An analysis of Internal Revenue Code Section 529 college savings plans: do they remain a viable investment option?

• Author: Lowe, S. Keith
• Position: Report

1. INTRODUCTION

   Funding a college education can be one of the most expensive financial endeavors in a lifetime. For many persons, the costs associated with successfully completing a college degree will rank second only to a home purchase in terms of most expensive purchase. Many parents and grandparents have traditionally taken on the funding burden for college students to ease a young person's future debt load. Expenses associated with higher education, specifically tuition rates, have continued to escalate at levels far outpacing general inflation (Standish, 2010). These increasing college costs have forced many to abandon the general savings and "pay as you go" philosophy and seek an alternative source of funding.

   The past 25 years have spawned a period of policy changes in a state's assistance to the financing of higher education (Baird, 2006a). Many states, in direct response to the seemingly runaway cost of higher education, have established new programs designed to assist individuals in saving for college. These programs, collectively known as Section 529 plans, are named after the 1996 addition to the Internal Revenue Code (Clancy, Cramer, & Parrish, 2005). Section 529 plans are revolutionizing the way parents and grandparents are saving for college, similar to the method by which 401(k) plans revolutionized retirement savings (Buttrell, 2010).

   With Americans pouring billions of dollars into 529 plans and contributions expected to increase dramatically in the next decade (Farmer, 2011), an analysis of these plans is relevant. This paper examines the historical aspects of rising college tuition rates, types of state-based Section 529 plans, advantages to the investor, and the current financial strength of these plans. Additionally, the future existence of Section 529 plans as a viable financial instrument to provide a hedge against inflation is examined.

2. INCREASE IN COLLEGE TUITION COSTS

   For the past half-century, postsecondary tuition rates have consistently increased at a rate that is approximately twice that of the general inflation rate (Standish, 2010). The index most commonly used to gauge the general inflation rate has been the Consumer Price Index for All Urban Consumers (traditionally referred to by the acronym CPI-U). The CPI-U is released monthly by the Bureau of Labor Statistics division of the U.S. Department of Labor.

   During any five-year period from 1958 until 2009, the average annual tuition inflation rate was between 6% and 9%, ranging from 1.2 to 2.1 times general inflation. From 1958 until 1970, college tuition rates are based on the Digest of Education Statistics (U.S. Department of Education, 2011) while all rates since 1971 are provided by the College Board (College Board, 2011). A comparison of tuition increases and the corresponding CPI changes for the past decade (2000-09) are provided in Table 1.

   On average, postsecondary tuition tends to increase about 8% per year. To provide an illustration of this rate's effect on future tuition levels, an 8% annual increase in tuition levels will cause these levels to double every nine years. Assuming the traditional college student will matriculate at age eighteen, college tuition rates will be three times current rates for a child born in 2011 (College Board, 2011).

3. HISTORY OF SECTION 529 PLANS IN THE U.S.

   A Section 529 Plan is a tax-advantaged savings plan designed to encourage saving for future college costs. Known as "qualified tuition plans" under Federal law, they are sponsored by individual states, state agencies, or educational institutions. The reason "Section 529" terminology is often used to describe these plans is because 529 is the section of the Internal Revenue Code (IRC) that governs their operation (Baird, 2006b).

   The groundwork for Section 529 plans was created by a Federal court case on November 8, 1994 (Zeiner, 2009). In the decision rendered in this case, the 6th Circuit of the U.S. Court of Appeals held that that Michigan Education Trust is an agency of the state and not subject to Federal taxation (Olivas, 2003). Although the ruling only applied to states included in the 6th circuit at the time (Michigan, Ohio, Kentucky, and Tennessee), this ruling provided a precedent for case law that would eventually be applied to all U.S. circuits (Doyle, McLendon, & Hearn, 2010).

   The U.S. Congress created the college savings plans in 1996 through the Internal Revenue Code Section 529. Ironically, 529 plans originated in a piece of Federal legislation known as the Small Business Job Protection Act of 1996 that had no relationship to saving for college (Eighme, 2006). The specific legal implications were refined in subsequent years, including the Taxpayer Relief Act of 1997, the Economic Growth and Tax Relief Reconciliation Act of 2001, and the Pension Protection Act of 2006 (McLendon, Heller, & Lee, 2009).

4. TYPES OF SECTION 529 COLLEGE PLANS

   All 50 states now offer at least one 529 plan as a vehicle for investment in a child's postsecondary education (Lucido, 2010). While the types of 529 plans vary significantly across states, each plan will be classified under one of two general classifications. These two classifications consist of a state savings plan and a prepaid tuition plan.

   4.1 State Savings Plans

   State savings plans allow individuals to save money for college tuition and related expenditures and these savings are stored in an individual investment account. These plans are operated by each individual state, which typically contracts with an experienced financial institution that provides operational oversight to the plan (Kobelsky & Wilkinson, 2007).

   Startup of an individual state savings plan is relatively easy. An individual completes an application, chooses a beneficiary to whom the proceeds will be distributed, and begins contributions. A unique difference lies between opening a private investment account and a state-based college savings plan. Individual investments are not chosen by the investor; several portfolios are usually offered which have been chosen by the plan's professional manager (Neath, 2002). For most investors, having a small choice of investment selections is less daunting than having to...