when it comes to making these payments.
Remy Blaire: Since we're talking about tax considerations, Doug, I want to move on to you and ask about how parents and grandparents can contribute for their children or their grandchildren when it comes to these types of plans.
Doug Sue: Yeah, absolutely. I think Tom did a great job outlining the fact that there is a great deal of flexibility. Ultimately, anybody can start a 529 plan where they are the owner for the benefit of a child, ultimately a student.
Doug Sue: There are differences when it comes to who should be the account owner, when you're thinking about things such as, potentially, financial aid. We get this question a lot, which is from a financial aid perspective, something that is commonly referred to as FASFA, which stands for the Free Application for Federal Student Aid, what is the best way to earmark funds for a future student from a maximization of financial aid perspective? The general guidance here is that we recommend to maximize potential financial aid benefit, those funds should be held in an account owned and controlled by the student's parents as opposed to grandparents.
Doug Sue: The rationale is this: If you think about ultimately, the student aid process, it's one that ultimately looks to calculate EFC. That stands for expected family contribution. Now, to maximize student aid, people look to minimize their EFC, or their own contribution.
Doug Sue: When you have funds that are held for the benefit of the student owned by an account controlled by the parents, that balance is ultimately recognized at around a 5.6% rate. Now, in a situation where those same funds are owned in an account controlled by the grandparents, or frankly anybody else besides that student's parents, those funds are recognized at a rate of 0%. They're not a part of that student's current FAFSA calculation, which is beneficial.
Doug Sue: However, when those funds are ultimately used, dispensed and used for the paying down of that student's tuition, those funds are recognized by FAFSA as income to the student, and recognized at a rate of 50%. Ultimately, even though there is not an initial recognition of those funds in an account held by their grandparents, it ultimately makes more sense, typically, for those funds to be held in an account owned by the parents, from a financial aid perspective.
Doug Sue: In general, though, there are a number of advantages to, let's say grandparents or other loved ones, still setting up an account held for the benefit of the student. Mike had gone through some of those at the beginning of our conversation. Typically, just as a reminder, some of those benefits include basically paying gifts forward to the benefit of a student, which has the result of lowering the taxable estate for an individual or a couple. Particularly for grandparents, who are more in that part of their lifecycle where they are thinking about estate planning, this can be a particular advantage.
Remy Blaire: I think it's helpful to understand the differences when it comes to parents, as well as grandparents, when it comes to this type of plan. Before we move away from this topic, Tom or Mike, do you have any advice, given that they're financial professionals watching this Masterclass? When they're advising their clients and talking about the best ways to contribute, do you have any insights or tips?
Tom Rowley: I think that the first tip I would say is if you're a financial advisor, you have this conversation with every client you have. Parents, grandparents, aunts, uncles, god parents, neighbors, strangers on the street. Basically, what you want is everyone to contribute to the 529. The 529 can be controlled by the parent, but anyone can contribute to it.
Tom Rowley: I would have the conversation about contribution for a 529, or a contribution for college savings and college education, with every client. Not everyone's aware of the 529. If you're a grandparent, you may have never seen the 529, because they really only came about in the mid '90s. You may not understand the benefits of it, and you may want to contribute to your grandchildren's college education.
Michael Conrath: Just to add to that. Where we've seen advisors have some of the best success, and when I say success, I mean getting clients to actually commit to a plan and following through with that and funding that as best they can, and doing that early and often, hopefully. Where they've had the best success is when they leverage that 529 or college planning discussion as part of a broader goals-based planning conversation.
Michael Conrath: As a parent myself, I tend to look at goals in isolation. I have three kids, just like Tom here. I like to know what each one has, but that's only a piece of the pie. You need to think broadly. Whatever money I contribute to my 529 may be money that could have otherwise been directed to a retirement plan.
Michael Conrath: I'm not saying you have to pick one versus the other. Ultimately, you need to do both. You have to have a separate strategy for both, but you have to look at these things together, holistically. That's really where, again, advisors really add tremendous value, is helping clients understand the trade-offs between those big goals, whether it's their estate or retirement planning, and funding college. Also, to the points that Tom and Doug made, understanding that there is some overlap, using a 529 plan as an estate planning vehicle, as well.
Tom Rowley: Right. I would also bring up that, I know Doug has a brand new child. That first birthday is going to come around. You're going to have the birthday party. You can tell everyone to contribute to the 529. If I was an advisor and I had a client who had a 529, I'd want to make sure that their relatives know that the 529 exists for the purposes of their contribution.
Tom Rowley: I may be going to a birthday party and we may want to give a small contribution. I don't want to fund the college education for my nieces and nephews, but I may be willing to make that small contribution. Over the years, it'll add up.
Doug Sue: One of the last things that I'll mention here is that we're all, most of us I would say, very familiar and used to the idea that part of our paycheck goes into a 401K. The same thing can basically be set up with a 529. Nowadays, most of the 529 plans that exist offer the ability for people to elect some sort of a regular percentage to go into that fund from a source like a checking or savings account.
Remy Blaire: Yeah. I think that's very helpful information. Mike, to your point, I do understand that situation. People might be concerned, "Do I allot these funds to your retirement plan or a 529? What do I do?" What would your advice be for financial professionals that are confronted with that? Is it more about the strategy?
Michael Conrath: Well, yeah, it is definitely about the strategy. I think it's important to recognize that strategy will be a little bit different for each and every client or family our there. What's important is that...
Michael Conrath: Just to take a step back, so putting on my hat as a parent, which by the way I never take off that hat. We never do. We try to on occasion, but we never do. You'll figure this out soon enough.
Doug Sue: Okay.
Michael Conrath: But I think what's important is that a lot of families... So, as a parent, your natural instinct is to take care of your kids first and foremost. Of course, I wouldn't argue with that statement. I want to be careful about it.
Michael Conrath: When it comes to financial planning, the dynamic changes a bit. You don't want to overshoot your college shavings goal at the expense of your retirement, or vice-versa. It is that balancing act. Again, that balance will be different for each and every family out there.
Michael Conrath: What we found from our research is that one in three parents have a "plan" in place to actually take money out of their retirement plan to fund college for their children. They're looking at their retirement plan, whether it's the 401K or their IRA, as potentially a piggy bank to pay those college costs down the road.
Michael Conrath: That can certainly have dire consequences for a number of reasons, compounding interest, tax consequences, penalties, so on, so forth. What's interesting is if you want to put some hard numbers to it, let's say that I have a 20 year time horizon before I'm going to retire.
Michael Conrath: I decide to take $25 thousand out of my retirement plan today to put towards my child's college. Every $25 thousand that I pull out of that retirement will cost me roughly $80 thousand, 20 years down the road in lost retirement savings. That's just pulling out $25 thousand. That's barely the cost of a public university today.
Michael Conrath: You can compound those numbers from there. I think, for advisors that are tuning in, it's important to run some of those numbers, because when you actually see the numbers... It's not for fear fact, just like we don't like to use costs for fear factor, but when you see the impact on their overall financial equation, we've seen that many clients say, "Okay, I do need a separate strategy for funding college. Here's what I'm going to do."
Michael Conrath: The other thing I would add is, if you're opening the account, sign up automatically for ongoing monthly contributions, unless you're making the larger gifting contributions, where you have some restrictions. If you're doing amounts below the gifting limits, sign up for automatics.
Michael Conrath: If you do not do it at the point which you're opening the account, life enters, kids enter the equation. The busyness ensues, and you just kick the can down the road. Fund it today and sign up today for the automatics.
Tom Rowley: I would also add that the nice thing about 529s is anyone can contribute. It would be strange to me to say to my mom and dad, "Would you like to contribute to my 401K?" Because the answer would probably be, "No."
Tom Rowley: But if I said, "Here's your grandchildren. Would you like to ensure that they go to college?" The answer is much more likely to be, "Yes."
Tom Rowley: Again, it may not be the bulk of the expense, but if I can get them in an ongoing contribution plan, that's going to really help.
Remy Blaire: Gentlemen, I think you both brought up very important points when it comes to making contributions to make sure that they're automatic. Also, to your point, Tom, it would be very interesting to request a contribution to a 401K, but I'm sure you'd do better with a 529 plan.
Remy Blaire: Now, we've highlighted some of the benefits of these types of plans. Tom, can you tell us about tax advantages, and also highlight some of the benefits when it comes to control and flexibility?
Tom Rowley: Again, 529, it was really structured so that it was easy to understand. The contributions go in after tax. You've paid taxes on the contributions. You'll never pay taxes on those monies again.
Tom Rowley: The money grows tax deferred, and then distributions come out tax free, provided, for qualified expenses. We talked about the qualified expenses that qualify. Any distributions for non-qualified expenses, there's a 10% penalty.
Tom Rowley: One of the strategies, of course, is you can move a 529 from one child to the next. You can change the beneficiary. In theory, if I had had money left with my oldest child, which I didn't, but in theory, I could have changed the beneficiary to one of my younger children.
Tom Rowley: That also brings up the point of, some people will say you have to open up a 529 for each student, as opposed to one and keep moving it down. Then you run into asset allocation questions. But the 529 structure makes it so that the flexibility is there to change beneficiaries.
Tom Rowley: I can change beneficiaries, in theory, every day. I know that I used to threaten to change the beneficiaries every night at dinner. Whoever was not eating their vegetables was obviously not going to go to college, so they didn't need their 529.
Michael Conrath: Does that work?
Tom Rowley: Just for a while.
Michael Conrath: [crosstalk 00:21:09] for dinner.
Tom Rowley: Just for a while, and then it all falls apart, once they realize, right?
Tom Rowley: The flexibility is there to change beneficiary. I can use the 529 at any college I want. Generally, any accredited college, I should say. Nowadays, we tend to say post-secondary education experience, right? Which means that you can use it for vocational school, trade school, colleges, universities, graduate school. I think that the 529 plan has all the flexibility that is needed by any of your clients out there.
Remy Blaire: Tom, I think you offered some sage advice when it comes to the dinner table with your children. Mike, I know that we covered this in terms of retirement accounts, but we know that college is getting expensive, whether we're talking about state schools or, of course, private school tuition. What about parents that can't afford to pay for their child's degree? What are the risks if parents dip into their retirement accounts?
Michael Conrath: I think the risk is that they end up in retirement and realize that they can't pull a financial aid lever for retirement. There is financial aid for college, as we all know. We talk about that with clients and families. But you don't have that same lever to pull for retirement. Yes, you do need to pay yourself first, but while also funding college for your kids at the same time.
Michael Conrath: I think this gets to a bigger issue, is that when it comes to financial aid, is that many families think that aid is synonymous with free money. For many of us, unfortunately that's not the case.
Michael Conrath: We've all been on the soccer field or the basketball courts. All three of my kids do play competitive sports. I'm right there and I look at every parent's eyes. They have starts in those eyes, and dollar signs to some extent, because everyone thinks they're raising the next star athlete.
Michael Conrath: One of the big pitfalls that we see is that families don't save or invest. They forgo that 529 because they're betting on financial aid being there as their backstop to cover their shortfall or their gap when it comes to their 529 plan, or college savings plan overall.
Michael Conrath: You have to be cognizant of that. Advisors who really do comprehensive planning have really done a great job with focusing on that financial aid piece.
Michael Conrath: As much as my son is a great baseball player, I know that when I was up at that last tournament in [Cooperstown 00:23:44] not too long ago, and I look out and see a thousand kids. Only three in a thousand are getting a full ride. By the way, that is the stat, 0.3% this past year got a full ride, so enough grant or scholarship money to cover the costs.
Michael Conrath: Again, as a parent, that kind of puts things in perspective. Financial aid cannot be your primary strategy. Again, you do need to think of the implications of saving now and how that will affect your retirement, as well as your other goals.
Tom Rowley: I think to add to that, the 529 doesn't have to pay for all of college. What's most important is that you're saving for college. If you had a 529 that paid for freshman year, where you're one year closer to your goal.
Tom Rowley: A lot of people think, "Well, I've got to have college paid for before I get there." The reality is, you have to save for college because it is expensive and it's going to get more expensive.
Tom Rowley: The goal is to, "Gee, I'll have more money in my 529 than I'll ever need." The reality is, you may come up short, but fill in the gaps with loans, and grants, and scholarships and work, because they can work.
Doug Sue: Yeah, I mean, I think Mike, something you mentioned earlier, I want to actually reiterate, because I think it is such an important point. Going back to the original question, which is this trade-off between funding from a 529 versus pulling out of a 401K, as an example. Not only will you incur those penalties, but the biggest trade-off is that additional time-value of compounding money.
Michael Conrath: That's absolutely right.
Doug Sue: People consistently forget what that additional 20 years is going to bring them if they're able to keep those funds, regardless of the market cycles that we go through. An additional something like 20 years is going to have huge benefits for their own retirement well-being. That's ultimately another thing that people should consider as to why they should really try not to dip into those funds earmarked for their own retirement.
Remy Blaire: Well I think you brought up a lot of points that highlight the importance of a reality check when it comes to saving for college. To keep in mind that our sons and daughters won't necessarily become the next Tiger Woods, or Serene Williams, or David Beckham, just because they're really good at a sport.
Remy Blaire: So Doug, that brings me to my next question. What if a very fortunate or lucky circumstance, your child doesn't need the money for college? Or what if they get a full-scholarship>
Doug Sue: Right. This is a question that we hear a lot, people saying, "Well, what if?" They may not be aware of the numbers and statistics that Mike just ran through in terms of that .3% getting a scholarship.
Doug Sue: There obviously are some individuals, some students who are lucky enough to receive a scholarship or a grant, whether it be athletic-based or for other reasons. In the situation where those children, those students receive that funding to cover entirely or part of their college tuition...
Doug Sue: The great thing about a 529 is that those parents who have saved for so many years, they're not necessarily at a disadvantage. In fact, parents who are the owner of that account can pull funds out of that 529 plan once that child goes to college, up to the value of that grant or scholarship, and not incur any of the penalties or taxes that we've been talking about.
Doug Sue: In that sense, they really are covered. There really is a built-in exception specifically for when a child does receive a scholarship or a grant to fund their college matriculation.
Remy Blaire: Gentlemen, before we move away from this section, I do want to touch upon financial aid. If anybody would like to chime in here, what do you think is the most important thing to highlight when it comes to financial aid? What are some of the myths out there that you'd like to dispel?
Tom Rowley: Well, the first myth is that it's easy to fill out the paperwork, because it's not. The only worse thing that you'll have besides the FAFSA form is when you have to get your kids to fill out the essay for their college. They don't want to do that, and you'll be like, "Fill out the essay. Fill out the essay."
Tom Rowley: The financial aid is based upon the assets of the parents, the child, the family contribution. The expected family contribution to college, the EFC that comes out of the FAFSA form.
Tom Rowley: I think that you'll be surprised by how high it'll be. That they expect the family to contribute quite a bit to the college experience, if you will. When you're filling out that form, you're going to be thinking, "I wish I had saved more money in a 529."
Tom Rowley: That's the biggest takeaway I got when I filled out the form, is I wished I had saved more. If I was an advisor, I'd be saying this to, again, every client you have. Whether your child is three months old or 13, it's never too late to save, and it's never too early to save.
Michael Conrath: Just to add to Tom's comments, I agree with everything he said. I think the other misconception that families have is, "If I do save or invest, then that will just clobber my chances of getting aid." That is not necessarily the case.
Michael Conrath: Tom, you eluded to this a bit, just some of the inputs into that FAFSA formula. Income is the biggest driver. The family's income, that number is what it is. Sure, we would never tell a family to make less money to try to get more aid. We all certainly agree on that.
Michael Conrath: That number is the biggest input. Beyond that, it's going to be the assets. The assets of the parents of the student applying for aid, and the assets of the student.
Michael Conrath: The way the FAFSA is structured, there's actually more onus on the child, in terms of the inclusion rate to save or invest. So, 20 cents of every dollar that is in a child's name... By the way that would include something like a UGMA, a UTMA account, because that is technically an asset of that minor child. That would be included at that 20% rate.
Michael Conrath: I think Doug may have alluded to this, but that 5.6% earlier, so roughly five or six cents of every dollar in a parent’s name. By the way, that would not include 401Ks, assuming they haven't tapped into those. Does not include their IRAs. For FAFSA purposes, does not include their home equity. Those are, for many families, their biggest assets, right there. Those, from day one, are excluded from the formula.
Michael Conrath: Now, pan the camera the other way and you look at their savings accounts, their checking accounts, their 529 plan. Stocks, bonds, mutual funds, separately managed accounts. Go down the list. Again, that's that 5.6% that Doug referenced before.
Michael Conrath: So, all in, that five or six cents of every dollar that family saves in a 529, or elsewhere for that matter, goes against the aid formula. So do the quick reverse math on that, 94 to 95% of every dollar you saved is exempt from that. That's after certain exclusions, as well. It's not dollar one. That's an important consideration, is that savings, and investing, and leveraging 529 plans is included at a relatively low level in that federal aid formula.
Doug Sue: I think that the only thing that I would add to this conversation is that in general there really isn't a lot of room to "game the system." People are constantly thinking about, "Well, is there a way that I am advantaged if I do it this way or think about it that way?"
Doug Sue: This has been well thought through by the financial community at large, and the legislatures that are behind the 529 plan creation. People shouldn't spend too much time trying to think about ways to do that, because frankly, the system is set up to be fair.
Doug Sue: You don't need to try to think about moving assets around. We covered already the idea that in fact when they're being held from a grandparent's perspective, there's still a reason for them to set up funds, but ultimately that's recognized as income. Income, as Mike mentioned, is recognized at a far higher rate than the balance of funds as if they were simply recognized from perspective of parental-owned account.
Tom Rowley: I would add to the point that you fill out the forms and what it is does is it gives you access, if you will, to grants and scholarships, but it's really loan. Most people are getting loans. So, if we compare the debt burden to the graduate, your kids graduate from college, they walk away with a loan that's huge.
Tom Rowley: If I had a choice between... If I looked at education not as an expense but as an investment, I'd almost be saying, "Save your money as opposed to getting the loan." The last thing I would do is want to hand a 24, 25 year old a six-figure loan that they'll spend the rest of their life paying off.
Michael Conrath: If I could just add one other comment is that, as you look at, as relates to this aid conversation, if you look at college savers, in general, about 44% of them who saved, they're saving for college for their children, they're sitting in cash. They're sitting in a checking account, savings account, CDs.
Michael Conrath: If you ask them why, it's either they haven't gotten around to actually investing. But often enough you'll here, "I'm worried if I do move out of a cash into an investment like a 529, then, again, I will get clobbered from an aid perspective." The reality is your cash, your savings accounts, checking accounts, are included at that same parental rate, that 5.6% roughly.
Michael Conrath: Again, you're better off investing, not just saving. There is a difference between saving and investing and leveraging something like a 529 plan for all those reasons.
Remy Blaire: I think highlighting all these points is very important, especially the misconceptions and myths out there. We know that many advisors may be approached by their clients in the coming weeks, as they have children, or they themselves return to university and find out they don't have enough financial aid. Loans are very expensive, as we know, looking at the student debt problem here in the US.
Remy Blaire: I do want to move onto our next section, which is leveraging 529 plans. Mike, starting with you, why is it so important to not just save and invest, but also leverage?
Michael Conrath: It's important to leverage a 529 plan for all of the reasons we've been speaking about. We have tuition costs that continue to go up, up and up, every single year. If you look back, jump back in the time machine 35 years ago, you probably never would have said, "Okay, moving forward 35 years, tuition is going to go up 776% cumulatively."
Michael Conrath: That is the number. On an annual basis, that's roughly 6.4% a year. You need to invest around that. Savings, loan, won't pay for college, just given where interest rates are, or where they might be headed. You need to invest around that.
Michael Conrath: A 529 gives you the tax advantages that we all spoke about. Ultimately, it will come out tax-free when used for qualified education expenses.
Michael Conrath: You need to think of this as an investment. Don't just set it and forget it. You need to think of this as an investment. Think of who's managing that portfolio. How they doing it? Do they take a set-it-and-forget-it approach, or do they actually look at markets and project to the future what those capital markets might look like?
Michael Conrath: What are some of the risks? And do they have the flexibility to pull on different tactical levers? As we see volatility in the market, can they de-risk in certain asset classes? Or if we see opportunities, can they redirect or redeploy some assets into those asset classes?
Michael Conrath: Again, not a set-it-and-forget-it strategy, but you do need to think of this as an investment strategy. I think sometimes that gets lost in the equation, just coupled with all of the huge tax benefits we've all spoken about. Those are fantastic, but ultimately it comes down to picking the investment that offers you those same tax benefits.
Remy Blaire: What might seem very obviously to some may not be that obviously to others, so I think it's very important that you mentioned those points. Now, Doug, I want to move on to you and hear about some of the aspects, as well as types, the features, that you would look for beyond a general tax savings, when it comes to choosing the right plan. What are they?
Doug Sue: Right. So, we've spoken mostly, thus far, about the tax advantages of 529s. They're clearly there. When you think about the choice, say, "Okay, I do want to invest in a 529, but now I need help in thinking about what is the right one for me?"
Doug Sue: For every state, there typically is a 529 plan that's aligned with them. You do have the flexibility to go outside of that state, as well. In terms of the types of benefits, of features, that we really think are important, there are really a handful that we like to talk about.
Doug Sue: The first one is to make sure that the plan is managed in a way that has an optimal strategic asset allocation. This is typically the backbone of any long-term portfolio. A good strategic asset allocation in the context of a 529 is going to be a diversified portfolio. Not only diversified, though, across your typical different types of asset classes, but also geographically diversified as well.
Doug Sue: Secondarily, we would look for a fund that ideal provides manager selection. This is the function of an asset allocator to look at, review, provide due diligence on a number of different funds, different asset managers, and ultimately find the right combination of funds and managers that are going to work well together.
Doug Sue: Thirdly, kind of along the same lines of manager selection, we would also promote the idea of manager diversification, as well. Manager diversification simply refers to the idea that you can benefit from having a portfolio that has exposure to different types of funds, different managers who may have different investment styles. Ultimately, this is another form of investment diversification, which tends to benefit investors over the long run.
Doug Sue: Lastly, but certainly not least, you would want to look for a manger or a plan that does a good job of constructing what we call a glide path. A glide path, the construction and ultimately the implementation of one, is simply a pre-determined schedule based off of time. Typically for a 529 plan, it'll be based on the number of years left till that child goes to college.
Doug Sue: In the context of a 529 plan, we see for a good glide path, is one that ultimately will, on a somewhat automated basis, move a portfolio down a spectrum of risk from a higher-level of risk portfolio, typically meaning that it has a higher proportion of equities in that portfolio. To one that is ultimately more conservatively managed as that child comes closer to their matriculation date, when that family might want to consider taking a little bit of risk off the table, so to speak. That's what a glide path does. It does that in an automated fashion for the ultimate investor.
Remy Blaire: Well, you mentioned the word investment. Tom, you've mentioned how the price of college degrees should not be seen as an expense but more as an investment, and you've highlighted why. Could you give us a little bit more insight, given your past experience? If you have to drive the point home, what else do you have to add?
Tom Rowley: I think that from an advisor's point of view, it's a hierarchy of decisions. It is an important... College is an investment. I mean, you look at the studies, and college graduates have a higher wage-base. They have a lower unemployment base. We don't have to go too far into studies to say, "Listen, a college degree is important." In the future, I believe a college degree will be more important.
Tom Rowley: From an advisor point of view, you realize you have this very important subject that's going to affect every one of your clients, whether they have kids or grandkids. You want to have that discussion with them, but especially as we come back to the back-to-school time. Whether it's graduation time, or whether it's the fall festival. Whatever they're doing at school, you've got something to plug into to talk about education.
Tom Rowley: From the advisor's point of view, I believe that they're going to go through a hierarchy of which 529 they would choose based upon the tax deduction of the state, based upon some of the things we talked about in terms of the glide path and the investments, and really the convenience of working with the provider.
Remy Blaire: Okay. So, Doug, are 529 savings plans more expensive than alternative investment programs?
Doug Sue: Well, I think that's another one of the benefits of a 529 plan, is if you look out there in terms of pricing and the costs... We've done extensive research on this. You typically don't see that most 529 plans have a substantially higher cost than many alternative savings plans.
Doug Sue: You could compare them to, for instance, model portfolios that have a target risk associated with them. You could even, frankly, compare them to a target-date fund, which does not have the same objective, but has a similar type of structure to it. You don't see, typically, that either from an active or passively managed 529 plan, that they are substantially more expensive.
Doug Sue: One of the things I would really highlight here, however, is that when you tap into a 529 plan, one of the advantages is that you typically receive access to the underlying building blocks. Which are oftentimes individual mutual funds at what we call institutional-level pricing. That is something that is typically very difficult for you to obtain, if you are a retail individual trying to do it yourself.
Remy Blaire: Well gentlemen, while 529s may seem fairly straightforward when it comes to some of the qualified higher education expenses, there might be some misunderstandings there. So, can you highlight what those are, in terms of coverage.
Michael Conrath: Sure. Well first, just to recap some of the things we've been speaking about. What are the qualified higher education expenses? So, it covers tuition, fees, room and board, books, supplies, equipment, computers, your laptop, internet-related charges. Those are all qualified expenses.
Michael Conrath: We also talked a little bit about higher education, as well as K-12. Just one thing for advisors and families to be thinking about is that if you are planning on using the 529 for non-higher educations, meaning not using it for two-year college, four-year college, vocational, trade school, so on, so forth, you want to be using it for K-12, you want to check to see what your state's rules are around that. While the federal rules do state that K-12 is a qualified expense, not all the state conform to that, or piggy back on that federal guideline.
Michael Conrath: The other thing, not directly related to your question Remy, is that if you are leveraging the 529 plan for K-12, I would just say you want to be somewhat cautious about that. What I mean by that is what is your level of funding for college today? If you are underfunded, you have to be careful about tapping into that 529 for K-12. By taking it out now, and assuming your state does allow that to be a qualified expense, you're actually giving up X number of years of compound return, called compound interest, on those returns over time.
Michael Conrath: I've even had close friends say, "Hey, Mike, I know you work in the 529 space. That's great. Hey, for my child's sixth grade, I can now use my 529 plan."
Michael Conrath: I said, "Well, tell me about your strategy."
Michael Conrath: They say, "Well, what do you mean?"
Michael Conrath: "How much are you saving? How much are you investing? What do you project the cost to be?"
Michael Conrath: You kind of get the, "Oh," questions. Once we get past the awkward part, they do ultimately share with me what they have. They realize that they're underfunded, but they don't quite think of it that way.
Michael Conrath: While K-12 is great, because it does speak to the flexibility that we've all been talking about, again, from a planning, or just from a dollars and cents perspective, you want to be careful about that.
Michael Conrath: The other thing that 529 cannot be leveraged for on a qualified basis is transportation costs. So, if my child wants to go to school in Hawaii and I live in New York, unfortunately that expensive flight to and from, not only the beginning and end of the year, but all the holidays, that is not covered by the 529 plan. So, you want to think about that, as well.
Tom Rowley: I think Doug brought it up earlier, is you're not really going to game the system. The system is not easily gamed. I think that some of the myths I heard is room and board, "Well, what if I bought the apartment and they rented it?"
Tom Rowley: The maximum you're going to do is the cost of attendance. Each school will list a cost of attendance, so you cannot charge more than the cost of attendance, so there's no gaming of the system as to room and board, wherever your child decides to live.
Tom Rowley: To go back to the K-12. The K-12 aspect of it is really where, we believe, really where grandparents can come in and play a role. Where the parents are saving for college, a lot of times, the amount of time you have to pay for that K-12, your child's born, K-12, they're in school at five. You've only got about five years.
Tom Rowley: The grandparents could contribute to a 529 for the express purposes of the K-12. Of course, all the state disclaimers that we were talking about earlier have to be checked.
Remy Blaire: I think you both brought up important points, that rules are different depending on the state that you're in. Mike, going back to you, can funds from 529s be used for schools outside the states?
Michael Conrath: Absolutely. This, again, speaks to the flexibility. That's a question we often get asked. "Well, my child is going to go to school abroad, and I've been saving in a 529 plan. What do I do now?"
Michael Conrath: The good news is that there are many schools overseas that are accredited. They're recognized by the US Department of Education. Some even conform to the federal aid formula, the FAFSA.
Michael Conrath: The best test around that is if you have a specific institution in mind, you can actually go on the FAFSA website and pull down a list of all the institutions that would quality. They're typically ordered by state. For overseas schools, I believe it's under F for foreign. There you can actually look up your foreign institutions and get your answer pretty quickly.
Michael Conrath: Again, that comes back to the flexibility as to how you can spend those 529 dollars.
Remy Blaire: Gentlemen, before we wrap it up, this is the section for closing comments. Now, we all understand and know that saving for college is very important and that the expense of college tuition will continue to rise. When it comes to student debt, we know that this is a hot topic as we head into an election year. For advisors as well as investors out there, what is your closing remark regarding 529 plans?
Doug Sue: Well, I guess I'll go first. I'd point out two things. The first of which is that when you look at the size of 529 plans savings in the US, it's about $329 billion. That sounds like a lot of money, but it's really a drop in the hat when it comes to comparing it to the US 401K market, which is approaching six trillion dollars. Which makes 529 assets only about 6% compared to 401K assets. This points to us as 529s being a massively under-utilized vehicle.
Doug Sue: The last point I would make, in terms of closing comments, is that we oftentimes see really high concentrations of use in certain states in 529 plans. We see a high correlation of that with where there are certain tax advantages in that state.
Doug Sue: The thing to consider here is that in every state you are advantaged by using a 529 plan, regardless of if you live in a state like California, that has no actual specific state income tax benefit, or a state like Texas or Florida where there is no state income tax. Even in these states, we would point out that there is a substantial massive potential savings advantage by reaping the rewards of those tax-free accumulation during the savings years and ultimately tax-free withdraw for qualified expense when that child turns of the age to go to college.
Michael Conrath: Yeah, I would say three things. One is families need to really understand the costs. We talked about that on the front end. Really understand rather being able to answer one question, "What is my number?" Not only, what is my number for college? But how much is my expected bill going to be, whether I'm looking at private or public, funding 50% of it versus all of it? What is my number?
Michael Conrath: The other number, just as important if not more so is, "How much do I need to invest today to get to that future number in the future?" Whether that's a lump sum or making automatic monthly contributions, helping clients and families understanding what that number is.
Michael Conrath: If they understand that, they're more likely to have a plan in place. That's my second point is you have to have a plan in place. It's one thing to invest, but you need to have a plan that you're investing around. That plan involves, obviously, the costs and the aid that we talked about.
Michael Conrath: Also, again, looking at this holistically from a wealth management perspective. Looking at the retirement plan trade-offs. Looking at college savings relative to your other goals, your estate, your legacy, your wealth transfer. All of these things come into the equation. Good news is, 529 can actually help with a lot of those things.
Michael Conrath: The third thing is don't wait. My oldest is 14. Being in this business, I said when my son was born, and I said it when my two daughters were born as well, "There has to be some end in sight, in regard to rising tuition. It has to come down." It hasn't really. It depends on the year, but overall it hasn't really tempered that much. You can't let that get in the way of having a strategy in place, now.
Michael Conrath: The election could be something else that enters clients minds. "Well, what if things are free?" But what if... Who knows? I'm not going to even venture into those waters. You need to have a strategy now. Again, 529 gives you the flexibilities to pivot, whatever the answers to all those questions are.
Remy Blaire: And Tom.
Tom Rowley: I think that I would go directly to the advisor who's watching. You've listened to the 529. We probably haven't said that much that you don't already know. We've hit on some points that you go, "Oh, I might not have known that." The reality is, your clients don't know. Your clients don't know.
Tom Rowley: One, you either have got a client who's a grandparent who 529s didn't exist at the time that they were paying attention to the cost of college. The cost of college, at the time, wasn't what it's like today. Or you have brand new parents who are worried about everything, so they're not keeping track.
Tom Rowley: As I say to advisor, this is a product that is really designed that you can talk to any of your clients about. It's a well thought out product. When you look at vehicles for savings, the 529 was actually well designed, it's easy to explain, and it works.
Tom Rowley: I've got three kids that went through college. I paid for them with 529s. If you put away a little bit of money for a long period of time, you'll have a lot more money saved than if you didn't. That's important.
Remy Blaire: Well gentlemen, I believe we covered a lot of ground here, and it's been very educational. Thank you so much for joining me today.
Doug Sue: Thank you.
Michael Conrath: Thank you.
Tom Rowley: Thank you.
Remy Blaire: Thank you for watching. I was joined by Michael Conrath, Head of Educational Savings at JP Morgan Asset Management; Thomas Rowley, Director of Retirement and Education Strategies at Invesco; and Doug Sue, Multi-Asset Strategist at QS Investors, an affiliate of Legg Mason Asset Management. From our studio in New York City, I'm Remy Blaire for Asset TV.