529 plans – A tax-efficient way to pay for college

May 29, 2013

Piggy bank with grad capIt’s the week of 5/29 – what better day to discuss the ways you and your family can benefit from a 529 plan?

If you’re a parent or a grandparent, you’ve probably worried about how you’ll help pay for your children’s college education. With the price of tuition outpacing the general inflation rate, planning for college has become a more critical component of financial planning than ever before. A 529 plan can be an immense help when it comes to paying some of these expenses, but it can depend on the plan you choose and how early you begin investing in it.

529s can help you save

In a nutshell, a 529 plan allows you to accumulate funds to help pay for a designated beneficiary’s qualified higher education expenses at an eligible educational institution. The plan gets its name from the section of the Internal Revenue Code (Section 529) that outlines its provisions. They are generally available to anyone, regardless of a family’s income level, and they’re tax-advantaged to boot, meaning that investment earnings from the plan are allowed to grow federal income tax-free, and withdrawals used to pay for qualified education expenses are also tax-free.

There are two types of 529 plans: prepaid tuition plans and college savings plans. Both are generally sponsored by state governments and administered by one or more investment companies.

Prepaid tuition plan

  • Contributions are made to a qualified trust
  • Lets you lock in tomorrow’s tuition at today’s rates
  • Allows you to purchase a number a course units/academic periods that are redeemed when a beneficiary becomes old enough to attend college

College savings plan

  • Lets you choose from a menu of investments typically managed by mutual fund companies
  • Amount available to help pay higher education expenses depends on growth in account
  • Offers more return potential, as well as risk

Eligibility and withdrawal rules

Generally speaking, everyone is eligible to contribute to a 529 plan – it’s not limited by age or income. Depending on the program, you could contribute upwards of $200,000 on behalf of a beneficiary. It’s a good idea to check with your program sponsor for details on how various factors such as age, current education costs and projected inflation rates could influence your maximum contribution limits.

As previously mentioned, tax-free withdrawals from the account may used to pay for qualified education expenses such as tuition, fees, books and supplies, among many other options. And it’s not just for undergraduate education – they may be used for graduate school expenses, as well! Withdrawals that are not used for higher education expenses are subject to ordinary income taxes – either at the owner’s rate or the beneficiary’s rate – and an additional 10% penalty tax.

Is a 529 your best option for saving for college?

Not always. A 529 plan can be a great tool, but it’s best for those who are relatively certain the beneficiary will eventually attend college. If the original beneficiary of the account opts not to pursue higher education, the account owner may change the beneficiary, but only if the new beneficiary is a member of the same family. Currently, there’s no federal income tax to transfer the account, but this could change.

To read more about what to consider when saving for college, including the 4 reasons why it’s worth the effort to save and invest specifically for your children’s college education, check out Bruce Helmer’s book: Real Wealth: How to make Smart Money Choices for what matters most to YOU.

Prior to investing in a 529 Plan, investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other benefits that are only available for investment in such state’s qualified tuition program.  Withdrawals used for qualified expenses are federally tax free.  Tax treatment at the state level may vary.  Please consult with your tax advisor before investing.


Warren Buffett hates bonds, but we don’t

May 16, 2013

When Warren Buffett, the so-called “Oracle of Omaha,” makes a bold statement about investing, people’s ears perk up. While his May 6th declaration that fixed income is “a terrible investment right now” might have made more than a few headlines, his sentiment was hardly anything Earth-shattering, as some pundits have been claiming for years that investors should rethink their fixed income investments.

It’s an understandable position: interest rates are at extreme lows, and if they rise due to change in Fed policy or inflation expectations, bonds could lose a lot of value.

While we agree that on a relative basis, stocks look more attractive than bonds right now, and that bonds seem riskier than they used to be, we don’t think that you should get rid of your entire fixed income allocation. We believe that:

  1. A prudent investor should still hold some bonds, and
  2. Your bond portfolio should be diversified, just like your stock portfolio.

Why you should hang on to your bonds

While no one can predict the future with 100% accuracy, an effectively diversified portfolio can help minimize the shocks of a volatile economy. Consider this scenario: if the market suffers another downturn, you need something that can perform well in a recessionary environment – something like bonds. In such a situation, if interest rates fall even further, bond prices will rise, and this gain might help offset some of the losses that may occur in your equity portfolio. If you react to some of these headlines and sell out of all your bonds, your portfolio might suffer more dramatically in a recession.

Of course, we have to consider what may happen on the other end of the spectrum: if there’s a period of growth and inflation, interest rates will likely rise. In this scenario, you could potentially lose money in bonds, but if you’re effectively diversified, the strength of your equity portfolio may offset some of those losses. That being said, there’s no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Not all bonds are the same

Keep in mind that while some pundits are talking about Treasuries, those aren’t the only bonds out there. Just like there are many different kinds of stocks – growth, value, small cap, large cap, etc. – there are many different kinds of bonds.

For example, US government bonds look expensive at the moment, but emerging market local currency bonds still offer good returns with acceptable levels of risk when added to a well diversified portfolio.

The bottom line?

The Oracle of Omaha may have gotten everyone’s attention, but there’s more to the story than the headline. While there may be heightened risk in fixed income, we believe that careful exposure to fixed income is a key component of an effectively diversified portfolio that prepares your portfolio for a variety of economic environments.