529 Plans – Are they worth it?

One of the biggest expenses to hit households is college education for their kids. 529 plans are the most common vehicle available for parents to save for their kids education. Via the SEC

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.

College savings plans generally permit a college saver (also called the “account holder”) to establish an account for a student (the “beneficiary”) for the purpose of paying the beneficiary’s eligible college expenses. An account holder may typically choose among several investment options for his or her contributions, which the college savings plan invests on behalf of the account holder. Investment options often include stock mutual funds, bond mutual funds, and money market funds, as well as, age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age. Withdrawals from college savings plans can generally be used at any college or university. Investments in college savings plans that invest in mutual funds are not guaranteed by state governments and are not federally insured.

The main advantage of 529 plans is the favorable treatment of taxes

Earnings in 529 plans are not subject to federal tax, and in most cases, state tax, so long as you use withdrawals for eligible college expenses, such as tuition and room and board.

So naturally the question for me was that are these plans worth it? If they are tied to the market are the tax savings worth the investment? 529 plans also offer the option of monthly contributions, which one is better, contribute monthly or lump sum contributions yearly? I wrote a quick R script to back test the 529 plan that I had in mind (NY – low costs only 17bps and managed by Vanguard) and the results look very convincing.

For the period of 2002 -2012 my allocation model would have generated a total nominal return of ~40% and a total real return of ~25%. If I invest monthly instead of yearly I get an extra bump of 6% in my nominal return (~46% total nominal return), so the data indicates that averaging into the portfolio monthly has a slightly better outcome. This simulation assumes that you buy and hold till the time the beneficiary (your kid) starts college, which makes sense as you will never want to sell and withdraw from the account earlier and take the 10% penalty hit. If I wanted a similar performance in a non 529 account (regular taxable account) I would have to generate a total nominal return of ~70% (at a marginal tax rate of 35%. 46%/(1-35%)=70%). This is a huge hurdle to cross!

The numbers seem to indicate that 529 plans are worth it especially for the tax advantages. The strategic question then becomes, how much should you contribute to it? Average private tuition costs are currently running approximately $250K all in ($60K a year) but will the current growth rate for private tuition be sustainable in the years to follow? Since the money can only be used for education, for maximum gain the value of the account should be as close to the final actual expected costs as much as possible. Hence my strategy is to slightly underfund the 529 account so that there is some headroom in the event that growth rates do not keep up. The best tactic seems to be to track actual returns each year as well as expected tuition cost growth projections, re-run the model and adjust the contributions accordingly.

What do you guys think? Any other strategies? Let me know in the comments. Feel free to tweak the R script to add more variables, let me know if anybody wants access to the github repo to make changes!

PS1: You could argue that starting the backtest in 2002 gives it a huge survivorship bias, as 2002 was near the bottom of the market. Point taken. I couldn’t find pre-2002 historical quotes for the funds in the NY plan.
PS2 : The return does not account for dividends and its re-investment. If you add that to the mix , the return will be greater

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