Thoughts on Saving for Kids’ College Educations

HOUSTON, TX - DECEMBER 22: J.J. Watt #99 of the Houston Texans enters the field before the game against the Denver Broncos at Reliant Stadium on December 22, 2013 in Houston, Texas. (Photo by Scott Halleran/Getty Images)
Rage on, eldest kids in classroom. (Photo by Scott Halleran/Getty Images)

If you live in a privileged enough strata of American life you’ll likely encounter questions about paying for your offspring’s college education starting around the age of 1. 1 day.  Even before the competition begins for the most coveted preschools and under-3 soccer leagues you can expect to start thinking about saving up for a diploma.  (In regard to the soccer leagues, remember to utilize birth control to plan your child’s birth date to ensure they are the oldest – and thus, biggest and strongest – in their class and can dominate like AJ Watt).

Although I belong to the economic class for which college savings is a major priority I don’t agree.  Primarily it is because I paid for my college education in full, and knew that would be the case from the time I was in 5th grade.  I was fortunate to receive a number of scholarships, loans, and good jobs that allowed me to pay for college.  I expect my children to do the same, or attend a less expensive school if their academic record doesn’t warrant scholarships or entry to a school with a robust needs-based financial aid policy.  Secondarily it is because it is more important to take care of my own financial house before my children’s since I will not be able to do much for them if I’m in a poor position myself.

A major tool for saving for college today is the 529 Plan, introduced in 1996. “Qualified tuition program” is the legal name though many refer to it simply as a 529 College Savings Plan.  The plans are different in each state and can offer a prepaid tuition plan and/or a savings plan.  Some states offer a tax deduction for contributions and the earnings in the plan are federally tax free if used for secondary education expenses.

529 Pros & Cons

Pros

  1. State tax break (depends on state) – In our state of California there is not a tax break for contributions to 529 plans.  You can live in one state and invest in another state’s plan and funds can be used across state lines as well, they are not tied to a specific state.
  2. Federal and state tax benefit – no tax on earnings of 529 plan

Cons

  1. Federal Penalties – 10% penalty on earnings for funds not used for education. Taxes also applied to earnings of 529 plan.
  2. State penalties – In my state of California, an additional 2.5% penalty applies if the federal 10% one does
  3. Pressure – Implicit or explicit pressure on children to attend college may be amplified by financial pressures from establishing and funding plan
  4. Limited options – Plans vary, but narrower set of options than investing outside a plan
  5. Limited flexibility – This is a big one for us. If we run into an emergency (or a great opportunity) we feel our financial needs must come before our children’s college funding.  A 529 plan locks in the funds applied for quite a while and limits the options unless one wants to take the penalty hit.
  6. Plan fees – On top of the fund fees (which you would also pay investing directly) the 529 plan likely applies a separate fee.  CA ScholarShare charges an additional .10% fee, for example.
  7. Financial aid – 529 funds count as a negative in financial aid applications (as do many other assets) in assessing student need.

Instead of utilizing a 529 plan for our kids, we’ve set up a Betterment account for each (which is currently in our name).  We make a contribution each month to grow the value over time.  The accounts for them are basic taxable investment accounts to preserve flexibility and due to this, we value the tax-loss harvesting Betterment provides as worth the fees charged.  In time we may choose to use these funds to purchase investment property, gift to our children, add to our retirement funds, or take another course of action.  Whatever we do, it will be with an eye to providing for our children but not be locked into a specific program and set of options.  In our case we’ll lose out on the tax break on earnings but will keep flexibility in the many years until our children are considering college.

[Disclaimer: This post is not and should be be considered to be investment or tax advice.  The post was typed by a goat while dictated by the author.  Please consult your religious authority, accountant, political official, or post-person for additional inquiries.]

 

 

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John P Anderson

I'm a Kansas native living in San Diego. I enjoy learning about environmental issues and connecting with good people that want to make the world a better place. Cheers!

4 thoughts on “Thoughts on Saving for Kids’ College Educations”

  1. My parents saved like crazy for three of us to go to college. We each had a set amount and I wish they never would have told me. I had no idea what I wanted to be but I went because it was important to them to go to college. I never really thought I had a choice even though I did. I squandered the first few years mostly by doing college type stuff and blowing the money on beer (each semester I got a flat amount for tuition & living expenses). Then I figured out what I wanted to do & the money ran out. I ended up taking out 25K in loans which I’m still paying off a decade later. 
    In retrospect, no one is to blame I wasted the time & opportunity except me. But both me & my parents agree it would have been better to let me figure it out on my own and tell me about the financial support after I was on my education path or at least part of the way working towards something. I would have appreciated it more & it would have been much more beneficial to me to make me think about my financial decisions early on.
    My middle brother never used any of his for college. Rather to cover bad debt. Later on he took out loans to go to school. My youngest was the smart one. He knew what he wanted at an early age and pursued it. He learned from our mistakes. But now a little older and set in his path he has some regrets that he couldn’t meander his thought process or education track with risking himself financially.

    So…I agree with the betterment plan idea. That’s basically, what I’m getting at.

  2. KingsleyMcManis Thanks for the thoughts and glad things eventually worked out for you.  I should have noted that although the funds we’re currently saving (outside a 529) are intended for the kids at some point a major goal is to not let them know about the funds until after college – then they can decide if they’d like to use the funds to pay off loans, if any, invest, etc.  It just seems too tempting to give a significant amount of money to an 18 year-old, even if the money is earmarked for certain expenses.

  3. I have to preface this by saying that what I will write here
    is not financial advice, and anyone should consult their own licensed financial
    advisor. This post was also written by a goat. A fainting goat, in fact. 
    That being said, I think you’re greatly underselling the
    benefits of 529 plans, and based on what you wrote,  I suspect that it might have quite a bit to
    do with your own personal background and how you paid for college.  Perhaps paying for part of your children’s
    likely post-secondary education isn’t a priority for you.  This is a family by family decision. Your
    goals are your goals – no concern there. 
    But I think you’ve let your goals bias the pros and cons of 529
    plans. So a few things on your pros and
    cons list:
    Pros:
    2)This one is pretty big.  How many other investment options do you have
    that get tax fee growth?  Roths are
    awesome but limited. 
    Cons:
    1)I guess I’ll spend most of my time here. How
    likely do you think it is that your kids won’t pursue any post-secondary
    education that is eligible for a 529 distribution? Because you have two (at least
    for now) kids, the odds that one of them will pursue further education are even
    higher (not to mention the fact that you and your wife both have graduate
    degrees… the odds that your kids will purse at least some college are sky high,
    and more than likely they will pursue graduate degrees, too). Because your two
    kids are so close in age, even if one of them doesn’t pursue post-secondary
    education, you can change the beneficiary on the plan to have the money go
    toward the other kid’s expenses.  Changing beneficiaries is a great benefit of
    529 plans. And if one or both of your kids don’t want to go to college right away… no worries. You can still use the money for them at age 25 when the figure out they want to be chefs. There is no upper age limit. 
    The 10% penalty has some outs such as
    scholarships, disability, death, etc.  The
    concern about a potential 10% penalty is fair, but as a poker player, I think
    the odds are better than 9:1 that your kids will pursue some additional
    schooling. Also, I don’t think you can say that the tax on earnings is a
    negative when your proposed alternative of a Betterment account also has taxed
    earnings.
    2)California is the only state the charges a
    separate penalty for non-qualified withdrawal.  That matters to you, but not to most of your
    readers.
    3)You don’t have to let your kids know about the
    existence of a 529 plan if you’re worried about them feeling financial
    pressure.  Lots of families don’t let
    kids know about funds that are intended for their benefit for a variety of
    reasons.  Again, you likely run in a
    circle of friends where there will be plenty of cultural pressure to attend
    college. That’s where the pressure will originate.
    4)You’re right that plans vary. This is really a
    state-to-state issue.  
    5)The accounts are just as liquid as qualified
    retirement plans such as IRAs and a 401(k)s. This is a fair concern, but it is
    a concern with any tax-qualified savings plan, and I would guess you support
    saving in other tax-qualified plans.
    6)There are some online comparisons of
    state-by-state all-in plan costs for a typical $10,000 investment, but even
    those are tricky because monthly auto-investments lower the stated plan fees in
    most states.  I would focus on those
    all-in costs more than on a tiny 0.1% plan fee.
    7)Almost every asset counts for the expected
    family contribution (EFC), so I don’t see how you can hold this as a negative
    against 529 plans given your proposed alternative strategy. Assets in the kids’
    names count even more (which is why I asked the question on facebook – UTMAs and
    UGMAs are an issue here).  The big
    problem I have with the EFC calculation is that it rewards people who don’t
    save.  Time to go on more vacations and
    drink more beer!
    Two final things – as you know, the purpose of tax loss
    harvesting is to reduce your capital gain and tax burden.  Since the gains on 529s are untaxed when used
    for education, Betterment’s tax loss harvesting is inconsequential.
    On liquidity – you expressed a liquidity concern and then
    said you might buy and investment property with the money saved in the Betterment
    account.  Now THAT would be a strategy
    that would has liquidity risk.
    Of course, if you make that investment property something
    that provides a good or service (i.e. not residential), then you get to exclude
    the value of that business from your FAFSA (good!) but not your CSS Profile.
    Again, this is not financial advice.
    That’s all I have.  Go
    Irish. Beat Clemson.

  4. Tribs Thanks for the thoughts, agree with much of what you’ve written here.  My take on paying for college is perhaps unique for my background and I’m sure many others have a firm commitment to paying for all the upper education possible for their children.  I very much hope that my kids decide to pursue college and graduate degrees in future.
    Perhaps I’ll put together another post about my specific thoughts that are outside of a 529 and why.  You touch on some of them here – reducing assets that count against financial aid is a big one.  Tax-free gains are definitely a big deal.  Not many opportunities out there – sale of primary home ($250K tax free per person), 529, Roth, gifts below annual exclusion amount.  Businesses have a lot more opportunity to reduce taxes, though I don’t know of any tax-free options other than some niche credits that can be pretty lucrative but are very specialized.

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