I’m finally getting around to setting up 529 college savings plans for my kids. It remains my opinion that you should make sure your retirement savings are on track before worrying about college savings. The government let me borrow over $50,000 in student loans for college, but they won’t let me do that again for retirement.
(Related: Top-ranked nationally-available 529 plans and state-specific tax benefits.)
Other than deciding how much money you’ll contribute, the big question is what do you invest it in? The most common default investment choice is an all-in-one fund that adjusts automatically based on the age of the beneficiary. Essentially, a tweaked target-date retirement fund. Under this model, each child of different age would then have their own standalone asset allocation.
However, I ran across an interesting discussion on the Bogleheads forum where some people used their 529 plans as an extension of their primary retirement portfolios. As the 529 offers tax-deferred growth and tax-free withdrawals for qualified educational purposes, you could treat it like an IRA and put some tax-inefficient assets inside. For example, I could squeeze in some riskier stuff like real estate (REITs), small value stocks, and/or emerging markets stocks for a couple of decades. Or safe stuff like TIPS. You wouldn’t have to adjust for beneficiary age, just rebalance things whenever you spend it down.
This gets a little tricky because even if you start early, you’re typically going to save up a bunch of money over 15-20 years and then spend it all within 4 years. Contrast this with retirement, where you typically save up over 30-45 years and spend it over another 20-35 years. Also, if you don’t spend the funds in a qualified manner, your withdrawals may be subject to both income tax and an additional 10% penalty.
In my opinion, an important factor to consider is your personal tuition assistance philosophy.
Are you going to cover a certain percentage of your child’s tuition, no matter what? Some parents will promise to cover 50%, 75%, or 100% of college expenses, regardless of actual 529 balance. In that case, the 529 plan is less of a savings bucket as it is just another way to gain some extra return via tax sheltering. Perhaps then it makes sense to consider your 529 as a piece of the bigger picture.
Let’s say you invest solely in 100% risky stocks for the entire 15 years, and there is a last-minute crash where you lose 50% of your value. If your final 529 balance is much less than expected, the rest of your portfolio probably did better and you can fulfill your commitment with other assets. (The same thing could happen if you invested solely in 100% safe bonds. The return might be so low that your final balance is quite disappointing.)
Are you treating the 529 plan as a piggy bank? “Here, I saved this much money for you. You handle the rest.” In this case, you are setting aside a fixed amount, labeling it “college funds”, and you’re done. It is separate in your mind. So why not invest it separately? You probably do want to make your investments diversified initially and also more conservative as your child gets close to college. Having the value drop in half at the very end could force your child to take on a significantly larger amount of debt.
After some thought, I am taking a hybrid approach. I am committed to covering at least a “good chunk” of my kids’ college expenses, without limiting it to a fixed amount. (I won’t guarantee 100% as I am wary as to how colleges use their huge sticker prices.) First, we have the financial means, even if it means working a little longer. Second, we feel an obligation to pay it forward because my parents covered a big portion of my own tuition and my wife’s parents covered all of her tuition. My goal is to have my kids feel free to take some career risk in their 20s, although I am not opposed to them having a little debt (“skin in the game”).
My plan is to make my 529 a miniature copy of my retirement portfolio. If my retirement portfolio asset allocation is 60% stocks and 40% bonds, then the 529 portfolio will also be 60% stocks and 40% bonds. So the 529 will be a standalone portfolio, but it will grow at the same rate as my retirement portfolio. Once the time comes, I will spend the 529 money and also withdraw from my retirement portfolio if needed (hopefully not). However, in the meantime, I won’t have to constantly rebalance across two additional smaller accounts.
My kids are 1 and 3 right now. I plan on keeping my cloned asset allocation setup for at least the next 10-12 years, and then taper down over the last 5 years so that it is 100% cash or short-term bonds by age 18. This differs from most age-based default options offered, as they taper steadily over the entire 18-year period. More details on why I like my way better in Part 2 tomorrow.
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I am also trying to develop a 529 strategy for my newborn. A question I’ve always had is whether it’s better to start a 529 with your state’s plan to make life easier or go where the best plan is available. For example, as a VA resident there may be better plans and plan options available in other states… so would I just accumulate in the best plan and then transfer to my state’s plan closer to our kid’s college attendance?
You may want to read over the article here:
https://www.mymoneyblog.com/529-state-tax-benefit-comparison.html
According to Morningstar, the Virginia tax benefit is great enough that you should probably use the in-state Virginia 529 plan. You may not fall into their income assumptions though, so run the numbers yourself.
You can deduct up to $4,000 per account (not per kid, not per person, per ACCOUNT) in Virginia each year. Assuming you are in the highest bracket like most of the population, that means you get an instant 5.75% return. If you’re married, you and your wife could each put $4,000 into a CollegeAmerica and a Virginia529 account and deduct $16,000 total. Other states are generally not as generous.
Also, there is no need to transfer money back into any plan closer to your child’s attendance. Any 529 money in any state can be used to pay for tuition in any state.
Something to consider
if the child will be eligable for relatively cheap financial loans, say at 2 or 3%
it may be worth it to take out those loans, and leave the money in the 529 for much longer
then when the 529’s value reaches the value of the loans, make the loan disapear
this could happen 2 years out of school, or 20 years out of school
So you can use proceeds from a 529 to pay off student loans? I didn’t realize that but it makes sense.
Alternatively, maybe it makes sense to borrow (take out a mortgage) to fund a 529 that will grow between now and when the kids enter college, since interest rates are so low and the tax deductibility makes your effective cost of borrowing even lower.
Borrowing to fund 529 could work out, but it also makes things more complex and risky. You’d need to keep making the monthly payments on the loan, even if your financial pictures changes. I’d rather not add more leverage to my life.
I’m with you on this. I mostly brought it up as a logic extension. On paper it may make sense, similar to the way taking out a mortgage to invest in an investment portfolio may maximize expected wealth, but it definitely entails a lot of risk.
I just double checked my information, it turns out it doesnt work that way. sorry for the bad information
I don’t believe paying down student loans with 529 proceeds counts as a qualified withdrawal. Would have been a cool idea though!
I am planning to open a 529 for my child this year as well. But I am having a hard time deciding if I want to put it my name or hers. Are you keeping it in your name and planning to transfer it to your children when they are older or are you putting it their name to begin with?
I have enjoyed reading your blog for 2 years now and this is my first comment. Thanks for continuing to blog.
I am the account owner, and my child is the beneficiary. This way, I am in control of the money at all times, even after age 18 of child. I also believe if it is in my name, the affect on financial aid is less as a parental asset vs. child asset.
Thanks for reading!
This was incredibly timely! I am years and years away from having kids, but am learning more about retirement investing, and asset allocation. I was wondering what was safe/suggested given the time frame.
FYI we started our 529s for each of my children before they were born (in one case prior to conception!). I opened a 529 with me as the account owner and my wife as the beneficiary. Then when our child was born and had a SSN I switched the beneficiary to our child. Doing this could give you more than the 20-year average saving period to save for college.
Another option is a Coverdell…. You can only put in $2K a year, but you can invest in an individual stock if you want. I realize that is very anti-boglehead, but in addition to my 529 for my kids (Utah) I also pick a stock or two that has some serious growth potential in my coverdell. (More than a few stocks and the fees eat away at the $2K.)
Coverdell is more flexible and can be used for grade school education as well. But I don’t think you get a tax deduction anywhere for it.
Few important things to note:
* There are limits to what you can contribute tax free. Watch out for the annual federal gift tax over $14,000.
* There are limits to how often you can change investments. Many plans limit your changes to once per year.
* Your children will most likely go to college before you retire. So the time horizon is often quite different for college planning than it is for retirement planning and mortgages.
A couple of things:
1) I like the Coverdell better than the 529. Allows for more flexible spending (e.g. during High School and other things). So if there are state tax benefits in your state that might be better
2) If there is a chance your kids are going to study abroad for a big portion of their college (maybe you are multi-national) 529 will only let you pay at specific ransom schools abroad the picked. Chances are your’s won’t be there
3) If you have the ability to get financial aid (and I read there are ways to “game” that) it might be wise not to put money into 529s for your kid since it will be counted against the financial aid – though you can always make yourself the beneficiary…
I would love to see an article on financial aid. Who qualifies for it, who doesn’t? What assets do they look at, etc? Does anyone actually pay sticker price or is the tuition knocked down for most students?
I have friend whose son just got into Rutgers for next to nothing. I don’t think they have much money and he was an excellent high school student. Are the people who don’t save a nickel getting rewarded with lower tuition compared to someone with a 529?
These are the issues I wonder about.