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.”
529 Plans
First, let me breeze through a quick 529 overview. (For the nitty gritty read Wikipedia or Bogleheads.)
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 All income / gains are tax-deferred, and when withdrawn for qualified education expenses (e.g. tuition) any/all gains are tax free.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?
Maybe.
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.)
10% Penalty
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.
Fees
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.
The Future
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.
Conclusions
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.
Really informative post as usual. I enjoyed getting the breakdown and had often wondered why all the hubbub about the 529. If everyone had a crystal ball…there would be a lot more than 529’s that would be unnecessary.
Yep. That’s right Beverly. And yours truly was caught up in the hubbub. BUT, thanks to Jeremy’s insightful post, I took pretty quick action. Same day as I read this, I stopped monthly auto contributions to the Fidelity 529s for the twins, then re-added the contributions to my traditional IRA on Vanguard. Now, to get the balance up to 10K so I can pick Admiral (low cost) funds!!!
Fantastic overview of why a 529 needs to be considered carefully. I have a 529 set up but I’ve stopped contributing to it for now. My situation is not as clear cut as yours. I’m currently over the tax bracket for tax free withdrawals. I will carefully evaluate annually to see if it makes sense to use a 529 or brokerage account with extra savings.
“Considered carefully” is a good phrase. Well stated.
I second this post. Although, I currently do not have kids, I also struggle to understand how a 529 Plan is better than other tax-advantaged investments.
Maybe it is the boasting that comes with saying “I set up a 529 for Jr”. I would like to think any disciplined saver/investor could craft a plan of their own of similar performance.
Just my humble two cents…
At first I was confused by your post because I didn’t realize that in some (most?) states there is no tax benefit to a 529. I’m in NY where there is a 10k/yr deduction for married couples so it makes a whole lot of sense to use that. I really don’t understand the point of a 529 without a tax benefit…
I could be convinced to contribute to a 529 for a $10k deduction.
If you did happen to move out of NY, there is a recapture on the deduction. Great for those who are New Yorkers for life, but not so good for those of us with rambling fever.
I don’t think moving out of state will trigger recapture (as long as you leave your NY 529 account in place, without rolling it over to another state’s plan).
Thank you thank you thank you!! I have had 5 different 529 tabs open on my browser for days, trying to evaluate whether it makes sense for us. 3 kids, probably will be college bound, but we have the ability to save $70k a year tax deferred. I had been trying to weigh whether the 529 would really benefit us, especially if it was taking from my other investments. The increase in EFC is pretty awful and I think I’d be better off just doing a Roth conversion ladder after semi FIRE and cash flowing whatever expenses arise from it, rather than guaranteeing a high EFC from the 529.
Not going to argue with anything about 529s, which I agree are only a good deal in states that provide a benefit and low fees. But just adding that many schools, mostly private, don’t look solely at the FAFSA, and determine financial need on the basis of assets not included on the FAFSA, like retirement assets, property value, income of non-custodial spouse, etc. So the financial aid or EFC picture can vary quite a bit school to school. Of course, I’m a big fan of public education, so to me, that’s just another factor in favor of public school. ;-)
Hope you guys are doing well!
Yeah, there is also the CSS profile which is much more holistic, and therefore harder to “hack.” Many of those institutions are also sitting on fat endowments and have generous aid packages if you qualify, e.g. Stanford, Harvard, MIT, etc…
And then there are the school where even if your EFC (as calculated by FAFSA) is small, the school may not be able to put together an aid package that fills the void, so your actual required contribution may be higher (even much higher.)
It’s good times all around
Another argument against 529’s that I never see is that there is a federal tax credit of $2500 for the first $4k you spend on tuition each year. But you don’t get it if you use 529 money to pay all tuition. So, 529’s should intentionally be underfunded by $16k if you’re eligible for the credit.
Excellent point! The AOTC is very nice
I wonder if you could move the 529 to another beneficiary to ensure you could pay at least $2.5k out of taxable funds. Something to look into
Yes, definitely. You don’t have to use everything in the account and it’s easy to switch beneficiaries.
This is pretty interesting. Unless you’re fatFIRE, this makes sense.
The tax deduction isn’t even really worth it for the 529 when you’re retired anyway.
You might run into trouble for rental properties though. Some private schools look at non-primary house assets as something you could theoretically sell off, but those are generally more generous with aid if you get into a T20 school.
Great analysis! We haven’t contributed anything to our kids’ 529 yet. It’s because we have other financial goals we want to reach. Our plan is to buy a rental property and sell it in the future for our kids’ education if they can’t get any scholarships. This might change as we update our financial knowledge though :D
I like the 529 plan. Our state tax is 10% so we get that deduction.
We will still have income when our kid goes to college in 10 years. I think we should get the long term tax deduction too. Our 529 is at Vanguard so the fee is very low.
The downside isn’t a big deal to me. We have nieces and nephews. If our kid doesn’t go to college, I wouldn’t mind helping them.
I think the subset that can benefit from the 529 plan is pretty big.
Hi Joe,
I’m with you. My parents financed my entire education by saving $150/ mo. until I was 18. Then, they covered any remaining costs. I was a good student in high school (3.67 GPA) but received no significant scholarships (less than $3,000). My parents’ investments allowed me to leave college debt free and pay off my wife’s college debt in about 2 years. Today, I contribute $110/ mo. to both of my children’s accounts and feel a little guilty that I don’t do more. I live in Wisconsin and invest with Edvest (TIAA-Cref, the state-sponsored plan), which does give us some savings on our state taxes.
I have often marveled at the head start my parents gave me by allowing me to graduate debt free. It has definitely been a leg up over some of my friends and colleagues who continue to pay off student loans a decade after leaving school.
Very nice of your parents, and doubly so that you feel gratitude for the head start.
Maybe I’m misreading your comment, but why assume that a family with no 529 wouldn’t do the same?
Hi Go Curry Cracker,
In the years when you withdraw additional money from an IRA, 403(b), or 457 to pay for college expenses, isn’t there a chance that you would go into a higher tax bracket? I assumed that the withdrawn funds would count as taxable income. Like you, I pay no federal taxes. The state benefit is small but helpful.
I won’t be withdrawing money from an IRA, 403(b), or 457 to pay college expenses.
ok… I’ll bite. I’ve been pondering this myself. We are planning to optimize the FAFSA as much as possible which includes quitting our jobs and downsizing our house 18 months before oldest would potentially go to school and then we plan to help pay for some education with 457+roth ladder. My thoughts are to just pay a little each year and consider our children taking low interest loans. It would be a balancing act of keeping EFC/FAFSA optimized vs cost of student loans and keeping your taxable income at whatever threshold makes sense. Then, after our youngest is through we could step all the way up to the top of the desired tax bracket to pay off the balance more quickly. I haven’t read this anywhere and am very curious of thoughts. I am definitely a guy comfortable with debt (e.g. paying minimums on 3.5% mortgage to help maximize our pretax buckets and keeping us in the 12% marginal tax bracket).
heh, sorry, I didn’t mean for there to be anything to bite. We’ll just pay college expenses from our taxable accounts, optimizing for minimum capital gains, or ideally even a realized paper loss. Given the choice of contribute to 529 or contribute to brokerage, we’ll do the latter.
The approach you are thinking about seems pretty solid. Since home value is excluded you probably end up with more cash / higher EFC by downsizing
What if the amount the child needs per year for college pushes you out of the 12% (2019) tax bracket? Wouldn’t a 529 not increase your income taxes or capgains/qdivs?
If I was trying to uber-optimize it, I could probably pull $200k (or even $300k) per year out of the taxable account for a few years without having more than ~$100k (12% bracket) in taxable income. See Long Term Long-Term Capital Gains
We set up three 529 accounts for our three (now adult) kids. Over 20 years, we avoided tax on $22,000 in gains, so we saved maybe $200 a year on our taxes. Not much savings considering the restrictions on the accounts. I wouldn’t do it again. I would just put the savings in a brokerage account, or I would have payed down the mortgage faster.
Yeah, I think you convinced me.
Now, our taxable funds are all in index mutual funds rather than their EFT counterparts. Would the analysis change at all in that case? I guess we could start buying EFTs now but they’d probably be 10 or 30% of our portfolio max, by the time we stop contibuting.
Vanguard ETFs and MFs are functionally equivalent.
Great analysis! We had the same thought as well. 20 years betting on education in the current system seems crazy. If there are no tax advantages out out do the 10% then what in the world…?!
Agree totally! With hindsight I would definitely have just put it to mortgage principal earlier. As it stands I now have 529 cash I can’t touch without eating the 10% penalty and a son attending a non-US accredited college in the UK, we definitely came out on the wrong side of the well intentioned 529 gamble.
DN
This is the situation I fear we would find ourselves in. Sorry :(
Great article. If you are FI and retired early and have a 0% marginal rate on investments, then a 529 is a horrible idea for the reasons you mention.
I have 5 kids and live in a state where I get a $10k tax deduction, which saves me about $700/year in state taxes. If one or two kids decide not to go to college, I feel I’m pretty well diversified in that I’ll eventually have to pay the expenses.
FYI, CA offers an all-in total US stock market fund for 0.08%: https://www.scholarshare.com/research/fees.shtml. Given the 5 kids, I’m heavily considering dumping some cash (in excess of the 10k in my state) into CA’s plan.
Also, I had a smart friend ask me the other day about sheltering 529 assets under a grandparent’s name. If you do this it won’t show up on the FAFSA. Some of the Bogleheads are apparently doing this: https://www.bogleheads.org/forum/viewtopic.php?f=2&t=210353&p=3228993&hilit=529+grandparents+fafsa#p3228993
Yeah, you pretty soundly match the profile that benefits from a 529. (up front deduction, high probability of paying for education, etc…)
Kitces (as usual) has a great article about grandparent 529s. tldr: grandparent 529s don’t count on FAFSA in year 1 (or 2 due to PPY), but withdrawals count heavily in subsequent years.
The part about grandparents owning the 529: The “grandparent” is just a placeholder for any non-parent, right? It can be replaced with “uncle”, “aunt”, “family friend” ….?
yes
we have a 529 set up for a nephew and will be setting up more as more nieces/nephews come along. I like that it doesnt count against the calculations for the FAFSA; our plan is to give that money to the beneficiary in their senior year / last year, so then it wont count against them in the following year (since there is no following year).
two nieces already have 529s through their parents so we contribute to those (at parent’s request to only have one set up), but I have been thinking about setting up separate ones in order to give them the ‘shelter’ benefits as well. (the nephew’s parents didnt have the 529 set up yet, so we did our own)
I think this article makes a lot of sense – when the set amount of money is being saved either way (I have X dollars that I will save, either in a 529 or elsewhere). However, I think for those people that arent as savvy or maybe would buy toys / stuff they dont need rather than paying down the mortgage or saving the equivalent amount of money, it helps them prioritize saving by dangling the (fake) carrot of tax benefits.
Ultimately, the student loan system is broken – so something that helps to mitigate it (even if its not the best solution) can be a good thing.
Howdy. I’m a nomad based out of a no-tax state. What if I’m still in a high tax bracket (working) so my low dividend ETFs are taxed 15%, and I expect at least some of the K-12 years to be spent in private schools abroad (English speaking, etc). Does it make sense to put a little money in a 529 to cover sporadic private tuition– at least for the years that Jr is in K-12 while I’m still working? I would get no state deduction, but at least I could shield that 15% dividend tax.
Girona George ;-)
p.s. I don’t care about Jr’s college. By then she can figure things out, or I’ll be retired and in a 0% bracket.
The 529 could save you the 15% tax on dividends. The current yield on VTI is ~1.6%, so a 15% tax on that is a 0.25% load.
Or you could invest in something like Berkshire Hathaway which pays no dividend and therefore has no annual tax penalty.
If you have significant gains between contribution and withdrawal for K-12, then that gain is also tax free, so 529 would be beneficial. If you had losses, that would require itemizing which is less likely after TCJA
This is *exactly* why I don’t contribute regularly to our kid’s 529. The grandparents gift them money occasionally, but we don’t. There’s just very little benefit, especially since we don’t have a state income tax here in WA.
I’d rather hold it in a brokerage account for them.
There is a new robo advisor that does not have trading and management fees. You can customize your own 529 portfolio called a pie(motif) with up to 100 securities including Vanguard ETF’s. You can set the percentage of each security. Fractional shares can be purchased. By months end, you can have dividends set aside in cash for later withdrawal if need be. The most sought out request. Google M1 Financial.
I am my own robovisor.
The new tax laws actually allow 529 accounts to be used for K-12 expenses now! So if you plan on putting your child through private school for K-12, you can still use the 529 funds for that.
Yes, the TCJA extended qualified education expenses to K-12. It will be interesting to see how States respond to it (see NPR.)
One of the main benefits of the 529 is the tax-deferred growth. If you are just contributing to a 529 and then turning around to pay for this year’s elementary school expenses, it may not be as enticing. But at least you can contribute 7-9 months sooner since a child in utero can be a beneficiary.
In Canada, our equivalent (I thought) to 529 plan is an RESP and the government will give you a grant of 20% on up to $2,500 annual contribution . I get to invest that 20% right away. We set up a family RESP which makes it more of an incentive as we always hoped at least one of our three kids would go to college or university, so we wouldn’t have to pay back the grant and the growth.
Two of them are now in University and so far I haven’t touched the principal (in all fairness our cost of education is MUCH cheaper in Canada).
For a 20% upfront benefit, I would contribute too
Hmmm, good post. I think you may have missed the one other benefit of 529s though. The tax-free distributions won’t count as income in the following year’s financial aid application. May matter for some who have to cash out to pay college expenses.
True.
Stock pulled out of our brokerage account at 100% basis won’t count as income either, which is probable with capital gain harvesting. But the 529 withdrawals are at least guaranteed in that regard.
GCC, as usual, you kind of blow my mind with these analyses. I don’t usually like the hacker mentality (which is about trying to get something for nothing), but your approach is different — it is simply mastering the details and recognizing that the obvious path is often not the optimal path.
Most of your writing doesn’t apply to me. I live in the U.S.; so I can’t hack the health insurance game. My income is too high to slowly convert to the Roth. I even live in a state with income taxes, which blows most of your strategies out of the water right off the bat. But I still learn from you. I think what you teach on a meta level is master the tax code, master the details of any program, and think for yourself. All to the good.
Keep up the independent analysis. It helps! Oh, btw, since I retired at 42, I could be following your strategies to the T, but I spent more than a third of my adult life outside of the U.S. Am enjoying soaking up family and friends back home for a while. Go Curry Cracker!
Thank you sir. I think you’ve summarized a good philosophy for approaching life in general
Has anyone nailed down how 529 accounts owned by non-parents of the beneficiary are treated? I opened a small 529 account for my niece & nephew (with state tax breaks), and at the time it was my understanding that the account would be ‘invisible’ on the FAFSA- the money is neither the parent’s or student’s, and so isn’t counted toward the EFC. Is this correct?
The 529 of a non-parent/guardian doesn’t count towards FAFSA, but distributions count as income of the student for later year FAFSA applications.
I-bonds could be a decent way to supplement college expenses, which are tax-free when used for educational expenses (but not sure if FASFA changes this). Of course, the probability is much greater that you’ll have more in all market stock ETFs in 18 yrs :)
I know your article is somewhat tongue-in-cheek, but you should probably get (all) the facts straight:
1. The 10% penalty is only on the *gains*. Each family will have to do the expected-value math here, but it’s much better than you suggest.
2. FAFSA/EFC is irrelevant at many institutions. If you think your child might end up in one of those, for example pretty much any of the elite ones, most of the EFC-hacking is irrelevant, today.
I’m sorry that my example calculation, in which I applied the 10% penalty to the gains only, was not to your liking.
I didn’t say I didn’t like your example — it’s the part above it that is objectively incorrect.
Sacrificing accuracy at the altar of a polemic is a turn-off in a financial blog, especially one as generally shrewd and on point as yours.
I have to agree. As I was reading the first part of this, I was quickly thinking how to reply and let you know it only is a penalty on gains, not all of the investment. You did it right in your example, but the prior area needs some retooling to not be misleading.
How would you retool it?
The only reason I contributed to a 529 was the state tax credit of $500 if you contributed $1,000. Otherwise, I would just keep saving in my Roth like I’m currently doing as well.
Another great post GCC!
I would contribute $1,000 too.
Good thinking and I agree that for you guys it may not make sense. But perhaps you want to emphasize your different situation. Not everyone will keep their income low enough to qualify for 0% tax capital gains in a brokerage account. And even if they do, selling positions to cover the tuition may trigger a 15% capital gains tax that year. Besides, most parents do want college education for the kids, so not using the 529 for education is not an option unless something went wrong. Here is another way I look at it: There are two possibilities for my child’s education from a 529. Either I will have to endure the pain of paying for college for which I can use tax free gains, or I relieve myself from this burden somehow and get to keep part of that money. I see positive on both.
This whole blog emphasizes our different situation ;)
I like how you find the positive in all outcomes, that is a great approach to life.
I like them for a portion of our education savings. We front loaded 24k each and that is all we are putting there, rest of needed we will help with from post tax accounts.
I am likely not going to be retired when at least one kid starts college and income may be high. If we don’t end up using this money I will consider it my inheritance money to I my kids given their rules of transferability. I don’t quality for Roth either anymore (unless conversion). Or I may use it to assist other younger family members that may need it. Or for myself studying abroad as a senior 😋.
I also liked having them in case we die when they are still younger – I am cheery like that.
I would not put more money though and I would not put it lat to in life when growth benefits would be almost minimal.
As always though very thought provoking analysis above – thank you for that!
Not an issue for most people, but one good use for a 529 is estate planning. One of the most effective tools available is the (now) $15,000 annual gift exclusion to any natural person, including a minor. In most cases it would not be a good idea to hand $15,000 in cash to a minor, nor to set up a UTMA account on his or her behalf. Annual gifting to a 529 is a way to get money out of the estate and to the minor child, without tempting the minor to misuse the money.
Now we just need to get our net worth up above $22 million
We live in NYC and in the first four years of our kid’s life have wiped $40,000 off our state AGI through 529 contributions. (And those above-the-line state deductions just became more important as a result of the changes to the tax code, since we’ll likely keep itemizing.) Apart from the tax advantage, the other nice thing about 529s is that you can fund them through gift cards via Gift of College, which lets you nab a lot of credit card sign-up bonuses merely for moving money around. For example, we just got a $500 BoA sign-up bonus solely by purchasing $3000 in gift cards that went straight into the 529, a contribution we would have made anyway. We’ve paid the entire cost of two international vacations using credit-card sign-up bonuses earned through 529 contributions. By contrast, it’s much harder (close to impossible, in fact) to travel-hack straight investment accounts.
I love this. We plan on hacking college by either continuing to teach part-time at one or becoming expats in a country like Germany or the Nordic countries. It might be a little bit more HCOL, but the quality of life will be excellent as well. Of course, by that time, there will probably some form of free college in the U.S.
Generally agree with you, I don’t recommend a 529, even though we have one. We opened one around birth without thinking about it. Wither sober reconsideration, I probably wouldn’t do it again. The existing 529 does have some uses for us. Instead of treating it as a separate account, I use it to hold the most tax inefficient funds as part of our overall asset allocation, so it ends up stuffed with REITs and bond funds. The Utah 529 plan also gives us access to DFA funds which we wouldn’t normally have access to without an adviser. Not a great reason, but I have a little bit of a soft spot for the DFA funds
Good one, GCC. About 8 years ago, I did a similar analysis and reached the same conclusion for my kid, who will soon enter his teens. Our state’s 529 plan funds would be in prison with lot of restrictions compared to simply having them under my name as typical taxable mutual fund account. Glad to see that thesis is still valid 8 years later.
There are ways to “hack” a 529 plan that can be beneficial, depending on the rules of your state. For example, when I went back to school several years ago for a Masters Program (didn’t finish), my state’s 529 rules at the time allowed me to contribute money into a plan, with myself as the beneficiary, take the 20% tax credit, and then turn around the next calendar year and use that same money to pay for school. I left the money in the plan as cash, to avoid any loss risks. So, for example, in December 2017 put $2,000 in to my plan, get a $400 tax credit for 2017, and then turn around in 2018 and pull the money out for tuition or other qualifying expenses.
I don’t have children, but I’m not sure I’d contribute to a 529 for them if I did. Too many unknowns, as mentioned above. But it was well worth taking advantage of some loopholes for short-term benefits!
Very nice!
I think there is a little over estimate of the tax deduction. I plugged in the numbers for a 529 with a 16k contribution and my tax deduction was $960 initially (6% tax state with a deduction for 529) but THEN you pay federal tax on the deduction the next year of ~$300. I can see tax free growth being a bigger benifit(but that depends on your post FI income). Little to no flexibility, higher fees(even if its a vanguard plan), no tax deduction when the child is in college, plus all others mentioned in the article and in the comments. I have one for my oldest child but not my youngest because we will be retired before she starts. I guess it is a way to say “here you go” this is for your college and if you want to spend more you’re paying for it!
Great article and topic. Glad I’m not alone in my thinking.
I don’t think I saw this mentioned but I have always felt like why do a 529 plan when a TIRA or Roth IRA can be used without penalty for educational expenses. I suppose if you are already maxing those out…you could look at 529’s but I agree it’s way to risky to know whether a kid will goto college or not.
Withdrawals are penalty free, but taxed as ordinary income. (In the case of Roth, only earnings would be taxed.) That income would increase EFC in the following FAFSA submissions. The 529 distribution would be penalty free, tax free, and wouldn’t impact FAFSA.
The withdrawal of Roth CONTRIBUTIONS would not be considered income though, correct?
For FAFSA, that is considered income as well.
And the corollary, tax-deductible contributions to Traditional retirement accounts don’t reduce income for that year’s FAFSA.
Good point on the EFC. While that’s true I have always liked the flexibility of IRA’s in educational, down payment, and medical expenses. It’s made me feel better about maxing them out as it does still give me some options.
If perfectly utilized, an IRA is best for retirement, an HSA is best for medical expenses, and a 529 is best for college. They are each designed for a primary purpose.
Good to have the flexibility and options too.
Well said. It’s interesting that your conclusion after maxing out tax-deferred investments is usually Capital gains type investments. I am still just barely doing that so I have just dabbled in your writings on tax loss harvesting…but interested. I also have to say I hate to complicate my tax situation. Do you ever feel/think that adding losses/gains creates some extra stress/complication? I feel the same way about the Roth conversion ladder and even HSA strategies. I can’t help but think that long term this gets to be a helluva lot to track. Again, I’m a newb at this so it may be I just don’t understand it well enough.
If you try to explain to a kid all of the nuances of riding a bike they probably aren’t going to learn very quickly. Pedal faster but not too fast. Lean to turn. Watch where you are going. Focus on keeping center of gravity in alignment with the frame. Etc… It’s complicated, yeah?
But when you just hop on and try it, it feels pretty natural.
Not sure I follow entirely on why you definitively wouldn’t want a 529 even without a state tax deduction. Paying college expenses out of your taxable account would require you to burn up a lot of your tax free space and perhaps could push you into a higher income bracket. Wouldn’t you want to fund some amount into a 529 so that you can manage your tax/income situation more precisely during those college years? (Similar to how some people have both taxable and Roth accounts in retirement)
Additionally, keep in mind that 529s can be used to pay (reasonable) student room and board expenses, which isn’t expected to stop rising anytime soon. I think the best advice is just not to overfund the 529, but worst case, it becomes an endowment to the next generation (which we plan on doing anyway). Only fund a 529 after you have funded your own retirement.
Hey JCI,
How much would you recommend as the the right amount to fund (but not overfund) a 529?
I don’t expect paying out of a taxable account to change our tax situation at all. I’ve been raising basis annually, and have another 16 years to continue doing so. It’s possible that we’ll have capital losses to realize by then, while still sitting on huge real gains.
The estate reduction aspect isn’t much of a benefit unless we manage to grow the size of our assets beyond $22 million (we’ll have a charitable trust before that point.) If I were in Jr’s shoes, I’d rather inherit a taxable account with fully stepped up basis than a 529 with potential tax burden.
I can’t speak for anyone else’s situation, but I live in CA, so no state tax deduction for contributions to 529 and I am funding 50% of in-state public school tuition for both of my kids. Any shortfall will be paid for by the kids themselves or them taking out loans – what is in their account is all that they will get from me. My feeling on the 529 is that if the govt provides you a vehicle to save paying for college, I’m going to utilize it. If college costs significantly drops in near future (which doubt it), I hope that the govt will change the 529 program to compensate (loosen penalty or widen scope of qualified expenses). It’s a good problem to have more money allocated than you know what to do with, rather than not enough and I like the mental accounting aspect of having a separate account earmarked for college expenses.
Regarding estate tax exemptions, new federal limit is $22 mil, but states like WA still have a lower limit of $2.1mil with a 20% hit on anything above.
My thoughts on 529’s exactly! I am/will be in a very similar situation to yours (1 kid, no state benefits, uncertainty as to whether my daughter will even attend college and the overall role/cost of college 17 years from now, ability to pay zero to very low taxes with a standard brokerage account, etc.).
Always cringe a bit when people rave about 529’s. Now I have a post to send them to :)
Sounds familiar ;)
I think we are in a special circumstance where the 529 is too much of a square peg / round hole.
We dont have a 529 here in the UK so I really enjoyed finding out about this. You have summed up everything I love about FI bloggers. non FI people (dare I call them ordinary) skim the surface of the latest finance thing and jump in feet first, the FI bloggers really delve into and go long term. Thanks for such a good post!
Little Miss Fire
https://littlemissfireblog.wordpress.com
Great article but it came 15 years too late for me. I used a 529 to pay for my kid’s college and I was in the optimal category by chance. It could have easily worked out differently but we got lucky. If I had to do it over I would follow your advice.
Another terrific read. Please keep them coming.
I disagree. 529 has state tax advantage
Fee is still use if you use Vanguard fund
Most impostant, you can use 529 as estate planning tools. Pass it to grand grand kids.
529 can be used a K-education now
The compound power and tax free statues are huge. Let’s say every 10 year the value double, let’s say you invest 10k. After 80 years, the 529 would become 2,56 mil
80 years from now, Grandkid inherits $2.56 million 529 and decides to buy a house at age 55 w/ no other income
529: $2.56 million
nonqualified withdrawal penalty: $256,000
Income tax: $954,000 (2017 #s)
Total remaining: $1.35 million
Or grandkid inherits a brokerage account with stepped up basis
brokerage account: $2.56 million
nonqualified withdrawal penalty: $0
income tax: $0
Thanks Grandpa!
Thank you for the reminder to keep to our plan. Out of guilt I reflexively started putting more money toward our 529s, but I’ve stopped those and I’m back on my original plan which includes putting that money into our Roth IRAs and making our 401ks before moving to something like a 529 or a brokerage account.
Sales teams are masters of guilt. “What, you don’t want your child to go to college?!”
It’s definitely best to save for your own retirement before saving for a child’s education. Worst case, you can borrow for school. There aren’t too many lenders willing to fund your retirement.
“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.”
Yep. That’s us.
Good post, I liked the perspective. Justin’s thoughts from RoG about paying for his kids’ educations was interesting too. We’ll likely not contribute to the 529 when we start a family in the future.
I think setting one up for family to contribute is the way to go. Instead of junk gifts, I always direct my family members to my daughter’s 529. If one is lucky enough to have generous family members, this can lead to some significant funds. Even if not, a couple thousand gathered over 18 yrs with growth is better than plastic crap. I even put a link to the 529 on my baby registry and got about $200 from that. I am not planning to add too much myself but I have a daughter and am pregnant with my second so I think I will gain some flexibility in its use with using it for more than one child.
I’ve never thought about 529s this way. The wife and I thought about starting them for our kids, but ultimately decided against them. Glad we had the right mindset (for us).
I did not have a 529 with my first son when he went into college. He was going to have to have some student loans if he wanted to go to college. Given I get a state income credit, I took the portion of money that I was willing to contribute, deposited it into a 529 to get the 6% state income credit, the withdrew it for college tuition. Assuming no catastrophic market event (or just dump into a money market account in the 529), it almost guarantees a 6% (or your state’s tax rate) discount on college expenses.
Thank you for this post. I’ve been very on the fence about the 529. My son is just a few months younger than GCCJr. We’re both in our mid forties and still working. If we stay on current trajectory FIRE is almost 10 years away (although believe me, I think everyday about making bigger changes like Geo-Arbitrage that would allow us to get there much sooner…I digress). We do have a very small 529 plan ($2,500) but I’ve been going back and forth on whether to keep contributing or to just put that savings in Vanguard taxable accounts. 401k and Roth contributions are already maxed. Our total savings rate is around 40% of income. What I like about the 529 plan is that it’s separate and everyone knows it’s earmarked for college. Estate plan is on the goals for this year but not done yet. You have made the case perfectly that in your early retiree situation 529 doesn’t make sense and in the process you have once again highlighted the financial beauty of early retirement. I would love to know how are you determining how much you’re willing to pay for college? With the 529 there is a natural ceiling of whatever is saved is how much Mom & Dad will contribute to college. Also, how are you separating those funds for Jr from the rest of your portfolio? Just in your own spreadsheet or by keeping it in a specific ETF/MF?
Great read! I’m pregnant with our first and I feel this strange guilt for wanting to take care of our own finances. Baby may or may not go to university, but we will definitely retire someday. We’re securing our own oxygen masks first, damn it!
Right approach, I think. In the extreme case, you can always borrow $ for college but you can’t borrow for retirement.
Our son is a sophomore in high school and my husband still works, so we have a pretty good idea what college expenses and our expected family contribution will be in a couple years. Living in CT, we get a deduction for contributing $10k/yr. There is also a way to defer deductions for 5 yrs, so basically we contribute $20k/yr (think we started in 8th grade), deduct $10k and roll the other $10k deduction forward. We don’t get the benefit of much tax free growth, but our income tax bill is lowered.
This post is completely one-sided! My state (Virginia) gives a tax break on contributions (I receive $500 a year for contributing 4,000), and I am able to invest in low-cost index funds. FAFSA also only considers a small percentage of the 529, unlike a taxable brokerage account. It is as if this person did not do enough research before posting this article.
>This post is completely one-sided.
That’s right! Thus the title.
Love your site! I am guessing more of the audience falls into regular tax brackets and capital gains. You have a very impressive story! On 529 another advantage could be legacy multi-generational(dynasty 529 Plan?) college funding. All if it can grow and be taken out tax free.
Hey there
I’ve learned a lot from you, and I threw together an EFC calculator for my family. Now the SAI has changed all that.
Also, the Secure Act made it so $35k of a 529 can convert to a Roth.
Do you plan to make a post about the SAI and how the 529-to-Roth ability may have changed your plans?
Basically I need you to explain it to me :)
I have not spent much time looking at this but it is on my very long list of things to learn more about.
EFC and SAI seem largely the same unless you own a giant farm or family business.
The option to convert 529 to Roth doesn’t seem all that special except as an escape hatch if you regret funding a 529. You still need earned income, but instead of moving $ from a checking account to a Roth you can move funds from the 529 to Roth.
At this time I don’t plan any changes.
The EFC split your expected contribution when you had multiple kids attending college at the same time, right? And the SAI does not? That’s a big change that will affect us. May increase our cost by ~33% since we have 3 kids, each spaced about 2 years apart.
There are probably other changes too. I dunno.