I hate default financial advice. I’ve even written an entire book dissing the common advice that you should have six months emergency funds in a high yield savings account.

Today I’m hating on 529s, a.k.a. college savings accounts. While millions of parents are devotedly funding their 529s month after month, thousands of fee chargers are laughing all the way to the bank. These constrained accounts aren’t nearly the darling that investment advisors make it out to be.

Reason #1 – Minimal return benefit

529s come with a ton of restrictions. But even the people who sell 529s point out that the return advantages are pretty limited. Check out this image from Wealthfront:

Less than a 14% benefit…and this is the most generous view of 529s! As you can see, Wealthfront is assuming you have the money invested for 18 years. But 529s tend to be funded over time, and later deposits will have an even smaller return benefit.

Reason #2 – You can now access tax-efficient investing without locking up your momey

What most attracts people to 529s is their after tax efficiency. But the rise of roboadvisors in the last few years has made tax-efficient investing available to the masses, without the restrictions of a 529.

For example, Wealthfront’s tax optimizing harvesting strategy generates an additional return of 58 to 107 basis points on a long term investment. Assuming a 6% annual return and a mid-point benefit of 82 basis points, the return would be 14% higher over 18 years. About as much benefit as having a 529 in the first place.

Reason #3 – Your kid’s financial needs for college are not predictable

What if your child gets a full ride? What if your child decides not to go to college? What if college becomes free? What if higher education evolves to a completely different model?

None of these is necessarily LIKELY to happen, but if any of them do it's not clear what will happen to your 529 funds.

Reason #4 – Fees

529 fund fees are typically higher due to their smaller asset base and outsourced administration and management. By one simple (and slightly dated) estimate, 21 basis points higher for a moderate allocation. That 0.21% per year chips away at your return: over 18 years that could make a difference of almost 4%.

Reason #5 – Gift taxes

529 contributions are considered gifts to your kids. This is subject to annual and lifetime exclusions.

On the other hand, tuition you pay directly to an institution is not considered a gift. Given a choice, you are better off preserving your gift allocation for other purposes and keeping your tax planning more flexible.

Reason #6 – You can’t access the money

Many bank loans require the borrower to show evidence of “liquidity”. For these purposes, 529s are not counted, whereas standard brokerage accounts are. This can make a difference to your mortgage rate, amount, and other loan terms.

On the contrary, not only do regular brokerage assets count towards liquidity, you can often borrow against them, and at low rates.

Reason #7 – Subject to stiff penalties, often incurred

On a related point, if you do ultimately need the money in your 529 for some unforeseen circumstance, not only do you have to pay all the taxes you would have owned had you been in a regular account, you are subject to an additional 10% penalty.

Think you’ll hold out? Maybe you won’t. 401(k)s are subject to the same 10% penalties and yet billions per year ends up being subject to the tax. Medical emergencies and unemployment top the list for reasons people do this. I couldn’t find any hard numbers on line, but I suspect a lot of 529s get liquidated for similar reasons.

What to do with this info

529 funds can still make sense in some instances, but it’s important to understand the tradeoffs you are making. Given that you will be most tempted to dip into funds for emergencies, it’s important to provide for an emergency fund first. Before funding a 529, you should also consider fully funding an IRA, which has far fewer restrictions and similar tax benefits. Some people might also create a Trust, which allows a more customized solution for your child’s financial needs.

My approach to funding for college

I initially funded 529s for each child before deciding it wasn’t worth the tradeoffs. So I have some small portion of their potential expenses in 529s.

I am overfunding my oldest child’s account relative to my other kids, because you can transfer 529s to younger kids but not vice versa.

The remaining amount I plan to fund out of a Wealthfront account which is set up for automated tax loss harvesting. I fund this account every month.

I’m happy to have a blend of sources (aka a “mixed strategy”) in case regulations change. Let me know what you think of 529s in the comments below!

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