How much money do you really save by using a 529?
You get the benefits of tax-free growth, tax-free rebalancing if needed (probably not since you can usually rebalance simply with new contributions), and tax-free withdrawals when used for education. You may get a break on your state taxes for some or all of your contributions. You also get some minor asset protection and estate planning benefits. In return for these tax benefits, you pay some fees. How much money are you really saving versus just using a taxable account? A lot of it depends on how much you're paying in fees and what kind of returns you see in the account. For example, if your investment return in the 529 is actually negative, you would have been better off using a taxable account. That way you could at least harvest the tax losses and have Uncle Sam share your pain, plus you saved all the fees!
Showdown: 529 vs Taxable Account
Let's use an example from my own state of Utah, which happens to have a particularly excellent 529 plan with very low costs and excellent investments including Vanguard and DFA funds. I also get a state tax credit of 5% of my annual contribution, up to $3680 per kid ($184.) Let's assume 18 years of contributions, 8% pre-tax, pre-expense, annual returns (remember I invest my 529s very aggressively), 15% taxes on dividends and capital gains in the taxable account, 0.10% average ERs in the taxable accounts, 0.06% average ERs in the UESP, and an additional 0.2% UESP fee. We'll assume, just for ease of calculation, that I take out the entire investment and spend it on educational expenses after year 18. We'll also assume the UESP tax credit is invested in a taxable account at the same rate.
Taxable Account: 131,184
So using the 529 instead of a taxable account under these assumptions is worth $20,156. This is the equivalent of a 1.35% higher annualized return.
Take Away The Tax Credit
If you eliminate the benefit of the tax credit, the advantage of the 529 drops to only $13,597 ($144,781 vs $131,184.)
The Effect Of A Lower Return
If you reduce the pre-tax, pre-expense return to 6% instead of 8%, the 529 advantage shrinks to just $14,514 ($122,753 vs $108,238).
The Effect Of Higher Fees
If you increase the 529 fees from 0.26% (.06% ER + 0.20% administrative fee) to 0.76%, then the advantage shrinks to $12,684 ($143,868 vs $131,184.) Inferior investments in the 529 would have a similar effect.
If you combine all 3 of these effects, the impact can be dramatic. The benefit of the 529 in that scenario after 18 years is just $3,186 ($111,424 vs $108,238). This is less than 16% of the benefit under the more favorable assumptions. It is only the equivalent of achieving a 0.28% higher annualized return. It isn't difficult to come up with some assumptions that can make investing in a 529 even worse than investing in a simple taxable account.
What do you think? Do you use a 529 to save for college expenses? What do you do to limit fees and maximize tax benefits? Comment below!