Why I won’t open a 529 plan for my kids

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My college years... ah nostalgia

If you have followed the blog lately, you may know that I’m a soon-to-be dad. Very soon in fact, about 10 days. I’m both excited and a little stressed.

Excited, because of course I can’t wait to hold my daughter, make her smile, see her grow and teach her all the good stuff this world has to offer. She has a lifetime ahead of her!

A little stressed, for all the same reasons. Man, that’s a huge responsibility!

So a few weeks back, I’ve wondered if there would be great a financial decision that I could already make for her? After some research, the most common advice was to open a 529 plan to financially prepare for her education.

It looks great on paper but I can’t see a good reason for me to open one for her.

An HSA for Education

Indeed 529 plans are great : it’s basically an HSA for college costs. You contribute after-tax dollars into an account, where investments grow tax-free. It’s even flexible enough to let you pick any 529 plan from any state, not only the one you reside in. There are also several rankings of the best plans available.

It’s also super flexible. The contribution limit per year is around 14,000$, per spouse. If the funds aren’t used with one child, the plan can be re-assigned. Almost anyone in the family can benefit: kids, parents, grand-parents, cousins, nephews and nieces … I suspect that there are smart ways to use this for inheritance purposes.

The only condition, is that if dollars aren’t used for eligible expenses, the returns (not the principal) are  subject to income tax and a 10% penalty.

There’s plenty of reasons to like these plans.

A case against 529 plans

One of the first comments my wife received when she had her baby shower was “you’ll see kids are awesome”. Shortly after was “go open a 529 account for her”.

We have discussed and we built a case against it. This will arguably not apply to everyone, but this is our reasoning.

  • International education: funds invested in the plan are meant to be used at US colleges. Our reasoning is that it’s very likely that a portion of our kids’ education will be abroad. If we move because of work (very likely), the company normally sponsors educational expenses. If we otherwise decide to relocate ourselves, we’ll pay out of pocket, but costs abroad can be significantly lower anyway. I can also imagine how in 15 years it will be even more important to have higher education in Asia. By then China’s GDP will have doubled and passed the US as the world’s largest economy, so careers may have different outlooks then. A 529 plan wouldn’t help in this case.
  • Avoid being a maxed out 529 plan poor: similarly to being house poor, I don’t like the idea of locking money into accounts for special purposes. At least for the 401k, we get a company match, it’s tax deductible and growing older than 60 is an almost sure thing (knocking on wood). I use the funds in the HSA more quickly than they can grow (a pregnancy is not cheap) so I’m not too worried about locking too much money there. Locking away 250k$ or more in an account that I’m not sure I’ll use makes me feel uncomfortable.
  • Keep capital available for other non-equity investments: in a 529 plan, i would typically be limited to investments in stocks and bonds. However, my goal is to buy another rental property starting next year. The return on rentals in Texas is quite good and returns of 15%-20% are not uncommon. That’d be a better use of capital. If my wife wants to start a business at some point, we could use seed capital. I don’t want to pass on these opportunities because my financial resources exist but aren’t accessible for this purpose.
  • Fund kid’s costs with rental properties: This isn’t a formal plan yet, but the idea would be to invest in real-estate and use the cash flow to cover all of our kids’ costs. From day care to college and everything in between, this is an approach that I find more flexible and scalable. If I can have 1 or 2 rentals per kids generating 10k$ of cash flow a year, rents would basically cover their costs.

So my approach will be to fund our kids’ education (and the rest) with rental properties instead of 529 plans, so we can keep the flexibility to use our cash and reinvest it as we wish. It will for sure be more work than investing in index funds. But since this would also support our FIRE plans and help us cover even more of our expenses, it currently looks like our best bet for the next decade or two.

So I’m curious what your opinion is:

  • Do you think the real-estate play is a good idea?
  • If you invest in 529 plans, what is your experience with the investment vehicles at your disposal?
  • Any advice for first time parents? 😉

-Nick

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18 COMMENTS

  1. Very exciting, Nick, you’ll catch onto the whole father thing quickly and I’m sure you’ll be great!

    As for 529s, you raise some good considerations, especially the plans you have for a foreign education. The good thing is 529s are very flexible and can be used at anytime and like you noted, you could always change the beneficiary and/or turn it into an inheritance. Lots to think about, thanks for the post!

    • Thanks for the encouragement Green Swan, I certainly hope I’ll be up to the task!
      I certainly do think the 529 plans are great for US based education and the flexibility is unprecedented. The future always changes, so we’ll see, maybe it could be a great inheritance planning tool. I’d like to know if your opinion changes after you guys have moved to the UK for a few years already 🙂

  2. I think they are a great idea. 18 years of tax deferred growth is an amazing thing. I might not fund 100% just in case they get scholarships or you want them to chip in a little. But funding at least 50% through a 529 sounds like a good idea.

  3. Congrats! That’s super exciting (and scary)!

    I am not yet a parent, but also have been thinking about 529s. On the one hand, it seems like a great vehicle for education savings. On the other hand, it requires you to make predictions about the future cost (and value) of education, which is hard to do in a rapidly changing world. Do you assume that expenses will continue to grow at their current rate? That they’ll get under control and rise closer to the rate of inflation in the future? What if MOOCs take off and drive the cost of an advanced degree way down?

    I’m torn between the tax benefits and the risk that you end up over-saving and have to pay an unnecessary penalty on your money.

    • Those are excellent points Matt, thanks!
      The cost of education, in my opinion, cannot continue to rise at the current pace. Students from 20 years ago had basically 0$ of debt coming out of college. These days, the total debt is 1.5T$, but the median wage is still the same. How can that possibly work?
      If MOOC had to take off or the cost of education go down, you could still keep an eye on yearly average cost to see if your contribution are still in line with your projections. This would limit over-contribution risks.
      If you also plan to have more than 1 kid, the risk of over contributing could be reduced by passing the surplus to a 2nd or 3rd child.
      The Green Swan had a great article on estimating future education costs, which could be around 250k$ in 18 years for public schools and up to 500k$ for private schools. http://thegreenswan.org/college-tuition-estimate/
      At these levels, either no one will be able to attend college but the richest, creating a impossibly large inequality gap, or wages will have to increase by around 6% a year for the next 18 years.
      The main risk for me is international education, but I think if you plan to have your kids attend college here and plan to have more than 1, then contributing to 529 still looks like a very good option.

  4. I was in your shoes last year. I was debating whether or not to invest in a 529 for my son.

    At the end of the day I decided to hedge my bets and allocate $4,000 a year, the maximum amount I can deduct on my state taxes, while allocating the other money towards the stock market where I have the flexibility in case my son chooses not to go to college or gets a scholarship.

    Good Luck in your decision.

    • Hi Mustard Seed Money – that is a good advice as well. Unfortunately (or fortunately), I live in Texas and we don’t have state income tax, so not there isn’t much deduction I can benefit from. But hedging your bets like you did is an approach that could probably benefit many readers, thanks for sharing!

  5. Hmm, haven’t considered the downsides of 529 investing. My parents started a 529 fund for us but it was like a year before we started college and we withdrew my senior year. I also never considered an alternative use of funds such as real estate that my parents could have taken account of. The downside of finding personal finance blogs late sure is meaningful!

    International education would be an exciting adventure for your kids!

    • Don’t get me wrong, the 529 plans are a great option. It’s also an easy option and it’s available to everyone, so your parents made the right move. There are however cases (admittedly very few), where alternatives might be more efficient. Real-estate is one, if your area can generate good returns. It also requires more capital and the will to deal with vacancies, tenants, … There are even cases when investing in rental properties would be more interesting than investing in a 401k with a company match.
      International education is something that is more common outside the US and I think it’s fantastic. In Europe for example, students can elect to go to University in a different European country (Erasmus exchange – one of the benefits that the UK would loose with Brexit btw). From learning a new culture, developing independence and commanding a higher salary at graduation, it’s something high on my list for our kids.

  6. We have 529 plans for our two kids. Our philosophy was to fund all other accounts first and 529’s were last on the list. That may well fit your philosophy of funding real estate before 529’s.
    As for new parents: If you’re standing – sit. If you’re sitting – lie down. If you’re lying down – sleep

    • Good advice here Mrs PIE, we could also prioritize the funding of these accounts last. I’ll keep this in mind.
      I like how you present your new parent’s advice, I’m presently sitting and I wouldn’t mind going straight to sleep!

  7. First, congrats on becoming a new dad. My first child was born in 2015 so I know the feeling of being a first time parent. Like you, I wanted to invest for my child’s future but did not go the way of a 529. I wanted to invest for my baby’s future in an account without any strings attached. Who knows what college will be like in two decades? With tuition rising the way it has been, future degrees become less valuable. We opened a regular custodial account for baby DivHut and started loading it with dividend paying stocks and reinvested all dividends automatically. I wrote about it on my blog. Just search ‘baby DivHut.’ The plan is to slowly grow that account every year with contributions from my wife and I as well as any birthday/grad/special occasion cash he may receive.

    • Congrats on baby DivHut too! First time parent is like a promotion into unchartered territory, with a lot of questions and few answers. I agree with you that it’s hard to imagine the cost of college in 2 decades and it’s even harder to imagine if it will still make sense. I like your “no-strings attached” approach, I’ll go read your post on the topic. Thanks for sharing!

  8. We don’t do 529s either. I don’t like the limitations, as you mentioned. I feel like education is on the verge of a major upset… formal education in a lot of fields isn’t a requirement anymore. You can learn programming a lot more efficiently through some online programs than in formal university settings these days. Education is everywhere. I’m definitely pro education (I have a Masters myself), but I don’t want to limit the choices of my kids. (I’m always happy to find someone else that agrees with no 529s!) 🙂

    • And we know that laws can change from one president to another, that education is now everywhere as you said and formal education may not be in 20 years what it is today.
      I have a colleague who does software development. He learns everything online because by the time he got out of school, technologies had changed already. 529s are of no benefit here.
      It wasn’t easy to come to this conclusion, most people favor these plans. I think they are good, but they aren’t the panacea.

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