By Adrian Colarusso, CFA, CFP®
October 16, 2022
The group chats are buzzing with baby news. I apologize in advance to all my expecting friends if I have to ask twice about: your due date, whether you’re having a boy or a girl, or whether you’re even “finding out”.
I also offer a sincere shout out to those who’ve undergone herculean (nay, eileithyian) struggles to conceive, carry, birth, or raise children. There is no more purposeful investment one can make than in the next generation.
As I write this, my wife is in London for the work week. Never will I ever wish away these years as a parent of two young kids, but if I ever fantasized about them heading off to college, it was this week.
I jest, to segue into a discussion on 529s, the tax-advantaged college investment account.
This newsletter won’t cover how to optimize your plan to cover tuition in the few years immediately before college. Nor will I lay out all the basics of a 529 plan.
This is just a reminder to go open one.
If you are new parents (or parents-to-be, eager for a jump start), and you are reasonably sure that your offspring is headed to an institution of higher learning, you have an unfunded liability on your balance sheet. What’s your plan?
The money will come from some combination of three places:
- Invested in the past (i.e. now)
- Earned in the present (i.e. your income during the years tuition is due)
- Borrowed from the future (i.e. loans)
I think it’s obvious where you get the most bang for your buck. Any time the government names an investment bucket after a section in the tax code, it’s probably a good deal and you should strongly consider taking them up on it.
A dollar invested on your child’s day of birth that compounds at, say, 7% annually will pay for $3.38 worth of college in 18 years. A 529 plan allows you enjoy the full investment growth without taxation if withdrawals are used for college tuition or a host of other accompanying expenses.
Check out this simple Google Sheet and make your own copy to test different scenarios. I set it up to illustrate that you could hypothetically contribute $4,750 per year for 22 years to meet the projected liability (a total of $104,500 cash invested to fund $430,000 of inflated tuition expenses). Or, you could front-load contributions – $15,500 per year for the first four years (a total of only $62,000) – to fund the same liability for years 18 through 22. Pay attention tostate tax benefits and deduction limits, where relevant.
There are several assumptions and risks that underpin these scenarios, and nothing is guaranteed. But the point is that a little foresight and the magic of tax-free compounding can make a daunting task a little easier.
It is possible to contribute too much to a 529 plan? Yes.
There are two types of parents reading this:
- Those who are resource constrained
- Those looking to prioritize where to stash excess savings
Although everyone’s situation is unique and I therefore can’t offer financial advice in a newsletter, below are some thoughts for each group. A risk for both is getting too gung-ho about 529 contributions – either neglecting other financial priorities or winding up with an overfunded 529.
Of course, I’d argue the bigger downside risk lies in neglecting to fund a 529 at all.
College saving for the resource constrained
The numbers are daunting. Don’t let the perfect be the enemy of the good. If that baby is here or on the way, go open a 529 account right now, even if you can only put $100 in it. Overcoming that first hurdle is a meaningful victory.
With the 529 account open, add it to your baby shower registry, just like you included an option to fund your honeymoon beach palapa rental on your wedding registry. Ask grandparents or other relatives to contribute for the child’s birthdays (note that these contributions are subject to gift tax limits). Run a lemonade stand with your kid and put half into the 529 account. I would probably stop short at trick-or-treating for 529 contributions.
Another strategy I heard from a mentor – an experienced mother of four – is to start deploying daycare dollars into the 529 once the kids reach public Kindergarten. After all, it’s already built into your budget.
A common adage in financial planning is that you can always borrow for college, but you can’t borrow for retirement. In that spirit, I wouldn’t forego 401k contributions that are matched by your employer in favor of 529 contributions. In fact, I’m not sure I’d contribute to a 529 at all until my retirement contributions are maxed out each year, but you might have different values. Perhaps you and your co-parent develop a strategy such that that the 529 gets $100 per month if all 401k employer matches are harvested, and more after the 401k is maxed out.
By the time your child goes to college, you’ll be grateful for those eggs in the 529 basket, however many there are. A 529’s effects on eligibility for need-based financial aid should be minimal.
College saving for the flush – front-load and shoot for half
You might be maxing out your retirement accounts and looking for more investment tax shelters that align with your future needs. If you have kids, or will soon, the 529 should probably get some dollars.
Two principles of this couple’s strategy: 1) front-load contributions to get the most benefit from compounding, and 2) aim to only cover “around half” the projected tuition liability with 529 funds.
“Around half” is a placeholder for “don’t feel the need to fully fund college with 529 assets”. You can always use taxable brokerage investments, income earned during tuition years, or other sources of funding to close the gap when the time comes.
If you get too aggressive with your contributions, and your investments perform well or college expenses wind up lower than you think, you might find yourself with the champagne problem of an overfunded 529.
Withdrawals unrelated to education expenses will trigger income tax, and not the lower capital gains tax on the investment growth, plus a 10% penalty (again, on the growth, not the original contributions. There are several key exceptions that help sidestep the penalty). It’s not a tragedy, but an outcome to avoid since you would have been better off investing in a regular taxable brokerage account.
What future account balance should you aim for?
Let’s say you and your co-parent are adamant that your child will attend a four-year private school and then a master’s program, or medical, business, or law school after that. Even private K-12 school is eligible for some 529 funding. Go ahead and project a massive liability and aim to fund 70% of it, leaving room for the possibility that your ambitious plans might not exactly play out.
On the other hand, you may not be sure what the college tuition landscape might look like in 18 years and how that will relate to your child’s needs. For all you know they’ll go to trade school and become a happy and successful electrician, for much less than what your parents paid for your schooling. Plot out four years of state school and try to fund around 50% of that number. Just be careful not to underclub it too much, given the power and leverage of tax-free compounding.
Either way and anywhere in between, come out of the gate hot with contributions. Check in with your plan each year. Maybe investment returns are higher than your original assumption, and you’ll take your foot off the gas for a couple of years. Or, markets give us several years of malaise and you might want to make up a projected shortfall.
College savings for the countercultural
Here’s a perspective I’ve encountered and would like to acknowledge: many millennials have a sour taste in their mouths after their experience with the college-industrial complex.
Our generation is saddled with well over a trillion dollars in debt. Many degrees represent levered six-figure investments that turned out to be of spurious value. College costs have risen inexorably in our faces, fueled by an arms race among schools to fluff up the campus experience with unnecessarily lavish accoutrement, paid for by debt, prodded on by the government.
It’s not unreasonable to hope that things may fundamentally change in 10 or 20 years, rendering our assumptions about college savings irrelevant by the time our kids go. Maybe Google will educate our kids for 1/10 of the cost, or there will be a revival of the trade schools, or we’ll adopt a universal college education model like some European countries. Or our kids will attend an overgrown version of a Montessori school to be founded in 2037, which just might accept magic beans from our organic home garden as payment.
Although I understand where they are coming from, parents who sketch this out as a base-case scenario might be naïve. It’s quite likely things won’t change much, their kids will want to attend a four-year college like they did, and it’s going to cost some money. Wouldn’t it help to have a few grand stashed away in a 529?
I think the middle-of-the-road perspective is that we must make better cost-benefit decisions about college – when and where to attend, how to pay, what to study – in partnership with our kids than we did for ourselves with our parents.