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Direct Stock Buys Can Be A Smarter Choice For College Funding

by DirectInvesting.com

"The bottom line: The tax cost of using DRIPs will be small compared with the flexibility, control, and profit potential they offer. What's more, you won't face an IRS penalty if you use that money for something other than college!"

College savers are enrolling in 529 plans. Strategic Insight, an Asset International company, just reported that assets in 529 savings plans topped $224 billion at year-end 2014, up 33% in the past two years.

The big attraction, of course, is the tax benefit. There's no tax deduction for 529 contributions (you contribute after-tax money) but any investment earnings inside the plan will not be taxed annually or when they are withdrawn as long as the money is spent on higher education.

So far, so good

What's not to like about tax-free investment income? With college costs reaching incredible levels, families need every possible edge to help their kids wind up with precious diplomas.

That said, 529 plans have cons as well as pros. I recently received an email from a mother I'll call Rita, who has a 529 for her child's college fund.

Rita's 2014 year-end statement from her 529 plan shows that she had invested more than $37,500 since 2007, when she opened the account. Her balance has grown to over $47,200, for an investment gain north of $9,700.

"That might look like I made 25%," writes Rita, "which would be fantastic, but on an annualized basis, the return is actually 5.82%." Besides mediocre investment results, Rita notes the high fees. She opened the account with a $2,000 contribution and immediately incurred a $160 (8%) setup fee.

Continue

"There are foreign taxes being assessed, too," Rita adds. "I'm not sure how expenses are accounted for. If this statement is meant to confuse the average investor....mission accomplished."

Rita concludes that she has stopped contributing to her 529 account.

Balancing the books

Now, it's hardly surprising that the financial firms offering 529 plans charge fees, or that their statements might be confusing. It probably won't shock you to learn that government-created 529 plans require paperwork, which also can be tedious.

You might be surprised, though, to learn that 529 distributions aren't always tax-free, even when the money is spent for legitimate college costs.

To see how this might work, suppose your daughter goes away to college for the 2015-2016 school year. You pay $15,000 for her education in 2015 and another $15,000 in 2016. When the school year ends in 2016, you add up the costs and take $30,000 from the 529 account where your daughter is the beneficiary, tax-free.

Well, no. The money you withdraw in 2016 is tax-free only if you spend that amount on qualified costs that year. If you withdraw $30,000 in 2016 but only $15,000 is attributable to the plan beneficiary's higher education in 2016, only $15,000 will be treated as tax-free.

You'll have to go through some calculations to figure out how much of the other $15,000 distribution from your 529 plan will count as a tax-free return of your investment and how much will count as earnings, subject to income tax and a 10% penalty.

In short, getting the most tax advantage from a 529 account requires careful recordkeeping and compliance with tax laws.

Out of control

What's more, the costs and potential hassles of 529 plans may not be the biggest drawbacks. When you invest in these accounts, you relinquish control over the amounts you've contributed.

Typically, 529 plans offer a limited selection of funds to investors. "Age-based" accounts are particularly popular; these accounts are heavily weighted in stock funds for young beneficiaries and gradually transition to higher bond fund allocations as the students near college aid.

Such one-size-fits-all accounts likely work well for many parents of college-bound youngsters, as they demand little time and attention. However, more self-reliant investors might not want to give up control over their college funds.

Direct investing

So what's the alternative? If you don't use 529 accounts for college funding, how should you put aside money to help assure your children will be able to afford the rising costs of higher education?

Well, let's go back to Rita. Rather than making more contributions to her 529 account, she has "opened DRIPs instead."

That is, she is putting her college money into dividend reinvestment plans (DRIPs). These plans, offered by more than 1,000 major companies, offer more than just the ability to reinvest dividends in the issuer's common stock. In addition, DRIP participants typically can invest substantial amounts into their plan accounts without paying a brokerage commission.

The bottom line is that Rita is investing for college by holding a portfolio of dividend-paying stocks. She can choose the companies she wants to include in her higher education fund, and Rita can sell the shares if she loses confidence in their future prospects.

The case for investing in stocks is well known: long-term, they have rewarded patient investors. Moreover, dividend-paying stocks provide regular cash flow, which can be especially attractive in these low-yield times, and relative safety in periodic bear markets. If you put college money into DRIPs, you can include some companies that your child will recognize, so this strategy also can help a youngster become familiar with investment concepts. 3M, AFLAC Inc., Bank of America, ConAgra Foods Inc., Dr Pepper Snapple, Duke Energy, Exxon Mobil Corp., Foot Locker Inc., General Mills, Johnson & Johnson, Kellogg Co., Kraft Foods Group Inc., Sherwin Williams Co. are among the hundreds of companies that allow direct investments through the company without charging fees.

When you can buy and hold these stocks at little or no cost and teach your kids about the stock market, 529 plans with all the fees and paperwork involved become less attractive.

Talking taxes

Proponents of 529 plans will counter that 529 plans offer professional management for your college money. That's true--DRIPs are typically for investors who want to pick their own companies.

Beyond professional management, supporters of 529 plans point to the tax advantages. As mentioned, distributions to pay for college costs can be tax-free, even if the distribution includes investment income inside your account.

Such a tax benefit is attractive, but the tax story doesn't stop there. If you invest in DRIPs instead, you'll receive a stream of dividend income each year. Those dividends generally will be taxed at only 15%, so getting $2,000 a year in dividends from a $100,000 DRIP portfolio would generate just $300 in tax, for example. That's probably less than the fees you'd pay for a 529 plan.

Even if you are in the highest tax bracket, you'd owe no more than 20% to the IRS for qualified dividend income. And if you have modest taxable income--up to $74,900 for a couple filing jointly this year--you'd owe 0% tax on those dividends.

The same tax brackets apply to long-term capital gains, so any stock profits you cash in to pay college bills will be lightly taxed. The real cost of the ongoing fees associated with 529 plans is the compounded value of money that could have been.

The bottom line: The tax cost of using DRIPs will be small compared with the profit potential you lose from 529 fees. What's more, you won't face an IRS penalty if you use that money for something other than college!