I do not have 529 accounts for my kids. There I said it. The reason we do not is not because we cannot afford it. I’ve stated we are on track to save 1 year’s worth of expenses in 2017. It’s also not because I do not plan to pay for my children’s college. It’s not even because I do not think it is a good deal to pay for college. So why don’t I contribute to a 529?
What is a 529?
A 529 Plan is a tax advantaged college savings plan. You place after tax money into the account and any earnings on the funds accrue tax free so long as they are used them for college expenses. College expenses includes the cost of community colleges, universities, post secondary, or vocational schools. It can also be used for items needed to support that education like computers. This makes them the tax advantaged equivalent of a 401K or Roth IRA. However, they come with a catch. They need to be used for education.
This requirement to use it for education is actually fairly flexible. It can be used for the person you set it aside for, or you can apply it to another family member who may attend college. Even if your kids skip school, you could use it for a grandchild. You can also use it to pay for continuing education for yourself. The point is that it must be used for education or you will pay a 10% penalty plus income tax on earnings to remove the funds.
529 College Education Exceptions
There are a few decent exceptions to the rule. If your child earns a scholarship, attends a Military School, becomes disabled, or dies you can avoid the 10% penalty, but you will still be on the hook for the income tax. In the case of scholarship, this exception is limited to the amount of the scholarship.
Plans are typically provided by states. In most states you will receive special tax treatment only on your own state’s plan. As such it makes the most sense to invest in your own state’s 529. However, there are some exceptions so you should check your state’s rules. Also there are no income limits on contributing to a 529, so anyone can do it.
Why do I still not contribute?
The above sounds like a sweet deal, and in some scenarios it is. However, I have decided it is not for my family for the following reasons:
- Fees of 529s are higher than their mutual fund equivalents. The difference is not huge, you’re talking perhaps in the neighborhood of .25 percent. That’s not a huge difference. Over about 18 years this will cost you about 460 dollars on a 10,000 dollar investment. Still it is a difference.
- Typically, you can’t choose your investments. They are chosen for you by the 529 Plan as something akin to a target date fund. I have stated before I am not a fan of target date funds for lack of control of the investment. The same applies here.
- Furthermore, many of these plans shift assets around various funds automatically over time to be more conservative as you get closer to usage. This may not be in line with the allocation of our overall portfolio, and I’m not entirely comfortable with part of our portfolio being out of sync. This would likely result in a lower return for this portion of my portfolio.
Money is fungible so there is no structural difference between paying for college out of my 529, my savings, or my paycheck beyond the tax benefits, the 529 costs, and the 529 rate of return. So if costs are higher as per my first point and rate of return is lower per my third point, then the tax benefits need to make up the difference.
My view on 529 Tax Benefits
So, about those tax benefits. They are pretty sweet and there are a lot of loopholes. However, I can not shake the feeling that I may need one of those loopholes. I’ve stated before I believe the costs of college will see a massive decrease in our lifetimes. I also like to think my kids will get some sort of scholarship. It is very difficult to estimate the amount I’d need in these accounts. Go above and I face a wipe out of any tax benefits. Remember there is no exception to the income tax benefits if not used for education, only the 10% penalty. So the 529 is not without risk.
Meanwhile, there is the risk that the laws will change and the tax benefit will disappear altogether. That balloon was floated in discussion in 2015 by the national government. It was roundly rejected by the public, but any investment in a 529 is essentially placing a bet on those tax benefits remaining. That makes me nervous.
Tax Advantaged Opportunities are Abundant
The final reason for me speaks to the volume of taxable accounts otherwise available. Think about it, as a worker you might qualify for a 401k of 18K/yr. You also could qualify for a Roth IRA of 5.5K/yr. Your spouse gets the same thing if he/she works (as mine had previously). You have HSAs which are 6.75K per household. Right there you’re talking about the median family income, 53K, in the US. You can add to that other tax advantaged options like Flexible spending accounts for day care (5K, but only on initial income), Employee Stock Purchase Plans (10% of pay limits, deferral of tax only), I and EE bonds are tax free when used for education (10K per year), municpal bonds are typically tax free, and mortgage payments.
If you’re self employed you can throw in up to 53K on top of that in employer contributions provided your company makes enough money. The point is you can really sock away a large number in tax advantaged accounts without incurring the lower return risks of a 529. Simply put it is better to prioritize accounts with more flexibility like a Roth IRA or a 401K over an account with spending limitations like a 529. You should also be prioritizing your own retirement over your children’s education anyway. It will not help anyone if you pay for their college and then 5 years later you move in with them because you’re broke. So those accounts become first and there are just so many options available there I do not see the need for a 529 in my life.
Infinite Money and a 529 College Savings Account
A final note, with infinite money I probably would get a 529. Furthermore, if my income were too high for many other tax advantaged accounts my decision might be different. I’d consider taking the risk of tax laws changing with the understanding that should my children not need it I could have my children inherit it and use it for their children. In the real world, to date it just does not meet our needs. Maybe that will change some day.
In Pennsylvania we have what is called the PA-529 GSP for guaranteed savings plan.
We also get a state tax deduction going for money going in to the plan.
Basically the guaranteed part is, your gains match the year over year increase of the colleges. I also noticed as you stated, the closer to college they were made the funds 1/3 to 1/2 in cash, and the other were in very low performing bonds. I have done well with this getting 3-5% gains plus a state tax deduction. Most people aren’t disciplined so earmarking it I think makes sense, and it also keeps money separate that I think most couples would try to leave the money earmarked for kids college in the event of a divorce.
I can’t say I agree with your ideas on college costs going down. Just to much tied to it not the least of which are teacher pensions. There are great online options in general, however the online college classes that count for credit, are generally not much if any cheaper thus far from what I have seen. I think options for being trained especially in a computer technical field outside of college will continue to increase and be cheaper, but that is an alternative route to college. My youngest is 16 so it’s not going to change in the next 6 years to help me out.
I might be wrong about the college costs, I’m just not willing to lock in funds just in case. For a counter point Georgia Tech just announced a second online masters degree that is indistinguishable from an in person degree. The cost is significantly less then in state. I have 13-15 years for things to change.
It’s very interesting how the tax system for education plan works in the U.S.. in the Canadian system, we don’t have any provincial plans, we have a national plan called the Registered Education Savings Plan (RESP). This plan, you get a free $500 grant when you contribute $2,500 per child. For this plan, you can invest like you would for your taxable account. When you withdraw, only the gains are taxed in the child’s tax bracket.
It seems like there are more flexibility and incentives in Canada, so I am more that happy to invest in my kids’ RESP.
It sounds like it. I gather your university options are also a bit cheaper to start.
I’m with you 100% on this. We originally opened 529 accounts for each of our kids, but haven’t funded them in years because there are just too many rules. Nice post.
Thanks for the feedback MBC. Are you intending to pay for the kids college?
We are, but like you we also expect some scholarship or grant money to come in too. Or maybe we will take up residence in a country where University is free?
I have a 529 plan in place for my daughter, but I only put about $125/mo. into it. Her grandparents put a little bit into it as well. We have a little over $10k in it, which is Ok, but it’s not going to pay her way through a year of school.
Sometimes I feel a little guilty like I should be putting more into it, but in the long run, this is probably the smarter move. She can get loans as needed and I feel it’s good for her to have a little skin in the game.
— Jim
We definitely as a culture lay an expectation that parents pay for college. I still plan to pay, I just plan on not explicitly saving college allocated funds.
Our state no longer provides tax benefits for 529s, but I think Jim has hit on one of the major reasons we still have and contribute to one…they allow other family members to easily contribute to our daughter’s college education as well.
Our state also provides no tax benefits. I can somewhat see doing so for grand parent contributions. At the moment we just push those into the kids savings accounts/bonds. If it gets sizable enough to worry about the kiddie tax we might consider other options. They are a long way from 2100 a year in income.
I agree with your general thesis that 529’s can be tricky,. but I think if you shop smartly across the states’ plans, you can find some that address several of your concerns.
I am in MIchigan, and invest in my state’s 529 plan in part because it is one of the few tax deductions the state allows, up to $5,000 per person. (so, $10,000 for me and my wife) Our plan is administered by TIAA, and in addition to target-date funds, has a selection of a few index funds in key categories (US stock, international stock, fixed income, etc.) There is an administrative fee that increases the costs. For example, the US Equity Index, with a direct fund cost of .05%, has a total cost of .12%–still significant, but not that bad. (certainly not as bad as the cost inflation in my HSA!)
My plan, in considering some of the same points you have, is to fund the 529 to the maximum deduction until my child is 5. (he is 2 now) This $50k then has 13 years to grow, which will grow 2x to 4x. My intent is to fund the bulk, but not all, of college cost with this, to avoid the penalty. (I call this “The Price Is Right” rules–come close, without going over)
So, there is some flexibility to make it work. It is also one of the few places where other donors can explicitly contribute. (grandparents take more coordination / estate planning)
What will you do if your kid skips school or gets a scholarship?
He has a bajillion cousins, who are valid beneficiaries we could transfer to. The likelihood that all would opt out in some way is low, so we would make someone’s year (or 4). If they were covered, and he got a scholarship, I would happily withdraw this now-surplus money and use it to celebrate his (and our) success. 🙂
To be clear, we have our retirement comfortably covered. At the moment, targeting FI at 50. (5 years) So, it is not an either-or choice for us.
We have a 529 for our son thru our state’s plan, but I have been thinking about reducing my contribution there and putting the difference in an ETF or index fund. The fees would definitely be lower and there would be more flexibility in liquidating or investments. Of course the drawback would be lesser tax deduction.
It’s all trade offs. I’d love to hear what you decide.
Thanks for challenging the ruling thinking on this. Most people treat 529 plans like a vaccine. “You have no (or underfunded) 529? Jimmy, get away from that little savage right now before you catch something.”
I do contribute to one, but it is a small amount that comes after the 457 & Roth are maxed out. I love my children, but having paid for my own education I know it will mean more to them if they pay for at least some of it. No one values a free ride.
That’s a great rationale as well. I can definitely understand ensuring your children have skin in the game.
I’m currently contributing to a 529 plan for each of my 3 kids. My current contributions sustained over the years will pay for 1/2 of their tuition at an in-state university. Our state offers a tax deduction up to $10,000 in contributions and our 529 plan is managed well compared to other states. I’m happy with this plan!
However, I think you’re absolutely right to say that retirement should come first. If we didn’t have a form retirement investing plan in parallel, it simply wouldn’t make sense.
The in state tax deduction does help to make he risks more palatable. Sadly my state is not one of them.
I would really encourage each parent to closely examine their state’s 529 plan. For example, the Oregon plan has fantastic equity index funds, low costs and is a huge advantage for state tax deduction since Oregon’s state taxes can approach 9%.
9 percent, ouch. I thought we had it bad at 5. What happens with the state taxes in Oregon if your kids get a scholarship exception?
We’re currently taking advantage of the tax benefits that our state offers for a 529. It’s not much money, $4k a year, but they have a really good plan that fit into our risk tolerance (not a target fund). So we decided to take the leap. But I definitely see your point of view.
What type of break do you get? What are the rules on the state break in case of scholarship?
Great thoughts FTF – I agree, I don’t think I’ll do a 529 because I don’t know if I want my kids to go to college 🙂 but seriously, if they want to, I hope to have the investment income to be able to pay for it myself.
I certainly want to have the funds. Saddling them with huge student loans is not something I’d want to do.
We are in Oregon too and 9% income tax really sucks. One of the major reason I want to move to Nevada or Florida…
My kid’s 529 is worth almost $60k now and I just transferred it to Vanguard. Vanguard is pretty flexible. You can invest in target date funds or other index funds.
The great thing is I don’t have to pay back the Oregon tax deduction I took. Score!
If our kid get a scholarship, we can gift the 529 to other family members. I don’t think that’s a big deal.
That’s a great benefit to keep the Oregon tax break regardless. That might have changed my personal decision.
Great content FTF. I’ve hemmed and hawed for years over the 529 and finally decided to do it. My state gives a tax deduction up front which is over 5%, so I look at it as a guaranteed return even if they change the law on gains later on. Additionally, I’ve realized behaviorally that I need an account dedicated to college savings or I will just keep it in a general investment bucket and lose focus. That said, I don’t want to overfund the 529 for the reasons you mentioned.
I’m fascinated by the bonds but I see 2 hurdles to the EE. First, the 20 year redemption means I’d need to invest buy it … a few years ago. Second, I notice that I already earn too much to claim the full interest exclusion. “For married taxpayers filing jointly, the tax exclusion income limit is an adjusted gross income of $146,300 and above.”
Great point about income cutoffs. We plan on being out of the W2 world sometime during the college years, so the hope is by then I can structure things to limbo under cutoffs. Time will tell. Thanks for the comment.
No 529 for me either. After our baby was born we set up a regular taxable custodial account and started filling it with dividend paying stocks. I wanted to create a portfolio for my child that could create an ever increasing passive income stream without having any strings attached. I guess the thinking was similar to going the route of a ROTH or taxable account. In two decades who knows what the college landscape will look like and there is a good chance that traditional college won’t even be necessary. Thanks for sharing your take on the 529.
We’re doing something similar. I look forward to the day they have an income and we can also match it into a Roth.
Very thought provoking post, FTF. As I wrote in my post today, we have a few dilemmas that we’re facing with 529 plans as we look at it harder with our second kiddo. A couple things we have considered though is that we already max out our other tax advantaged accounts, we have found a couple states with Vanguard index funds that we can hold static to match our overall investing strategy and with modestly low fees in the 16 to 20 bps range (vs 5 to 7 bps on the same funds in a taxable account). So all in all, we think the tax benefits are worth it to some extent. But we definitely don’t want to over fund especially considering the “risk” of the kids getting a scholarship or deciding to go an alternative route than college.
If someday college because cheaper, I think the importance of an advanced degree will be more important so the 529 can still have good use there. And Lucy and I do plan on leaving an inheritance for the kids which we can use the 529 plan for by changing the beneficiary to perhaps the grandkids’ names.
Lots to think about and you raise some great points. Thanks!
Good luck with your decision, I look forward to reading about your final one.