Hello folks! Hope all is well. Thanks for the feedback on last week’s post regarding my 529 plan dilemmas. As a quick refresher, I was looking for some advice on whether I should 1) switch my 529 plan from Utah to NY based on about 8 bps differential in the total fee structure on my investment selections and 2) whether I should ultimately hold less in my 529 plan in favor of greater flexibility in holding some funds to be used for college in my taxable brokerage account.
Based on all your helpful advice and further research I’ve completed, I have come to a conclusion! Drum roll please….
Utah or New York 529 Plan
First up, on where I will continue to hold my 529 plan assets. I’m still a little wishy-washy on this one, but for now I have come to terms with keeping all 529 plan assets in one location (for ease and simplicity) and for that location to continue to be Utah. While the investment options are basically the same in both, the fees are slightly higher in Utah…at least for now.
My plan will be to continue to monitor fees. It is not uncommon at all for states to lower fees to jockey for more assets under management (AUM per the industry jargon). Given how Utah has been a perennial stakeholder on the low fee front, versus New York who is new on the scene from the low fee perspective, I plan to hold out in Utah with the expectation that fees will be more in line with New York eventually.
If by chance another year or two down the road and the fees are still decently far apart, it may be time to pull the trigger on a move. But what I don’t want to end up doing is switching the assets back in forth between states every other year.
For now, I will keep my 529 plan assets in Utah; however I will hold this decision up for further review regularly in the future. And if I do end up switching…you’ll be sure to hear about it :).
That said, I appreciate the feedback from Vicki who lives in New York and also benefits from the tax deduction of the contributions!
We live in NY and use NY’s 529 plan – but we get a tax advantage too! – Vicki from Making Smarter Decisions
529 Plan or Taxable Brokerage
Now for the next dilemma I was facing, whether to save for college in a 529 plan or a standard brokerage account.
Two factors come into play here. Let’s take them one at a time.
Estimating the Cost of College
First, how to go about estimating the cost of college 15 and 18 years down the road for our two kiddos. Certainly not an easy feat…
As you can see from my prior post on estimating college costs, I’ve checked online calculators annually since 2014 to update assumptions on the cost of college. As for my most recent update on my estimates per SavingForCollege.com, T Rowe Price, and American Funds as of June 2017, things haven’t changed much from last year.
Saving For College still comes in on the lower end of the range compared to the other two based on a lower inflation factor. The American Funds calculator comes in much lower compared to when I ran it last year ($178,281 compared to $254,256) not because of a change in the inflation estimate, it was still at 6%, but because of a change in what they report as the average cost of college today at $17K compared to $23K last year. Who knows the rationale for that change or how each of the three services come up with different numbers for the average cost today?! But nonetheless, I’d expect the starting point of the cost of college today to be around $20K to $25K.
What has changed though is my belief more in the lower inflation number. Last year I concluded college at a four-year in-state public university would cost between $200K and $250K and I was planning to conservatively fund the upper end of that range in a 529 plan by age 18. That was in line with the T Rowe Price and American Funds which both used a 6% inflation target.
I think there is some truth to the argument that 6% inflation is unsustainable. I’m probably more in the camp that college tuition inflation will be more in the range of 3% to 4%, similar to Saving For College. While this is still above general inflation levels, it is moderated from historical inflation on the cost of college.
Based on the cost of college today coming in around $20K to $25K and inflation to be in the range of 3% to 4%, below are the given ranges for the cost of college 15 and 18 years down the road for my two boys, Cygnet #1 and Cygnet #2.
While the ranges are still pretty wide, I’m ball-parking the total cost of college at $150K for Cygnet #1 and $165K for Cygnet #2. Note that this is a change from my prior thinking of $200K to $250K outlined in my post last year on the cost of college, but as previously noted this is due to a change in thought process around inflation. Before I was thinking around 6%, now I’m thinking around 3% to 4%.
While my new estimates are most certainly going to be wrong, that is after all the nature of projections, the good news is I still have plenty of time to refine these numbers :).
And I appreciate the feedback from Stock Street last week who made a good point about the affordability of in-state tuition:
And in many states with cheap in-state tuition, many people have more than the college costs in a 529 and that ends up being disadvantageous! – Stock Street
Over-funding the 529 Plan
The second factor is not wanting to over-fund the 529 plan.The underlying premise to factor is the fact that I plan on retiring early and switching to the 15% income tax bracket or less for the majority (if not all) of retirement thereby resulting in 0% capital gains tax on my taxable brokerage account.
Having a 0% capital gains tax on a taxable brokerage account would negate the basic benefit of a 529 plan which is the investments growing tax free. Plus, the added benefit of flexibility in using the cash in a taxable brokerage account for anything (as opposed to only education related expenses in the 529 plan) makes the risk of over funding the 529 plan a major detriment.
The only reason I can think of to over-fund a 529 plan is the possibility of using it as a vehicle for inheritance to be passed on to either my kids or potentially future grandkids. My answer to that though is I can always make that election in the future. I’d rather preserve this optionality and therefore elect not to risk-over funding the 529 plan today.
If I do end up over-funding the 529 plan and chose to withdraw the extra funds (rather than pass them down to future generations still intact in the 529 plan) then I would incur income tax and a 10% penalty on the earnings portion. Yuck!
Assuming I’m at the 15% marginal tax rate, that would be a tax and penalty of 25% versus the alternative of 0% tax if held in the taxable brokerage account. The key note here is that earnings withdrawn for non-qualified reasons (aka not for college expenses) are subject to income tax, not capital gains tax which they alternatively would be subject to in the taxable account (which would effectively be 0% if I’m within the 15% income tax bracket).
Therefore, if I end up over-funding the 529 plan, I’d basically be subjecting the earnings from those assets to a 25% haircut (tax plus penalty) versus 0% in the alternative scenario by keeping them in the taxable brokerage.
And I’m not the only one worried about over-funding. Thanks to the feedback in last weeks post from Liz, Grant, and Mr. SSC:
I like your idea of transferring $40k into #2’s account and letting both compound, while investing in after-tax brokerages for flexible funds. That way if there’s a shortfall because the market doesn’t perform, you’re covered – but if the 529’s do perform well, then you can just use those funds to cover college. – Liz from Chief Mom Officer
I am looking to fund half of college with the 529 and the remainder through brokerage accounts or scholarships. – Grant (reader)
Take the penalty, or roll it over for one of their kids or do what with it? Either way, we decided to keep them both in a 529 and worry about it if the time comes that we have to do that. – Mr. SSC
Dr. Curious made a good point about the behavioral finance aspects of 529 plans:
The only real argument I can think of for a 529 over taxable in your case would be a behavioral finance one: the 529 is earmarked for education, no questions asked. – Dr. Curious
Likewise, Amber Tree Leaves made a great point of having some funds in a specifically designated account for college, but does also favor the flexibility in taxable brokerage accounts:
When it is in your name and something happens, how to make sure the money is for education? – Amber Tree Leaves
Scholarships or College Hacking
As I noted above, I’d ballpark the cost of college for Cygnet #1 and #2 to be around $150K and $165K, respectively. That estimate though, is based on the assumption for the average cost of a degree. I wouldn’t be surprised if the actual cost comes in below this estimate based on one or a combination of scholarships or college hacking.
My wife and I didn’t get much for scholarships, but we admittedly didn’t try too hard and that is a knock on us. We could have done better, in all likelihood.
With the right incentives in place, I wouldn’t be surprised at all if the kiddos get some scholarship money. It could be either an academic or athletic scholarship…who knows. But the potential is there. Typical parent… believing their children are perfect :)!
If they were to get some scholarship money, it would put us back in the same spot as over-funding the 529 with exception to the fact we’d get out of the 10% penalty on withdrawals up to the scholarship amount. That means income tax on earnings. Say that is at the 15% marginal tax rate, but no matter what it is unavoidable whereas if those extra funds were in a taxable brokerage account we’d at least have some control on limiting capital gains tax by staying in the 15% income tax bracket.
Scholarships are a good thing, we certainly hope our kids will earn scholarship money, but in planning for that potential situation it may be better to have less in the 529 plan than more.
As I mentioned last week, I “hacked” the cost of college without even really trying or knowing it. Imagine what a little more focus and determination could result in the college hacking department for the kiddos!
For example, I received some college credit through CLEP tests, dual enrollment during the later years of high school, taking a few community college classes in the summer and winter breaks that were transferable to my university and I ultimately graduated in three years.
By the kiddos doing some of the same, and us being cognitively aware of this potential and actively looking to take advantage of various “deals” on the total cost of college, I imagine the cygnets will manage to reduce their cost somewhat below the average benchmarks I laid out above.
Other Noted Variables
- Who knows what will happen to the tax code 15 years out with regard to either capital gains tax rules or 529 plan rules (for the better or worse). Status queue may not be the reality.
- What if I “hack” the FAFSA application process because I’ll be retired early with little taxable income and most assets tucked into retirement accounts (not included on the FAFSA application) by the time the cygnets enter college?
- If I over-fund the 529 plan, I could change the beneficiary to myself and then perhaps use the qualified withdrawals to fund my “education” in international travel or culinary arts in Paris…but that might be getting a bit too cute.
- I could also change the beneficiary to grandkids. But say I overshoot funding the 529 plan by $50k for each cygnet and that sits in the 529 plan growing 7% to 8% for another 30+ years until my kids have kids and they become college aged. Those assets would then grow to ~$400k to $500k by that time! Assuming this gets allocated among two grandkids from each cygnet that might be a reasonable college inheritance to pass onto them. But then again, that’s a lot of assumptions to get to that point…
Thanks to FullTimeFinance who shared his perspective and wrote a great post on why he doesn’t plan on putting money in a 529 plan:
I wrote a post a few weeks back on why I do not have a 529. I have some of your same fears and since money is fungible I’ve decided to treat my normal savings tax optimized collectively as my kids college funds. – FullTimeFinance
A reader comment from MPH struck a cord with me as he/she explained the benefit of paying his/her own way through college. Not too much unlike myself, as I paid about half my college costs, not having help from his/her parents was the best thing for him/her. MPH’s advice:
I do not recommend 529s. Save it all in taxable accounts and when the time comes to decide whether they need your help or not (or if they even want it) you’ll have that flexibility. – MPH (reader)
The combination of (i) my estimates for the cost of college coming down (due to a lower inflation factor), (ii) my now unwillingness to risk over-funding the 529 plan and preference to maintain optionality to fund more in the future if needed (compared my indifference to over-funding the 529 plan no less than a year ago), and (iii) greater appreciation for the potential for the cygnets to come in below the “average” tuition cost via scholarships or college hacking has led me to revise and lower my planned lump sum contributions to their 529 plans.
In summary, I now plan on investing roughly $40K in each 529 plan for a total of $80K in contributions. This is down from my prior plan of $70K in contributions to each. Since I’ve already contributed $70K to Cygnet #1’s plan, I will transfer roughly $30K over to Cygnet #2 and add another $10K in the near term.
The $40K planned contribution is based on the assumption of it growing approximately [8% as it will be allocated entirely to stocks] (no bonds for me, thank you very much), and therefore I’d expect it to grow to $125K to $150K, give or take.
I would still expect this to roughly fully-fund the total cost of college, however depending on how inflation shakes out I recognize it could be woefully underfunded. While the benefit lies in contributing early to let it grow tax free for many years, I can save optionality to contribute more later. This could be a benefit in the situation where I move to a state that provides a tax deduction for 529 plan contributions (which NC doesn’t today) or in the great scenario where the investments generate outsized returns compared to the historical average of the S&P 500.
Funding $40K for each cygnet allows me to “split the baby” by contributing a good amount upfront to get the tax benefits from growth while still preserving some optionality to contribute more in the future.
Sound off in the comments below. Any other feedback or advice for me?
Thanks for taking a look!
The Green Swan