Since having a kid of our own I have often found myself in the company of other parents. And let me tell you, there is nothing in this world parents want to talk about more than the latest exploits of Little Johnny or Young Suzie.
“Oh man, you do NOT want to know what I found in Johnny’s diaper!” (you’re right)
“Oh my gawd, Suzie said the cutest thing today! Let me tell you all about it.” (that’s, uh… really cute)
And my personal favorite:
“Yeah this kid is wicked smart… probably gets it from his old man, hehe. So anyway, I opened up a 529 plan for him last week. We even did that thing where you contribute 5 years’ worth all at once. You knew you could do that, right?”
Me: “Yeah, uh.. Jr doesn’t have a 529.. And we have no plans to start one.”
A 529 is a tax-advantaged account used to save for future college expenses. (And now K-12 after passage of the TCJA of 2017.)
You gift contributions to a beneficiary (e.g. your kid) which are invested in mutual funds. All income / gains are tax-deferred, and when withdrawn for qualified education expenses (e.g. tuition) any/all gains are tax free.
Sounds nice, right?
Why GCC Jr has No 529
Why let the opportunity for tax free growth slip by?
Tax Deferred / Tax Free Growth
We already have a very interesting investment account that has tax deferred and tax free growth: a standard brokerage account.
I’ve demonstrated this over the past 4 years. Low/no yield stocks and ETFs grow tax deferred, and qualified dividends and long term capital gains are taxed at 0%.
If I’m going to commit dollars today, solely for education expenses in a decade or two, I want something substantial in return. Now. Like a big fat tax deduction or credit. No up front benefit, no deal, and there is no deduction at the Federal tax level. (Some States offer a small benefit, but I don’t live in those States.)
If 529 funds are used for something other than qualified education expenses, a penalty of 10% is assessed to withdrawal of gains.
By making a well intentioned commitment 18 years in advance, with no tax benefit, I sign up for a potentially large penalty.
What the 529 plan offers us is a pair of handcuffs and a stick with no carrot.
Some exceptions apply, such as if your kid gets a scholarship, but then…
Ordinary Income Tax Rates
By having an acceptable exception I avoid the 10% penalty, but I’ve converted my very nicely taxed capital gains (0% tax rate) into very poorly taxed ordinary income (up to 37% tax rate.) I’m not looking for opportunities to pay more tax.
Of course, you can avoid that penalty and tax…
Penalty Exceptions aka Other “Benefits”
One benefit that is often highlighted by the 529 Sales Team is that you can easily change the beneficiary of a 529 to your cousin’s 3rd wife’s brother’s child (or other qualifying family member), and then withdrawals are tax free. Which is nice if you want to pay for your cousin’s 3rd wife’s brother’s kid’s education.
529 plans are organized by individual States and managed by a 3rd party. 3rd parties charge fees.
Even the lowest cost plans have expense ratios starting at 0.16% (but many MUCH higher) vs the 0.04% I currently pay on VTSAX / VTI. Higher fees can quickly wipe out any State tax benefit (e.g. none) and result in reduced spending capacity.
Will Jr attend a traditional University? Will the education system in 20 years resemble that of today?
I worked with a few computer programmers who had no formal education, and they earned as much or more than the Harvard and MIT graduates.
As the cost of information approaches zero, I imagine the University’s historical role as gatekeeper will be diminished. See here for more.
Zero FAFSA benefit
Dollars held in a brokerage account are weighted equally to dollars held in a 529 when calculating parental responsibility for education expenses under FAFSA. Moving money with no restrictions (a brokerage account) to an account with many (529) doesn’t change our EFC (Expected Family Contribution.)
Are 529s always a bad deal?
Not at all. For many a 529 is a great tool for college savings.
This would typically be the case for families with multiple children (with high expectation of pursuing higher education), where the parents earn high incomes and expect to continue doing so throughout the college years, who are already making full retirement account contributions, and who live in a State that provides an immediate tax benefit on contributions.
For families who don’t match that profile, they may be better off by trying to minimize the EFC, aka hacking the FAFSA.
Or there is always the old fashioned method.
Hacking the FAFSA
A family with $500k split between a brokerage account and a 529 might be expected to contribute $25,000 per year from these assets towards their child’s education.
The same family with no 529, $0 in a brokerage account, a paid off house and fat IRAs, would be expected to pay zero (but some from earned income.) Family net worth is the same, but the EFC formula clearly has preferences.
Assets like a personal home and 401k / IRAs aren’t included in FAFSA calculations. Paying down the mortgage, making large contributions to retirement accounts (including after-tax contributions and/or the mega backdoor Roth), and taking a mini-retirement while your kid is in college may provide the greatest benefit. (But don’t let the FAFSA tail wag the dog.)
Similar to optimizing ACA subsidies, families with the ability to choose their Adjusted Gross Income can minimize their EFC. This article on Forbes has an interesting chart that shows EFC at different AGIs.
For better or worse we will never be in a position to receive need based financial aid, but Justin at Root of Good has shown even families with healthy balance sheets can get significant assistance. This is in large part due to having 75% of net worth in housing / retirement accounts vs our 25% +/-. (Hmm, maybe we should just buy a really big house.)
Is there any benefit for GCCJr to have a 529?
If GCCJr attends college, then there could be a small benefit in some specific circumstances.
That perfect storm scenario includes:
- Small or Zero Scholarship – he is responsible for most tuition and expenses (not exactly a positive)
- 529 value is equal to full EFC burden, and no more (predict the future 2 decades in advance?)
- Major bull market in 2 – 3 years before college (inability to withdraw funds from brokerage account at 100% basis)
- A 529 would typically shift to bonds and cash by this point
For simplicity, let’s assume the total cost of education is a lump sum of $100k in today’s dollars, in 16 years when Jr reaches age 18.
Also assuming a (optimistic) 7% real rate of return over that time, I could contribute ~$34k to a 529 today to yield that $100k.
If Jr attends college and pays $100k, then the full $66k of gain is tax free, the same as if I didn’t contribute to a 529 at all.
If Jr doesn’t attend college (cuz he starts a business, is self educated, retires early, etc…) then that $66k gain is now subject to a 10% penalty and ordinary income taxes. At a 12% tax rate (assuming minimal other income), with 10% penalty, total tax due is 22% of the gain or $14,520. Or we could give the funds to my cousin’s 3rd wife’s brother’s kid. Or wait another 10-20 years or so for grand kids?
That kind of risk/reward ratio isn’t to my liking.
There are great cases to be made for 529 plans for a subset of the population, which make for fun discussions when hanging out with other parents.
But for us…
No immediate tax benefit, no long term tax benefit, no flexibility, no thanks, Not For Me.
Does the 529 work for you?
Let us know in the comments.