On top of everything else, you are now an irresponsible parent if you don’t have a 529 plan in place. Well…if you’ve eliminated high fructose corn syrup, and you permit no more than 37 minutes of TV per week, then your child still has a chance of getting a scholarship and becoming a supreme court justice. If not, a 529 plan is for you.
Most articles on 529 plans are very light on actionable recommendations. Not this one.
In this highly practical RossAsset thought piece I recommend specific 529 plans, and I provide concrete ideas on investment options, should you choose to 529 without help.
Mostly Pros, Few Cons
529 plans have no huge cons unless you are in the midst of a substantial inter-generational wealth transfer. If you are following the dictates of a complicated estate plan that involves maxing out gifts to a UTMA account, then a 529 plan may be the wrong choice because tuition payments are not considered gifts.
“We’re from the government, and we’re here to help.”
Considering that 529 plans were created in Washington, they are surprisingly flexible:
- The Owner is usually a parent, but it can be a grandparent or other relative. In your case, you want to be the owner, and have your parents gift into the plan. This will simplify the mechanics of dispersing the money when the time comes.
- The Owner designates one beneficiary, but can change this at any time, even after some money is spent. This is a very important benefit that even permits generation skipping.
- Money is contributed post-tax, like a Roth IRA.
- Money grows and is then removed and spent tax-free, also like a Roth IRA.
- You can spend the money on virtually anything college-related, including room and board. If your kids surprise you by going to a state school, you can still burn through the money.
- If the money isn’t spent (impossible as we all know – money always gets spent) then you can remove it and pay a 10% penalty, or save it for your grandkids.
The Main Thing: Gifts
529 plans can help grandparents start contributing now to their grandchildren’s education. If begun early, this can be a simple and effective way to transfer something like $200,000 per grandchild – a nice start on generation-skipping wealth that will grow tax free and can be used for undergraduate and graduate education.
Simply open one 529 plan per kid, and work with your parents to get an annual contribution for each child. If you have multiple children, then gifting over the holiday season works better than birthdays because it limits the hassle of transferring money to the 529 plan to once per year.
If the grandparent strategy doesn’t work in your case, then contributing yourself is still a productive use of resources.
Target Annual Contribution
Whether contributions come from you, your parents, or both, there is no reason to exceed $10,000 per kid, per year if you start before age 3. If this is a daunting number, then contribute less. You will still be a responsible parent, and you can safely park your kids back in front of the TV.
Many States, Many Plans
When the federal government conceived of the 529 plan, the idea was that individual states would each create a 529 plan for their own residents and provide state income tax deductions for contributions. As things evolved, many of the big, populous states did not make contributions tax deductible, and as a result the plans began competing for assets nationwide.
Although the absence of income tax deductions for contributions is a shame, plan assets still grow tax-free, and the competition among plan providers is great for investors.
Residents of the following states can choose ANY state’s 529 plan without sacrificing any benefits:
- No state income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, Wyoming
- No deduction for contributions: California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Jersey
- Deduction for contribution to any plan: Arizona, Kansas, Maine, Missouri, Pennsylvania
If you live in one of the other 29 states that offers some benefits, chances are high that you will still want to shop other states’ plans. You can either confirm this with some elbow grease, or just keep things simple, ignore your state’s benefit, and focus instead on the plans I highlight with strong investment options.
Stingy Maryland – An Example
Maryland allows a state income tax deduction of $2,500 for each beneficiary. In other words, if you put $10,000 away for one of your children, you will not have to pay state income tax on $2,500 of that amount.
Since Maryland’s marginal tax rate is approximately 5%, this $2,500 deduction yields a savings of $125. To decide if this princely sum is worth saving, we compare the $125 saved to the amount by which a good plan’s expected investment growth would exceed Maryland’s mediocre T. Rowe Price based plans.
If you have a 529 plan with $50,000 inside, then your investments would have to perform an incremental 0.25% better with a non-Maryland plan in order for you to overcome the $125 tax savings. This is a low bar, but more to the point: if you kill even one brain cell thinking about how to save $125, you have made a poor choice. This is why I generally advocate keeping things simple, and just picking the plan with the best investment options.
Straight Talk on Picking a Plan
I’ve read a lot of 529 advice columns, and they all leave a lot for the individual investor to research, which is boring and unfair. As with investing itself, the trick is to simplify. Here are my thoughts:
If your child is under 15, then go with West Virginia’s 529 plan, which is the only plan to offer the same Dimensional funds that I use extensively in my practice. West Virginia’s plan includes Dimensional’s Core funds, which bake in a modest small-value tilt, essential for meaningful growth from equities. (More on the importance of small-value tilts in your portfolio in another recent blog entry).
The West Virginia / Dimensional plan also has some international equity exposure, again with a small-value tilt, and the investment options are good. The age-based portfolios are very thoughtfully conceived. Use them, or look on the Static Options tab for the Growth or the Moderately Aggressive Growth Options, as you will benefit from having some bond exposure even for little kids given today’s extreme volatility.
If your child is 15 or older, you are getting close to actually using these funds, and you will want a higher proportion of bonds. In this case:
- …if you live in NY, then use Vanguard’s NY plan. Your first $10,000 in contribution per year is sheltered from state taxes, and the savings you get will offset the slightly poorer investment choices.
- …if you live anywhere else, then go with West Virginia, choosing the age-based option for your investment choice.
Summing Up
- One 529 plan per child. You can always consolidate or transfer down the road.
- Combine parent and grandparent gifts to achieve a contribution of no more than $10,000 per child per year.
- Most people can choose the West Virginia plan and go for the age-based option.
A Final Caveat
The West Virginia age-based options for children up to age 12 are going to be very volatile, more so than portfolios I construct for clients. If this volatility is going to make you (or your gift-giving parents) uncomfortable, then look at the pictures and choose one of the portfolios designed for older children. You can jump up 2 or 3 age brackets and still be investing wisely. There is nothing wrong with being a little more conservative if it makes you happier.