529 Essentials: 529s vs. Taxable Brokerage Accounts

This week, we will compare and contrast 529s and taxable brokerage accounts for college financial planning. 

The Tail of Tax-Advantaged vs. Taxable Investment Vehicles: 529s and Taxable Brokerage Accounts. Both investment vehicles allow families to save for higher education. While 529s are known for providing tax-advantaged savings for higher education, taxable brokerage accounts are generally known for providing liquidity for general spending including higher education. For simplicity, this article will stay centered on using the investment vehicles to pay for higher education, as opposed to the merits of using taxable brokerage accounts for liquidity, multiple savings goals or as an emergency account. That being said, the next section on market sizing notes the high volume of assets earmarked in taxable brokerage accounts for college financial planning, given the value of and demand for liquidity and flexibility in the current volatile marketplace and overall economy. Therefore you as an advisor can provide value by knowing the pros and cons of these investment vehicles, selecting the right investment vehicles based on the unique needs of your clients, and executing a customized plan based on the knowledge of the investment vehicles to achieve the unique financial goals and needs of your client.

Market Sizing: As of December 2015, 529s allowed 12.7 million families to save over $253 billion in assets based on data by Strategic Insight. Of that, 11.6 million families saved over $230 billion in 529 savings plans while 1.1 million saved over $23 billion in 529 prepaid accounts. In addition to the $253 billion in 529s, families have saved approximately $77 billion in taxable brokerage accounts as of December 2015 for college financial planning. This $77 billion represents a decrease from $86 billion as of December 2014. This decrease is due to volatility in the marketplace, as well as the increase in value of tax advantages and other benefits of 529s. Therefore assets in 529s and taxable brokerage accounts earmarked for college financial planning represent a significant amount of assets, and therefore an opportunity for advisors.

Compare and Contrast:

—Income Limit: 529 plans and taxable brokerage accounts do not have an income limit or restriction.

—Age Restrictions: 529 plans and taxable brokerage accounts do not have an age limit or restriction.

—Contribution Limits: 529s allow investors to contribute up to the annual gift taxing limit of $14,000 per year per account-owner beneficiary relationship, or $28,000 per joint filing married couple as of 2016. 529s allow an accountowner to make five years of gifting in one year such as $70,000 per single filer or $140,000 per joint filing married couple, and allow a sizable maximum account size that aligns with the cost necessary to provide for the qualified education in a state, which is typically more than $300,000. Lastly, assets in 529s are removed from the taxable estate. Annual limits for federal gift tax exclusions are not applicable to taxable brokerage accounts, though the assets are not removed from the taxable estate.

—Tax Benefits on Contributions: Though there is currently not a federal tax deduction for contributions into 529s, residents in over 30 states plus D.C. receive a state tax deduction or credit for contributions into a 529 plan. Taxable brokerage accounts do not have any state or federal benefits on contributions.

—Market Risk & Cost: 529 college savings plans allow parents to self-direct their investments among a menu of options, and therefore adjust their level of risk. Taxable brokerage accounts can allow investors to adjust their level of risk in a self-directed manner across a selection of investment options based on the brokerage platform used.

—Investment Changes: 529s are granted two investment changes per year, while taxable brokerage accounts allow an unlimited number of changes.

—Account Control: 529s allow the accountowner to maintain control of the account, and allow for an unlimited number of rollovers if the beneficiary is changed to a member of the family of the previous beneficiary. Therefore, 529s allow changes in beneficiaries while the accountowner maintains control of the account. Taxable brokerage accounts allow accountowners to maintain control of the account.

—Financial Aid: 529 assets increase expected family contribution (EFC) by 5.64%, but distributions from 529s do not impact EFC. Like other taxable accounts and bank balances, assets in taxable brokerage accounts increase EFC by 20% and distributions from the account increase EFC by 50%.

—Qualified Expenses at Eligible Institutions: 529 savings plan assets can all be used for any qualified higher education expense such as tuition and fees, supplies and computer technology for the vast majority of colleges and universities in the U.S. and many abroad so long as they are eligible for financial aid from the U.S. Government. Otherwise, the gains portion of the 529 distributions are subject to a 10% penalty and taxes. There are exceptions to the penalty, as covered in a previous issue of the 529 Dash. Taxable brokerage accounts are not a dedicated investment vehicle for higher education, and so assets can be distributed for any purpose including higher education. Generally, distributions from taxable brokerage accounts are subject to the ordinary income or long-term capital gains tax rate.

—Distribution Restrictions: 529s allow distributions to the school, accountowner or beneficiary. Taxable brokerage accounts can be used for any purpose.

Therefore, advisors, accountants and estate planners should understand the key product features of 529s and taxable brokerage accounts, how the two types of plans function independently and ensure the most appropriate investment vehicle is used for your clients given their specific needs.

Next week, we will compare and contrast 529 college savings plans and ABLE accounts (529A).