This is a relevant question for a lots of parents in our boat, who are thinking of saving money to, at least to some extent, fund the education for their kids going into college.
With the explosion of MOOCs and other disruptive technological forces, education in 10 years time will certainly look very different from today. While it is difficult to know how this impacts the future of our kids education, we certainly hope for our kids to have the same traditional university experience as we had, assuming that option is still around.
The background that I come from, parents tend to pay for their children education in its entirety. However, living in the US of A for the last 18 years, we have embraced the “independence and go-getter” culture, and expect our kids to have “skin in the game” for their education. Having said that, we don’t want our kids to burden themselves with enormous student debts, so we are saving to potentially pay a large chunk of our kids college education.
When it comes to saving for education, much the same as saving for retirement, US government offers some tax incentives. This is where 529 comes in.
529 plan, is a “qualified tuition program” (QTP), that allows a contributor either to prepay a beneficiary’s qualified higher education expenses at an eligible education institution or to contribute to an investment account to pay for those expenses.
Before we delve further into the pros/cons of 529 plan, let us look at what the cost of education will look like when our kids are ready to venture out into the 4 year college programs.
Cost of 4 Year College
I found two tools particularly useful. The first one is the College Savings Calculator. The findings for this calculator are reported below for our two kids based on the type of college and the year they will start their college education
| Tye of College | Year | Cost |
|---|---|---|
| In-State Public | 2030 | 136,755 |
| In-State Public | 2033 | 149,220 |
| Out-of-State Public | 2030 | 200,780 |
| Out-of-State Public | 2033 | 219,078 |
The second tool is from Wealthfront.com. This tool can be tailored to specific 4 year college that one desires. The cost for a 4-year program at Univ. of Washington starting 2030 and 2033 are $153,482 and $167,526 respectively.
Both these calculators compute the total cost of attendance including tuition, housing, transportation, cost of books and other related expenses. Assuming that we will cover about 80 % of the topline cost estimates, we will need about $160,000 by 2030 and additional $175,000 by 2033, for a total of $335,000 for funding college education in the next 10 to 13 years.
Now that we know what numbers we want to hit, lets dig further into 529 QTP to investigate whether it would be a right vehicle for us to consider.
529 Plan- The Basics
529 plans come in two flavors: (1) pre-paid tuition plan, under which one pays tuition at current rate and the beneficiary will have their cost covered at a later time whatever that cost be, and (2) savings plan, a more popular version of 529 plan, which is essentially an investment account with the student named as the beneficiary.
Tax Benefits
Tax benefits at the federal level are the same no matter which plan one selects. One invests post tax money and under the savings plan, the money grows tax-free. There is no withdrawal penalty or tax levied on funds as long as they are used for “qualified” education expense.
In addition, one can get tax breaks on state income tax if one lives in state with state income tax. Living in WA, this is not a benefit that we can avail.
Starting from 2018, cost for kindergarten through high school also qualify under 529 plan. In addition, upto $10,000 from the plan can be used to pay for private schooling. For private school funding though, there are some caveats to consider and they vary at state level. For example, California imposes a 2.5 % tax on earnings when the money is withdrawn to fund private K-12 education.
Things to keep in mind
Every parent, if they are eligible under the income guidelines, should avail the American Opportunity Tax Credit (AOTC) to pay for their children college education. The AOTC gives full tax credit on the first $2,000 paid toward college expenses for a dependent child each of the first four years. The AOTC also gives a 25% credit for the next $2,000. That’s a total of a $2,500 tax credit if one can directly pay $4000, as opposed to using the 529 plan.
The maximum contributions to a 529 plan vary by the state. Saving for College is an excellent resource for up-to-date data on 529 Plans.
The Downside
The downside is that there is a penalty of 10 % and income tax on the earnings produced by investments in 529 plan, if the funds are used for any other purpose than those that qualify as education expense.
Another consideration is the impact of 529 plan on financial aid (see here).
Below are some federally mandated guidelines on how 529 plans are treated when it comes to Free Application for Financial Aid (FAFSA), which all students must fill out when seeking financial aid.
The 529 plans owned by college students or their parents count as assets and reduce need-based aid by a maximum of 5.64 percent of the asset’s value. For example if a parent has $20,000 in a college-savings plan for his/her child, the child’s aid would be reduced by roughly $564. For financially independent students who hold their own 529 plans, the assessment is a far larger 20 percent.
529 plans not directly owned by parents or their dependent student, for example by grand parent are again treated differently. While these assets are not included in year one FAFSA application, any money withdrawn to pay for college education is reported as untaxed income on next year’s FAFSA application and can reduce the aid by as much as 50 %.
These are just federal rule. Several private schools make their financial aid decisions based on College Board Profile form, which asks for more detailed information than does the FAFSA and treats all 529 plans as asset. Suffice to say that many schools are starting to adjust their awards when they discover 529 accounts in the family.
529 Alternatives
Should I 529? discussion would be incomplete without thinking of alternatives to 529 and there are several.
The use of Roth IRA money to fund college education. The biggest advantage of this option is that the money can be taken out tax and penalty free to fund college education as long as the account is active for 5 years or more. Yet another advantage of this option is that funds in IRA do not count towards asset on FAFSA.
The biggest downside of this idea is the strict limit on how much one can contribute to Roth IRA per year.
Another idea is to simply invest in a taxable brokerage account. There are no limits on how much money can be contributed, how the money is invested and how the money is used after withdrawal. And, if invested for the time horizon’s we are considering, 10 years or more, the tax drag can be minimized as well.
I am particularly in favor of this strategy. Especially so because the I cannot avail the benefit of state income tax deduction on 529 contribution, and the freedom to invest and use money as we see fit may outweigh the potential drawbacks of the limitations imposed on 529 money.
A third and very intriguing option is investing in a rental property and use the proceeds to pay for college. Chad Carson of from coachcarson.com, has a fascinating article on this topic. The basic idea is to “use safe leverage (debt) against a solid rental property to grow your down payment into significant equity that can be used to save for college“.
Some Math
Estimates vary on how much annual rate of return (ROR) on average one can expect from a typical 529 plan. On the high end I have seen 6 % ROR and on the low end the number is 3 %. The reality is probably somewhere in between.
On the other hand, per my earlier calculations, investing in a self-directed well-diversified investment portfolio such as AVP, should easily produce a 7.5 % annual ROR.
The table below lists the annual contributions necessary to reach to $160000 in 10 years and an additional $175000 in 13 years, assuming the two extremes of ROR and $0 current balance in college savings account.
| Goal | 3 % ROR | 6 % ROR | 7.5 $% ROR |
|---|---|---|---|
| $160,000 in 10 years | $15,290 | $13,135 | $12,169 |
| $175,000 in 13 years | $11,971 | $9,786 | $8,835 |
| Total | $27,261 | $22,921 | $21,004 |
In 10 years, the earnings from investments in self-directed brokerage account would be $38,310 and those invested in 529 plan with 6 % ROR would be $28,865.
Assuming, long term capital gains tax of 15 % on taxable account, the net earnings from taxable investments would be $32,564, which is about $3,700 greater than those available through tax free 529 plan.
Furthermore the money in taxable account comes with no strings attached and should my child decide to be an entrepreneur instead of pursuing 4 year college, the funds are available to him as seed money, not the case without penalties with 529 money.
The answer to the question, Should I 529?, for me is therefore clear enough. NO!
Instead, I plan to stick to self-directed investments in diversified portfolio of ETFs under AVI portfolio. And occasionally when markets offer bargains, invest in individual stocks.
I would be curious what readers think.. Do leave feedback in the comments section.
Article/Audio for this week
This weeks interesting read/audio was all about Berkshire
- Analysis of Berkshire Hathaway by Whitney Tilson
- Full version of Andy Sever interview with Warren Buffett on Yahoo Finance