Firstly, in response to those of your that compared DRIP (or maybe DSPP would be better) to 529 for breakeven, I reviewed my "first pass" spreadsheet and did not find any obvious errors. Under the assumptions I used, 529 still slightly better than a DRIP but not by much; with 9%/year appreciation, $10,000 original funding, 0.8% yearly 529 fee and 4.25% Connecticut tax, the 529 was slightly better. After 18 years, had about $500 more in 529 on total of about $40,000.
Did alittle more reading today on this subject and like to pose questions on two more issues regarding 529 plans for comment.
First, a comment about ownership. In setting up 529 ownership it can be in student's name and transfer of money to fund the account is same as a UGMA payment to student. To avoid this the parent or grandparent (or other benefactor) can have ownership, recognizing tax implications discussed below.
One word about the term beneficiary regarding 529s. It seems to me that unlike other financial instruments, the beneficiary does not have the absolute right to the money; that is at the discretion of the account owner. If the owner (ie. parent) decides not to give the money to the child, that is perfectly legal. This differs from a trust, for example, where the beneficiary has a legal right to certain benefits that cannot be denied.
The second question is how much one might want to put into a 529 when children are young. Let us say that one has two children and assumes that a private college will cost $200,000 when children are ready, a state school $100,000. All goes well, the law is made permanent, the 529 performs well and the assumption about future college expenses is right. At one extreme, if both kids go to private college, the costs will be $400,000 and the 529s will fund those educations fully. At the other extreme, if neither kid goes, the cost is zero. What do you plan for? If one goes all the way and funds the 529 for $400,000, it is possible to have the entire $400,000 unused for college expenses.
Combining this with the owership issue above, it presents two uncomfortable choices. The account holder, either parent or grandparent, can either cash in the account and be subject to perhaps 40% tax on gain of about 75% of the account value, or $300,000 (27% federal, 10% penalty and 4.25% state tax in my case) or he can find another beneficiary for this account.
If the ownership of this account is with the two kids, it could be disaster. At the age of majority they gain full control over the account and could well feel that a new sporty car or music gear is more important than a college education. I would avoid this scenario at all costs.
In my case, we offered our two children their pick of any school that wanted to go to. One choose not to go to college, the other selected a state school. If I choose to fully fund the $400,000 number, I would be left with about $300,000, of which $225,000 would be gain taxable at about 40%.
Going back to my original calculation showing a $500 difference in favor of the 529 plan versus the DRIP on $40,000, that means I would have had $5000 less if I used the DRIP approach versus the 529 when my kids were ready for college looking at the $400,000 target. In return, I would save about 22% (40% to cash in 529 vs 15% federal+ state tax for DRIP) of $225,000 in taxes, or about $50,000. In this scenario, the DRIP approach is $45,000 better.
As a bit of editorializing, I am concerned about the vested interest the parties involved with 529's (State governments, investment firms and schools) have in having people maximize the 529 accounts. I do not argue that if everything went according to plan, they are great. However, if the plans did not materialize then a 529 plan can have serious downsides, which are not clearly spelled out. Using a low cost mechanism such as DRIPs in the parent or grandparent's name would provide substantially more flexibility at very small potential penalty with potentially substantial savings if things went differently than originally planned.
To respond to some specific questions:
Mike Erpenbach-I agree that dividends received from a DRIP/DSPP would be taxable each year and have factored that into calcuation. For stock itself, do not see why any yearly capital gain tax would be due if stock held over many years. Only be due when stock is sold. In fact, holding a stock not paying dividends but realizing entire increase in value by share appreciation is a better case.
tjb_nc, per your comment about 15% laws sunsetting in 2008, if that occured would certainly consider rolling money in a 529 at that point if it appeared attractive against other available options. On other hand, the old law permitted a maximum 18% capital gain rate on stocks held more than 5 years, so this could work too.
SanpatSaraf's, your idea to transfer appreciated DRIP/DSPP stocks to student when he is really in college is an excellent thought. Recognize basis is still purchase price of parent or grandparent but with his lower tax bracket, could reduce tax load. Perhaps would be a good move to do in last year of school, when it would not impact financial aid considerations and/or be used to pay off loans.