Q: We received a 529 plan from my parents as a gift for our newborn, how much should we invest in it each year? –Sylvia R.
A: Hi, that is a great gift! Much better than an oversized stuffed teddy bear from a life planning perspective.
Saving for college isn’t a terrible decision. However, you have to look at your personal finances to see if you want to add any extra funds.
I do not recommend saving in a 529 plan for most of the people I work with.
Your Retirement is Much More Important
You should be maxing out your 401ks and IRAs before even thinking about contributing to a college plan. Many parents struggle with funding their personal plans because they are stressed about providing for their child’s education. Parents’ financial future comes first.
There are many paths to paying for college. Your child can earn a scholarship, work part time or apply for grants or attend a college that isn’t as expensive.
The Actual Benefit of a 529 Plan Could Be Small
The reason people use a 529 plan is so they can take funds out of their investment tax-free for education expenses. That may sound amazing but many parents do not contribute nearly enough to really see a substantial tax benefit. Even if they do contribute a lot they do it at the wrong time. If you are going to contribute, you need to do it now when the child is a newborn. That would give the money time to grow. If you do it when they turn 10 you are wasting your time.
Let’s use an example:
You contribute $100 per month from newborn age to 19 years old. That totals out to $22,800. If you earn 4% after fees, that gives you $34,181. This is a gain of $11,381. That seems like a lot but let’s look at the benefit of the 529 plan. The 529 plan gives you the ability to withdraw the funds tax-free for education expenses. Let’s say the tax rate of the individual is 15%. That is a total tax savings of $1,707. It is not a small savings but not life changing.
You Have Other Options
The 529 plan limits you to education expenses. In the previous example you are investing nearly 20 years for only $1,700 in savings. With that account you are completely limited. It would be better in an IRA or just a general investment account. You could potentially have better returns in an investment account through low cost providers which would eat into the minor tax penalty savings.
You can invest in your child right now. What if your 14-year-old wants to start a business? Take a small amount of money and fund that. It would be far more educational than most undergraduate courses.
Who Knows What College Will be Like in the Future?
Over the last 20 years college has been getting exponentially more expensive. There are plenty of reasons why this is happening but one thing is true, it cannot continue for the next 20 years. Just like the housing bubble that caused our most recent depression; there is a college debt bubble looming. In my opinion, higher education will most likely correct itself in costs. There are plenty of other options for education in the marketplace. Ask many recent graduates if they would have chosen to go to college again if they knew how much debt they would incur for the limited pay in relation. There are certifications that can be gotten online and in other local classes. Right now people who did not go to college, who are also driven, are having better lives than the average person who did go to college. That may not sound correct but it is true. An average beginning plumber makes over $25 an hour and they do not have any debt. A similar new graduate makes the same but carries $40k in debt. The current loans have a delinquency rate of 11%. It is far tougher for a college grad to make it in life than a person who is driven without a college degree.
What Should You Do?
With a newborn, you are at the right point to fund a 529 plan. However, if you do not have a substantial amount of money (50k+) to immediately save, it does not make sense. The tax savings are not worth the limitations they place on the funds. If you are an average American, I highly suggest not using the 529 plan, focusing on your personal finances, instead and waiting to see what happens to the current education system in the next 20 years.
—Edward Brockschmidt, CPA & Co-Founder of SeedTrust Escrow
Every Friday, CPA and Co-Founder of SeedTrust, Edward Brockschimdt, will focus on “financial fitness” by answering the most commonly asked financial and tax questions relating to surrogacy and egg-donation.
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