This year I’m considering opening up a 529 account. I don’t have any children (yet).
Why would this even cross my mind? Unless you’re in the fortunate situation of having graduated without substantial student loans, you’re probably aware that college tuition has been outpacing inflation at an astronomical pace.
It’s easy to see this inflation in my own life. My alma mater charged $3,192 in tuition and fees per year when I started my undergraduate degree in 1999. It’s hard to believe that I could knock out tuition for a year back then in what amounts to about one month of rent in NYC.
Not surprisingly, millennials are saving more for college than their parents and grandparents according to a recent survey (thanks to Andrew for the link). This is probably a function of rising tuition costs and crushing student loan burdens. If left unchecked, it’s pretty easy to feel like we’ll be paying $100K a year to send our kids to the local state school.
This isn’t even considering the possibility that any future kids might want to go to professional school. One can only hope that the continued decentralization of education puts downward pressure on tuition.
With all the pressure to come up with an education plan, it’s not a bad idea to do a little planning before you even have kids. Of course this is a much lower savings priority than your own retirement, so some perspective is needed. Your kids can always borrow money for school. Retirement has no such option.
529 plan basics
A 529 plan allows you to contribute post-tax dollars into an account that grows tax-free and can be withdrawn tax-free if used for qualified education expenses.
529 plans are sponsored by states, which is why you’ve probably heard of the “New York” 529 Plan or the “Utah” 529 Plan.
You are not obligated to use your state’s 529 plan, although as we’ll see there may be some tax benefits for doing so. All of the 529 plans are open to you regardless of where you live and regardless of where you or your future kids go to school.
Some states, such as New York, will give you a state and local tax break if you make a contribution to the 529 plan. New York in particular allows you to deduct up to $5,000 per year per individual or $10,000 as a married couple that files their taxes jointly.
With a marginal state and city tax rate of about 10%, saving $1,000 in taxes gets my attention. Luckily, New York also offers one of the best 529 plans in the country, complete with access to low-cost index funds from Vanguard.
Not all states have great plans, so you’ll have to look at your state to see what type of tax benefits you get and whether those tax benefits make up for poor investment choices.
If you live in a state like California that doesn’t offer a state income tax deduction, you’re probably going to shop around to find the best plan (likely Utah or New York but there are other good ones too) since you’re not going to see any tax benefit by contributing to the California plan.
Why contribute before kids?
It might seem strange to consider contributing to a 529 plan before you even have kids, but there are a few reasons why I think this might be a good idea.
The first is that you take advantage of the long runway of compound interest by getting an account set up sooner rather than later. Since the investments grow tax-free, these are accounts that are going to capture the full value of the US economy over the years. In fact, if you contributed $10,000 to an account today and let it grow for 50 years, your grandchild could have $238,601 in inflation-adjusted dollars waiting for them to pay for college. Thanks grandpa! Try the numbers yourself.
The second reason to contribute is that you get the tax break today. We’re always looking for ways to cut down on taxes, particularly during our peak income earning years, so saving 10% is a nice benefit that we get to realize immediately. Similar to retirement accounts, the New York state tax benefit is a use it or lose it benefit, so if we skip contributing this year we won’t be able to recapture this benefit at some later point in time.
A third reason to open the account today is so that it’ll be available in case any friends or family want to contribute to it going forward in lieu of traditional gifts. I’d much prefer future gifts to kids come in the form of less physical stuff and more cash. Sure, the kid won’t appreciate it today but a cash gift towards education will have a much bigger long-term effect on their life. Having an account open and ready to receive contributions makes it that much easier to make it an option for future gifts.
What are the risks?
If you’re opening a 529 before you have kids, there is at least one big risk that comes to mind: What if for some reason I never have any kids?
It’s a reasonable concern but this isn’t going to keep me from contributing to a 529 account.
First, you’ll have to make yourself the beneficiary of the account anyway before the kid is born since you can’t open up an account for an unborn child.
Later you’ll end up switching the beneficiary from yourself to your kid. There’s nothing that keeps you from switching it to another family member, such as a niece, nephew or keeping the money for yourself and potentially using it for your own education expenses later in life (e.g. taking a part-time course in retirement). Needless to say, you have a lot of options.
Second, it’s important to remember that the money in the 529 account doesn’t belong to the beneficiary. It’s your money and you can use it as you see fit. Yes, you’ll have to pay a 10% penalty on the earnings along with ordinary income taxes if you withdraw the money for a non-qualified education purpose. But this is only on the earnings portion, which is the part that’s been growing tax-free all these years anyway. It’s not an ideal situation but you’ll still come out with significantly more money than you invested. I’ve written before about why 10% penalties are a little overblown.
For these reasons, it hardly seems like a big risk to put a few thousand dollars into a 529 plan before a kid is born. So while I wouldn’t invest $100,000, I’m comfortable with the risks for a relatively low amount like $10-$20K.
There are other risks too: What if your child decides not to go to college or ends up with a full scholarship. What will you do with the money then? Again, I think I can work with both concerns. Since the 529 money is money I’ve invested after I’ve hit my other retirement and savings goals, this is really “extra” money for the benefit of a future family. We could easily keep the account open for grandchildren or, if we’re in the lucky situation of having excess funds, give it to other family members in need of tuition assistance.
Since there’s also some risk in overfunding a 529 plan, I’m more inclined to start making contributions early and then slow down contributions later in life once the account balance has grown to a reasonable size. This way I take advantage of the tax-savings today and get the benefits of compound interest but still leave myself room to fine tune the balance at some point in the future. Plus, once the kids arrive, I can start teaching them how to invest as well.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.