Are We Putting Too Much Into Our 529 College Savings Accounts?

Answer: Quite possibly. Mortgage paydowns and retirement plans are often better places to stash savings.

Ben Affleck’s honorary degree didn’t cost anything. (Photo by Mike Cohea/Brown University)

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“We recall you advising that 529s may not be the best investment and paying down loans with interest (e.g., a mortgage) may be money better spent, and also that there are ample opportunities for college aid.

“With all that being said, we are trying to target how much to put aside since education is so expensive.

“I came up with a possible schedule for the kids’ savings, attached. They each have a 529 NY account now, and both schedules result in having approximately $200,000 per child by the time they are in college. The schedules assume we increase our contributions by 5% per year with an average rate of return of 7.5%.

“According to a college cost calculator I found online, the four-year cost at a private school would be approximately $289,000 for the older one and $325,000 for the younger.

“Do you think we should try to save more, or perhaps less?”

Julia, New York City

My answer:

If what’s on the back of your envelope were solid, you’d be in good shape. By putting an average of $5,000 a year into each account, you figure, you’ll have more than half the bills covered. Financial aid might cover much of the balance.

I have bad news.

—Your investments will earn less than you think.

—College will cost more than you think.

—Some of your 529 money will be confiscated.

The big downside with college savings accounts is that they work against you in the financial aid office. The college calculates that if you’ve got savings set aside to pay our (ridiculously stiff) tuition, then you don’t need much help from us.

If you are prosperous enough to be sure of never applying for tuition assistance, then 529 accounts are clearly a winner. But if your kids end up qualifying for aid, you will discover that 529s work no great magic. Indeed, they can have negative returns in purchasing power.

I’ll explain how the aid formulas work, and how you can avoid some of the damage. But first, I’ll show why, apart from the side effect of damaging you in the aid office, a 529 is a good idea. That’s especially true where you live.

An account held under Section 529 of the Internal Revenue Code permits you to create something like a Roth IRA to cover education costs. Investment earnings are tax-free on both federal and state returns if you use the account for its intended purpose. Some states also grant a tax deduction for contributions to plans. New York allows a couple to deduct, against the taxable income on their state and city return, the first $10,000 a year they put in.

Inhabitants of New York City have three motivations to invest in 529s. (a) Their home-state college savings plan, run by Vanguard, is an excellent one with low costs. (b) The tax exemption on account earnings is worth a lot because their state and local income taxes are high. (c) The deduction for putting money in is worth a lot for the same reason.

Let’s see what that means in dollars. Your spreadsheet is a bit complicated because it has escalating monthly contributions for two youngsters who are a few years apart. I’m going to simplify it by assuming you are investing a flat $5,000 a year for 12 years. You put in $60,000. What’s that going to be worth in 2034?

Throw out the 7.5% return assumption. Stocks are trading at steep prices now, so steep that you get an earnings yield of not even 4% on equity capital. Bonds are overpriced, too; they yield on average only 2.5%. Vanguard recommends a blend of stocks and bonds in its age-based portfolios with moderate risk. I think you can expect only 4% a year from this blend. That 4% is a nominal return, before deducting the effect of inflation.

Yes, you could select a double black diamond investment, all stocks, and you might get lucky. But you might just as easily have an unlucky 12 years. As for the bonds, there is no way for you to get lucky with those. The 2.5% coupon is all you get—before inflation.

If inflation averages 2.5% (it’s much worse at the moment), a reasonable expectation for the real return on a stock-bond blend is only 1.5% a year. Savers just aren’t being well compensated these days. Nothing you can do about that.

I did my own spreadsheet, and I boosted your effective return by giving you credit for the tax savings from deducting contributions. I’m guessing your state and city tax bracket is 9.85%, applicable to upper-middle-incomers. So you could put in $5,546 a year and then get back $546 in your tax refund, for a net cost of $5,000.

With my assumptions, your $60,000 turns into $86,700 on the way out. (This is again in nominal dollars.) Investing the same $60,000 outside the 529 would have delivered only $73,200. So far, 529s look pretty good.

But will $86,700 cover even half the four-year cost for one student? No.

I’m going to make up names and ages for your kids. Harry is 8, Sally is 5. And I’m going to assume they wind up at prestigious schools, like Amherst or Brown. The tab at such places (tuition, room and board) is $80,000+ for the coming year. College cost increases have been running well ahead of inflation. I project that, before aid, Harry’s degree will run you $560,000 and Sally’s $650,000.

It’s more likely than not that you will qualify for price concessions. So you have to start thinking about how those aid formulas work.

Most schools base their aid on the Free Application for Federal Student Aid, or Fafsa. It includes measures of both wealth and income. A few hundred schools, including all the prestigious ones, use a different document, the College Scholarship Services Profile.

The CSS Profile is a far more comprehensive dive into your finances. For example, it considers a 529 owned by a grandparent and naming either Harry or Sally as beneficiary to be part of the family’s wealth and subject to assessment. Fafsa doesn’t count grandparent 529s in wealth.

At Profile schools, the hit to a 529 is 5% of the money in the account for each year of scholarship. You’d limit the damage by having Harry exhaust his 529 in the first year, so that only 5% of his money is snatched by the college bursar. But Sally’s account will reduce Harry’s aid for all four years Harry is in school. In effect, Sally’s savings will be taxed almost 20%.

This takes some of the wind out of your sails. Harry’s account will do passably well. Sally’s will not. For her, the financial aid effect will be larger and the New York tax benefit will be smaller, because of the $10,000 deduction cap. In real, post-aid terms (after discounting for inflation both the contributions and the end value), Sally winds up with a negative return.

There are four defensive mechanisms. All come with cautions.

Method I: Pay down your mortgage instead.

Fafsa schools disregard home equity. Profile schools count it as wealth, subject to the 5% annual assessment, but often only up to a point (such as a certain multiple of your income). Thus, making extra principal payments on the mortgage might shelter some of your wealth from the college.

The negative: You still have to come up with cash for your share of the tuition. You might have to refinance your house when Harry matriculates.

Method II: Put more into your retirement.

Fafsa ignores 401(k) and IRA balances. The Profile questionnaire asks about them but the school’s aid formula will probably give them a pass unless they are large. That is, you won’t necessarily be expected to cover college by raiding a $1 million IRA, incurring a potential tax penalty along the way, but a $10 million IRA means you can afford both penalties and tuition.

The negative is the potential IRS penalty for funding college by making an early withdrawal from a retirement account. You can minimize this risk by using Roth accounts, not pretax IRAs, as your secret college stash.

Method III: Have Grandma set up a 529.

She puts in $10,000 a year, naming herself as beneficiary and grabbing a tax deduction if she lives in a state that grants one. Your college won’t know about this account.

When Harry is a college junior, too late for either the account value or a withdrawal from it to impact an aid formula, Grandma decides that she is not going to pursue a Ph.D. after all. She changes the beneficiary from herself to Harry and uses the proceeds to pay his tuition.

The negative: It’s possible that neither Grandma or Grandpa will be alive in 2034. If you are the successor owner when both are gone, you’re back to square one with the 5% annual assessment.

Method IV: Have Grandma make a gift.

In this scheme, Harry and Sally cry poor, taking out loans for college. Grandma pays off the loans as they near graduation.

The negative: same as for Method III.

So, should you save for your kids’ college? Definitely. Should you use 529s? Up to a point. Will any of this be easy? Definitely not.

Do you have a personal finance puzzle that might be worth a look? It could involve, for example, pension lump sums, estate planning, employee options or annuities. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Query” in the subject field. Include a first name and a state of residence. Include enough detail to generate a useful analysis.

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