The 411 on 529s

I don’t think I’m saying anything controversial here, but I think giving your children a solid education is the best gift a parent can provide. Despite the nationalistic economic trends emerging throughout the globe, the (high paying) jobs of the future will continue to require a strong education in order to compete globally. Additionally, there is strong research out there forecasting that the economic divide among the millennial and future generations is going to be much less based on race, and more based on who was able to graduate college without student debt. I owe so much of my current financial situation to the fact that I was able to graduate one of the most expensive schools in the country completely debt free.

As a new parent, saving enough to send my kid to college ranks as one of my top goals. While it doesn’t beat out retirement (you can’t borrow money for retirement but you can for school), it does beat out EARLY retirement. I would view it as a worthy sacrifice to have to work a couple of extra years if it meant sending my child to school debt-free. Though I have learned one thing over the last several weeks: the cost of college is scary high. I mean, it-Halloween-month-so-culturally-relevant-IT-remake scary.

The Cost of College

There are many fancy calculators for estimating the future cost of college, but in my experience it’s often the simplest models that are the most enlightening. Vanguard has a very simple college cost projector, with only 2 assumptions that need to be made: education inflation rate and school type (public 4-year, in-state; private 4-year, average; etc.). For NFF Jr., with the average inflation rate of 5%, the cost of a private 4-year institution will average ~$470,000 in 18 years! And that’s just the average. I looked up my alma mater, just for “fun”, and the cost in 18 years will be ~$680,000!

There are several caveats about this number that keep me somewhat hopeful. 18 years from now is a long time and a lot can happen between now and then. The growing student debt problem in this country could explode, leading to major reforms in the cost of education. Additionally, some schools are already taking steps to help reduce the burden of college costs, though those efforts are usually limited to schools that have outsized endowments and can afford to absorb those costs. While I’m not optimistic about meaningful changes, one can certainly hope.

Saving for College

While not significant and definitely geared towards higher earners, the government does help with these costs a little bit through tax cuts. A 529 account is an investment account designed for education expenses. Similar to a Roth IRA, contributions are made after tax, but gains are federal tax free as long as they are used for qualifying education expenses. This can mean significant dollars over the long term. A $50,000 investment in a taxable account for 18 years will equal about $177,000. Meanwhile, the same investment in a 529 would equal about $200,000, a $23,000 increase.

What makes 529s complicated is that, unlike IRAs, each state has their own 529 plan administered by that state. DC, Maine, New York, California, etc. all have their own 529 plans that invest in different things (though they’re usually not clear about what they are), have different fees (also not very clear about what they are), and provide different incentives for investing in their plan (much easier to find). The incentives, when available, usually come in the form of a tax deduction from that state’s income tax. If you live and pay taxes in DC, California’s tax incentives aren’t going to mean anything to you.However, someone in California might find a lot of value in those benefits.

My family and I live in Washington, DC, which provides a very nice tax incentive for using their 529 plan. Each individual can deduct up to $4,000 ($8,000 for a married couple) from their income taxes for contributions to the DC 529 account. With a DC income tax rate of 8.5%, investing in DC’s 529 would save us $680 versus investing in another state’s 529 plan.

There can be downsides to your state’s 529 plan, including high fees or bad investments. High fees can kill any tax incentive there is to your state’s 529 and hurt performance for years into the future. After some digging (it was not easy to find), I was able to track down what the DC 529 actually invests in and they sound fine with me. Based on the investment plan description, I’m pretty sure they are iShares index funds but it says a lot that after an hour of looking I’m still not 100% sure. An additional level of complication is that DC just changed their 529 vendor last year, so old research on DC’s performance and fees are irrelevant. However, these investments seemed reasonable to me and the tax deduction helped sway my decision to invest in DC’s 529.

I won’t detail every state’s 529 here, but I did want to highlight New York’s 529 plan. The plan website is very easy to move around in and understand what the investments actually are. There is a wide selection of portfolios to choose from and most are made up of low-cost Vanguard index funds. In the absence of tax incentives for DC’s (or your own state’s) 529, I highly recommend considering this 529 as your preferred plan.

Summary Framework

Below is a simple framework for deciding where to put your college savings. I encourage you do thoroughly research your own state’s plan and make sure you are comfortable with what they are investment your money in and how much they are charging you to do it. Every state will be different, but the same investing philosophies that govern your retirement savings (i.e. minimize costs, invest for the long term) should apply here as well.

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