Stay Away From State 529s

Matt wants to know if Dave recommends a state 529 plan or an ESA for college savings. Dave doesn't recommend a state 529 plan because it's basically prepaid tuition.

QUESTION: Matt on Twitter wants to know if Dave recommends a state 529 plan or an ESA for college savings. Dave doesn't recommend a state 529 plan because it's basically prepaid tuition.

ANSWER: I would not use a state 529. A state 529 is prepaid college tuition. There are two major problems with prepaid college tuition. Number one, several of these states have managed these funds so poorly that now they're not even going to be able to honor the prepaid portion. It's really up in the air. I wouldn't put a dime in the state prepaid college tuition—ever—for that reason alone.

On top of that, let's think about what is your rate of return on your money? What is your return on investment of your money? If you prepay your college, when the kid's eight years old, 10 years later when he goes to college, what did you make on your money during that 10 years? How much did your money grow? It grew however fast college tuition grows. It's more expensive 10 years later than it was 10 years before, right? The amount of money you made on your money is the inflation rate of college tuition, which nationally for the last 50 years has been about 7.2%. You're making about 7% on your money when you do prepaid college tuition plans. I don't recommend it. It is better than doing nothing, but not by much. It's about a break-even. If you can make more than 7% on your money, you'd be better off.

I recommend the Educational Savings Account (ESA) for the first $2,000 a year that you invest. Now, $2,000 a year invested will grow completely tax-free, and if you put that in good growth stock mutual funds, you should average more than 7%. You certainly would if you'd done that for the last 18 years. You would have made 12-14% if you'd selected a decent fund. I certainly have. I know the market's up and down, but it's a whole lot better than prepaid because even with its ups and downs, it makes you more than 7% on average.

I don't use a mutual fund to invest unless you have at least five years. So if your kid is 13 years old or older, you're just saving money for college. You're just chunking it in an account.

If you want to save more than $2,000 because you're going to send your kid to graduate school at Harvard, then you could use a different kind of 529. That's the kind of 529 where you can choose the investments inside the 529. That grows tax-free when used for college, and you can put thousands of dollars—depending on the situation—in it each year, and you choose the plan. You choose the mutual fund. You want the kind of 529 where you control the options.

The ESA at $2,000 is one of the evil Bush tax cuts. It appears Congress is not going to renew those in any form during this session. We don't know where the ESA for $2,000 a year will stand for 2011. It appears that the Republican Congress will ask and put on the president's desk for the Bush tax cuts to be extended for a couple of years. That $2,000 a year as of January 1 will become $500 a year under the current law. You're probably going to want to do a 529 where you do the investing.