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When you've been in the college funding business over twenty-five years and trained over 5,000 advisors, you've heard every possible story, received every possible pitch, and seen every possible blunder.

In the financial services industry, every advisor has their 'favorite' investment. You want to make money. I get that. But regardless of the money made, you really should have your client's best interest in mind when suggesting products and investments.

So the other day I get into a discussion with an advisor who seemed to think that, when it comes to college, every client needs to have money in a 529 plan; even if the family starts their 529 plan when the student is in high school. College savings (529) plans have always been hailed as the best way to save for college... but are they?

In some cases, this advisor may be right. After all, the 529 is tax-free and there are some states that give a whopping state tax deduction for first-time investments. But when you withdraw money from a 529 plan, it may come with conditions; such as it can only be used for qualified education expenses, which according to the IRS means tuition & fees, room & board, books, supplies, equipment, and computers and software only.

However, if you happen to get any kind of grant or scholarship, then you need to deduct that amount from those qualified education expenses. If you also happen to qualify for the $2,500 American Opportunity Tax Credit, you must deduct another $4,000 from those qualified education expenses. You can get a more in-depth explanation on this here: IRS Publication 970

The state tax-benefit is an illusion.

Everyone talks about the state tax deduction benefit of 529 plans, but take a closer look. Let's say you live in a state where you get a whopping $10,000 state tax deduction for your contribution of $10,000 into the state's 529 plan. If your state tax rate is 5%, you get a $500 tax break ($10,000 x 5% = $500). So if you contribute $10,000 to your state's 529 plan for four years, you'll have a total of $40,000 in the plan, and you'll have received $2,000 in tax breaks over those four years ($40,000 x 5% = $2,000). That's great, right?

However, when you take a closer look at the fee structure of the state's 529 plan, you discover that the state charges an extra 1% investment fee on top of the fees charged by the 529 fund manager. So if you have $40,000 in your 529 plan and your child is still five years away from college, you will have paid an extra $2,000 in fees by the time your child is ready to go to school (1% x $40,000 x 5 years = $2,000).

In this particular case, the state giveth and the state taketh away.

My point is, 529 plans can be a great investment for college, but like everything else in the financial industry, there are pros and cons to every investment and every advisor needs to be keenly aware of the nuances of each, especially when it involves a child's future.

What is the most cost-efficient way to save and pay for college and retirement at the same time?

When building an education fund for your client’s children, you need to consider four important factors:

1. Investment Control

2. Investment Flexibility

3. Tax Implications

4. Financial Aid Implications

Pros and Cons of 529 Plans vs. Tax-Efficient Mutual Funds.

 College Savings (529) Plan

Investment Control

Money deposited into a College Savings (529) account must be used for qualified higher education expenses. Withdrawals for any other expense will be assessed ordinary income tax (at the account owner’s tax rate) and penalties on the earnings.

Investment Flexibility

Money deposited into a 529 plan must remain in that particular portfolio for a minimum of twelve months, before transferring to another 529 portfolio or beneficiary. Furthermore, each State sponsors their own unique plan, adding to the confusion of which state plan is most suitable.

Tax Implications

Earnings withdrawn from a 529 account are tax-free. However, you can only use the money for qualified higher education expenses, or you will be assessed ordinary income tax (at the account owner’s tax rate) and penalties on the earnings.

Financial Aid Implications

Earnings withdrawn from a 529 account, for other than qualified higher education expenses, may be considered student untaxed income for financial aid purposes and assessed at a 50% rate. Furthermore, 529 funds cannot be used to repay student loans, or they will be treated as a non-qualified withdrawal, subject to tax and penalties on the earnings.

Retirement Implications

Money deposited into a 529 account must be used for qualified higher education expenses only! Withdrawals for any other purpose, such as moving money to another account, will be assessed ordinary income tax (at the account owner’s tax rate) and penalties on the earnings.

Tax-Efficient Mutual Funds

Investment Control

Money deposited into a Tax-Efficient Mutual Fund account can be used for any expense you choose, including K-12 education expenses, college, and even your retirement. You can determine exactly when, and how much, to withdraw for educational purposes, thus giving you complete control of your investment.

Investment Flexibility

Money deposited into a Tax-Efficient Mutual Fund account is actively managed and can be re-balanced at any time. The investing concept of using a standard tax-efficient mutual fund is simple, easy to understand, and fits virtually every investor.

Tax Implications

Earnings withdrawn from a Tax-Efficient Mutual Fund is taxed at the capital gains rate. These taxes can be reduced or eliminated by implementing education tax strategies provided under the Internal Revenue Code.

Financial Aid Implications

Earnings withdrawn from a Tax-Efficient Mutual Fund can be used to repay student loans after the student has graduated from college, thereby avoiding the student‘s 50% financial aid income assessment during their college years.

Retirement Implications

Money deposited into a Tax-Efficient Mutual Fund can be used as an Education / Retirement Fund. It’s your decision how and when to use the money. You retain maximum control and incur minimum taxes.

Nobody is discounting the power of a 529 plan for college planning when used properly. Investing in a child’s future education is a very powerful way to “get your foot in the door” with a potential client to discuss other investment opportunities. Just be aware of the investment parameters and limitations, and don’t assume that the 529 investment is right for every client.

Grandparent-Held 529 Plans

One more thing. When it comes to financial aid, any money distributed from a grandparent-held 529 plan to pay tuition bills for must be reported on line 45j of the FAFSA financial aid form. These 529 funds are considered as money received, or paid on the student’s behalf (gifts), and are added back into the student’s income and assessed 50% for financial aid purposes. Same goes for the CSS PROFILE financial aid form.

Are grandparent-held 529 plans counted as assets on the FAFSA and PROFILE?

FAFSA = no.
CSS Profile = who knows.

In most cases, PROFILE schools ask about grandparent-held 529 assets, but these colleges more than likely will just use it for professional judgment purposes to provide for special circumstance cases for students requesting additional aid. In other words, the grandparent-held 529 plans may not be counted as assets on the CSS Profile, but maybe they will, depending on the school.