To 529 or not 529

I have no clue how my kid will turn out. I don’t know if she will be an insatiably curious and enlightened human with titanium discipline or if she will be a wanderer. She may drift through all of these states, and one could make the case that some wandering (like a gap year or vocation before college) is beneficial. Regardless of your parenting views or speculations about the future of education, when your children turn eighteen, they will need money.

A growing, but still underutilized, investment strategy is a 529 savings plan. This type of account allows you to avoid paying taxes on investment gains when used for higher education. Before we explore this further in the context of your child in an uncertain future, let’s breathe in hard money facts together.  

If your child is born today, the upper end for a traditional, accredited education is half a million dollars. That’s because in the United States, university tuition is projected to increase by 5-6% annually, which will make it greater than 3 times more expensive than it is today (which ranges from 100K-200K as of 2020). Costs are influenced by institutional settings (geography, funding) and other things we take for granted like finishing on time.  

My hands go numb as I think about saving for more than one child. Financial institutions actually measure how much parents lose sleep over saving for this cultural milestone.

For the top 5% of American earners (and even that status badge fluctuates), their annual household income averages around $376K. They can save around 10-12% of it pre-tax. At a 35% tax rate, that leaves roughly $24K annually to cover everything (yes your retirement is at odds with your children’s education).

The overwhelming majority of the US population has difficulty with saving. With a 40% rate of underemployment, or the idea that your child is working in a job that does not require a college degree, I can clearly see why families would opt out.

Universities can’t guarantee what we care most about in the professional world: insatiable curiosity and high judgement. A curious, disciplined kid might do better with a self-directed curriculum from alternatives like online cohort-based education, apprenticeship, and entrepreneurship.

But what about my potential wanderer?

Let’s assume that traditional college, which has its roots in faith and charity, will exist in the future at least in some form.

Wanderers benefit from this type of instruction. They need structure, systems, support, and discipline that are promoted in a rigorous accreditation process.

529 investment plans were an afterthought on the IRS code a decade after Michigan proposed a prepaid tuition program in the mid 1980s. Families can make contributions to different state plans where they do not pay any kind of tax on the gains of their investment when used for higher education, and in some cases primary school expenses. With some prepaid plans, you can buy future tuition for today’s prices.

Land-manicured institutions of faith will evolve and adapt as alternatives arise. Similarly, the 529 plan itself may expand its views on what type of education is fundable. Even now, additional expenses include certain vocational schools - legislative efforts going forward could expand to cover more alternative educational models. Since 1996, the 529 plan and its tax advantages have been iterated on several times over.

Because I am clueless about what will happen to education and more clueless on how my kids will turn out, I am going to bet on diversification and optionality.

In order to provide optionality, a simple split between 529 and an index fund that tracks S&P 500 might work for many families. Based on growth of 6% for 529 and 8% for S&P 500, a 50/50 split can look like this:

That’s roughly $502,500 split relatively evenly between the two, assuming you contributed $625 to the 529 and $625 to a mutual fund which tracks the S&P500 monthly. For most families, the split would be 50/50, but the total amount will be whatever you can manage to save.

But wait, 8% return on S&P 500? Are you sure? As of 2020, there was a return of 16%! Wouldn’t it make sense to put all the money in that?  

First, there is uncertainty here. If S&P 500 was a sure thing, then it would make sense. But let’s say your child was born in 1990. If you double down onto mutual funds that tracked the index, you would have landed in the recession of 2008 with staggering losses of ~40%.

Also, the roles of these two investment vehicles are different. While 529 plans are conservative and will underperform other investment vehicles on average, they are designed to decrease the market exposure of risk (by utilizing more solids like bonds) as your child gets closer to maturity. It is meant for protection while other investment funds are meant for growth.

A blended approach can offer your wanderer approximately half of their university tuition in the vast majority of US schools. As for the rest, I say let her have the money from the index fund and decide what to do with it. She can either spend it on the remainder of college, take other online cohort-based courses, start a business, or even save and re-invest it.

This model allows you to preserve flexibility. You have also positioned your child with choices. As parents we do our best to invest for our children’s future. But we also invest in something day in and day out that is much greater: the grooming of an adult.