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  • Archive for the 'College' Category

    529 plans: The 10% Penalty Solution, Part 2

    Posted by ML on 30th January 2007

    In Part 1 I laid out the basic question we’re trying to address:

    Since the money inside a 529 plan grows tax-free, is there a break-even point, beyond which it’s more advantageous to invest in a 529 plan than in a regular taxable account even after paying penalty.

    I showed that the tax advantage of 529 plans are indeed sufficient to overcome the plan costs and given time would overcome the adverse tax treatment and penalties for nonqualified withdrawals, albeit after 30 years or more in most instances. In addition, it should be understood that higher current tax bracket and lower fees will tilt things more towards 529 plans, while tax-efficient investments in taxable accounts will tilt things the other way.

    Dimensional Fund Advisors (DFA)
    For reasons that will soon become apparent, we enrolled in West Virginia’s Smart529 Select plan last year. We did this before the birth of our daughter to take advantage of my state’s recent tax law change to allow a deduction for contribution to an out-of-state plan. One key reason for selecting the particular plan was its use of DFA funds.

    DFA funds are backed by research done by Nobel laureates in economics. I first learned of them via Paul Merriman and Index Fund Advisors (IFA). They are probably the best index fund managers, only Vanguard comes close. Altruist Financial Advisors has a great comparison chart that I think every do-it-yourself asset allocators should study. Unfortunately, there is a catch. DFA funds are only available through financial advisors who normally charge a fee for assets under management. If you are lucky enough to have a million dollar portfolio, consider Evanson Asset Management who charges a flat $2000 fee, or 0.2%, which is among the lowest that I’m aware of. A more realistic choice for me personally is IFA, which caters to account sizes of $100k and up. Their fee is 0.9% for the lowest tier.

    In comparison, West Virginia’s Smart529 Select plan that gets you into DFA funds at an annual expense rate of 0.55% must be considered a bargain. I ran the same calculation as before but the 529 plan now enjoys a 0.35% advantage in fees in addition to the tax savings. The results are quite different.

    Now the 15% future bracket beats the (hypothetical) 10% future LT cap gain rate in only three years! It beats the 5% rate in 10 years. Even the 25% future bracket beats the corresponding 15% rate in 13 years! The DFA funds may be more tax efficient than I supposed, but the extra advisor expense makes the 529 plan very appealing.

    Qualified Educational Expenses
    Even though the examples I have given so far have shown 529 plans to have the potential to be a stand along retirement savings vehicle, they are best used as intended, that is, for qualified education expenses. IRS defines these expenses as

    … the tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution (defined in the next column). They also include the reasonable costs of room and board for a designated beneficiary who is at least a half-time student.

    When used for qualified educational expenses, the 529 plan is almost as good as a Roth IRA: there is an extra plan expense, off-set in part by possible state tax deductions. Many people plan on taking college courses in early retirement. As a matter of fact, numerous college towns around the country consistently rank as the best retirement destinations, so the 529 plan will come in handy then.

    When the qualified education expense is reduced by a scholarship or fellowship, the earnings are taxable, but not subject to the 10% penalty. In this situation, the 529 plan acts like a non-deductible IRA. Unlike retirement plans, losses in the 529 plans are deductible, but subject to the 2% of AGI limit on Schedule A.

    Rollover and Transfer of Designated Beneficiary
    The 529 plan owns much of its flexibility to the freedom to rollover the plan or change the designated beneficiary to a family member of the old beneficiary. For this purpose, a “family member” is defined as

    1. Child or descendant of a child.
    2. Brother, sister, stepbrother, or stepsister.
    3. Father or mother or ancestor of either.
    4. Stepfather or stepmother.
    5. Son or daughter of a brother or sister.
    6. Brother or sister of father or mother.
    7. Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
    8. The spouse of any individual listed above.
    9. First cousin.

    This is a far-reaching list, especially since multiple rollover/re-designation of beneficiary is possible (limited to one per 12 months in some cases). Assets within a plan can be used to pay for the education of your children and the excess amount can be left to the generation after. It is certainly possible for one to pay for the education of a family member out of the 529 plan for a return payment as a way to sidestep the ordinary income tax and 10% penalty. These possibilities make the 529 plan an excellent multi-generational planning tool.

    One point of note: many financial planners advocate the grandparents (of the student) be the owner of the 529 plan because the assets of the parents count against the student in many formulas used to calculate financial aid. For the same reason, it’s usually not a good idea for the student to be the owner of the 529 plan. With proper planning, gift tax for skip-generation contributions should not represent a problem.

    Implications for Investment Choices within the 529 Plan
    I’m currently the beneficiary of the newly-opened 529 plan. The intention is, of course, to switch over to my daughter later. I have all the money in the most aggressive (all equity) option. Chances are the money will be there for a while.

    Most 529 plans feature age-based portfolios which are similar to target retirement funds that increase the fixed income portion as the target date approaches. The rational is that return expectations should be sacrificed for shielding from untimely market declines. One cannot argue with that logic if the 529 plan is established to pay for the education of a single beneficiary. However, when the 529 plan is viewed as a multi-generational planning tool, its time horizon is easily 20-30 years longer, so that the investments can be left in the most aggressive option, where the expected return is the highest, for much longer.

    To compensate for the extra volatility, I will increase my contributions slightly (perhaps10-20%) above originally planned. This will likely result in an account value exceeding the educational expenses for one person down the road, but as I have demonstrated above, this is not a bad thing after all.

    I originally planned for a 2-part series; however, one reader raised an interesting question of comparison to a variable annuity. I’ll try to address that in part 3 along with the asset protection feature of 529 plans.

    Posted in College, Investing | 4 Comments »

    529 Plans: The 10% Penalty Solution, Part 1

    Posted by ML on 19th January 2007

    A while ago, I wrote about 529 plans and new tax deductions in some states. Just to recap the basics about 529 plans:

    • Contributions are not deductible on federal returns; however, many states provide a deduction for contribution to in-state plans. Certain states even have deductions for contribution to out-of-state plans.
    • Although the state income tax deduction has an upper limit (e.g., for contributions up to $12,000), there is no overall contribution limit that I’m aware of. [You should consult a tax advisor here. This IRS publication states that the amount of contribution cannot be more than the qualified education expenses of the beneficiary, but I’m not sure how it is enforced. Most plans have an account limit of $2-300,000 per beneficiary.]
    • Inside the plan, money grows tax free. Qualified withdrawals for education purposes are not taxed.
    • Nonqualified withdrawals, however, have the earnings taxed as ordinary income with a 10% penalty levied.

    This last point is what I want to address today. Two blog entries at MyPocketChange and RetireEarly started exploring this question:

    Since the money inside a 529 plan grows tax-free, is there a break-even point, beyond which it’s more advantageous to invest in a 529 plan than in a regular taxable account even after paying the penalty?

    Essentially, the interlocutor is asking whether the 529 plan can function as a stand alone retirement savings plan without contribution limits. This can be calculated quite easily if we make certain assumptions about the rate of return, current and future tax bracket, etc. But to gain a better understanding, let me rephrase the requirement into two separate conditions.

    A. In each given year, the advantage of tax-free compounding must out-weigh the extra expenses for the 529 plan, viz.

    R529 – ER529 > Rtaxable – ERtaxable – TRtaxable

    Where R is the return; ER is the expense ratio; and TR is the tax expense for the taxable account. If this condition fails to hold, then compounding will only make things worse.

    The current tax expense, TRtaxable, is given by,

    TR = D * STportion * STrate + D * LTportion * LTrate

    Where D is the distribution rate; STportion and LTportion are the fraction of D that are short term gains or long term gains and dividends; STrate and LTrate are the current applicable short and long term marginal tax rates. D also includes any gains realized for rebalancing.

    Assuming the 529 plan has a wide enough choice such that R529 and Rtaxable are equal, you can tilt things in 529 plan’s favor by choosing a plan with low fees, choosing investments with high distribution rates and be in a high current income bracket.

    B. The second condition is that you have to wait long enough for the money in the 529 plans to grow enough to offset the tax penalty.

    P529 (1 – MR529) > Ptaxable (1 – MRtaxable)

    Where P is the portfolio value; MR529 is 10% + future bracket; MRtaxable is the future long term cap gain rate. Again for things to be in 529 plan’s favor, you have to wait long enough and withdraw the money when your future tax bracket is as low as possible; or to be more exact, when the differential between MR529 and MRtaxable is as small as possible.

    Putting the numbers together
    Since no one can predict future tax law changes, an exact analysis is not possible. For example, it’s highly debatable whether the current low capital gains and dividend tax rates will be extended after they sun-set in 2010. The best we can do is to take the current tax rates and make reasonable projections into the future. My assumptions are as follows:

    Portfolio annual return: 10% (As you’ll see later, I suggest investing with the most aggressive option. At any rate, it matters little when the returns of the 529 plan and the taxable plan are equal.)
    Taxable plan fee: 0% (No extra fee besides the intrinsic mutual fund expenses.)
    529 plan fee: 0.60% (e.g. the Nebraska program)
    Current marginal tax rate: 31% (federal + state)
    Current long term capital gains rate: 15% (ignoring any state tax liability here)
    Early withdrawal penalty: 10%

    Distributions and gains realized for rebalancing as a percent of the portfolio: 6%
    - Of which are long term capital gains or dividends: 75%
    - Of which are short term capital gains: 25%
    TRtaxable: 1.14% (This is the amount of annual taxes to be paid from the taxable account. Since this is greater than the 0.6% expense rate of the 529 plan, condition A is satisfied. Given time the 529 plan will overcome the extra tax burden at liquidation.)

    The output is in the table below. For each dollar invested in year 0, I computed the after tax (and penalty) liquidation value of the accounts as a function of the respective future tax rates and number of years invested. Some rows were hidden to make the table smaller.

    It can be seen that a LT cap gain of 5% is pretty tough to beat. Even at a low marginal rate of 10% (+10% penalty), it takes 33 years for the 529 plan to catch up ($15.712 vs. $15.695). However, if the future LT cap gain rate goes back to 10%, the break-even occurs after year 20. Still a very long time but doable. The difficulty of the task grows if your future brackets are higher. It will take 36 years for the 15% future income bracket to break-even with a 10% LT cap gain. And if you are fortunate enough to be in the 25% income bracket in retirement, it will take a long, long time (54 years to be exact), to exceed the corresponding 15% LT cap gain.

    At this point, you’re probably thinking, “Why bother!” Indeed, 401(k), Roth IRA or the traditional IRA, even the non-deductible kind are much better ways to save for retirement. It is only after those have been maxed out, does the 529 plan emerge as a potential alternative. As described so far, it’s applicable to only a very small segment of the population with high disposable income or a lump sum to invest early on.

    If the story ends here, this would not have been a useful exercise. Fortunately, there is much more, both in terms of the 529 vs. taxable plan comparisons and ways of utilizing the 529 for qualified educational expenses thus avoiding the 10% penalty. Please stay tuned for Part 2!

    Posted in College, Investing | 5 Comments »

    Thank you, Gov. Rendell

    Posted by ML on 11th November 2006

    My wife and I are expecting our first child, a daughter, next February. Being the good father, I’ve already looked at various educational savings programs (this girl is going places, baby!). Perhaps one of the most popular options is the 529 savings plan. It has the following advantages:

    • The plan can be withdrawn to pay for many education related expenses at most institutions. The child is not locked into a certain school or even schools in a certain state.
    • The benefactor of the plan can be switched to an immediate family member.
    • The gains are exempt from federal taxes.
    • The amount of contribution is practically unlimited.
    • Some states offer tax deductions on contributions from state taxes.

    This last point is an important one. Although most states have a 529 savings plan, they are not created equal. Some has limited fund options while charging high management fees in addition to mutual fund expenses. While I reside in Pennsylvania, the two state plans that I like the most are from Nebraska and West Virginia.

    The Nebraska plan features a wide variety of funds from Vanguard, American Century, Fidelity, State Street, Goldman Sachs, and PIMCO. The program charges a management fee of 0.60%. With Vanguard in the mix you know the underlying fund expenses will be low: only 0.09-0.37% in age based portfolios.

    The Smart529 Select plan from West Virginia features funds from uber indexer Dimensional Fund Advisors that are normally accessible only through advisors. The plan changes a management fee of 0.55% with the underlying fund expenses from 0.20-0.50%.

    Back to the point on state income tax deductions: More than half of states provide deductions — generally ranging from $2,000 to $12,000 — on state income-tax returns for 529 contributions. However, previously they are only available when contributing to the 529 plans administered by the state of residency. This year, however, Pennsylvania, Maine and Kansas have approved tax deductions for contributing to other state’s 529 plans. Gov. Rendell of Pennsylvania won re-election handily with 60% of the vote. I’m sure this middle-class friendly tax break didn’t hurt.

    Given the flexibility of being able to switch plan beneficiaries and the ability to shop for the best plan, I’m considering starting a plan with myself as the beneficiary this year and switching to my daughter later. This way, I can take advantage of the tax break next April. In fact, this move is available to all the expecting parents out there. There is no free lunch of course, if the funds are not withdrawn for qualified education purposes, a 10% penalty is levied in addition to regular income tax on the gains. State income tax deductions may also have to be disgorged. So this is not an unlimited tax shelter. But still, even if having children is only a future possibility, if you have plans to go back to school, starting a 529 plan early is still a nice way to make tax-free gains now and jump-start college savings for your kids down the line.

    In the end, this move by Pennsylvania and others will not only benefit residents for those states, but also, by increasing competition, force all 529 plans to improve as well. So there, Gov. Rendell, well done!

    I did most of my research at

    List of 5 best 529 plans from MSN Money.

    Posted in College, Investing | 3 Comments »

    Engineering Salaries from MIT, Stanford, and Berkeley

    Posted by Frugal on 5th August 2006

    Ever wonder how much is the salary of the graduates from the top 3 engineering schools according to US News? I just came across the exact pages. Here is the 2004 salary survey for MIT(2005 data seems to be a little messed up), and here is the 2006 salary survey for Stanford. I couldn’t find the corresponding page for UC Berkeley, but from PayScale, I was able to find some salary information for UC Berkeley graduates. The PayScale data for MIT is here, and for Stanford is here.

    A couple of observations:

    1. The payscale data from MIT seems to be higher than the others probably because the percentage of highly paid engineers is bigger.
    2. From both MIT and Stanford data, it appears that the highest paid graduates are the computer science, or software engineers. This is consistent with the data in my post of Engineer Salaries in Silicon Valley.
    3. Comparing the data to the post of engineer salaries in silicon valley, both the new graduates from MIT and Stanford tend to be quite high. Graduating from a top school does help.

    Of course, both MIT and Stanford are private universities, and very expensive. The graduate program tuition at MIT is $32300, and the graduate program tuition at Stanford is $35184=$11728*3 quaters. Both figures don’t include any living expenses in the high-cost cities of Boston and Silicon Valley area. You are looking at an investment of close to $50,000 per year. Is it worth it? If you just invest in the shorter Master’s graduate degree (1 to 2 years max), probably it is worth the money. Comparing to UC Berkeley which is a public school in California, the tuition is only $4500 for CA residents, and $12,000 for non-residents. It’s so much more economical.

    Probably a more invisible benefit of attending these three schools is the school reputation. The reputation of these three engineering schools are very high. I have never seen them dropping out of top 3 spots, any of the years that I have checked. The reputation by itself can land you multiple offers a lot easier, and in a down cycle of employment, that could be the only factor that matters.

    Posted in Career/Salary, College | 16 Comments »

    Consolidate Your Student Loan NOW

    Posted by Frugal on 6th June 2006

    Interest rate on student loans are going to jump by almost 2% on July 1st, if you don’t take this chance to consolidate it into a low fixed interest rate.  Many thanks to Cynthia’s links.  I won’t add too much of my own, since everything has been very clearly explained in those pointers.  Please click to read the original articles from US News.  Here are some excerpts from US News:

    ….Students currently in school could cap payback rates on loans they’ve already taken out at a fixed rate of no more than 4.75 percent. If they do nothing and let their existing loans continue to fluctuate with treasury rates, they’ll be charged 6.5 percent starting July 1…. Most lenders offer discounts—such as knocking anywhere from 0.25 to 0.5 percentage points off the rates of those who pay by automatic debit.

    And here is the why you wouldn’t want to consolidate the loans:

    This is another similar news story from CBS.

    Posted in College | 1 Comment »