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529 Plans Part I - Saving for College


When people bring up saving for their kids’ education, there are several factors to discuss to establish a strategy.

Strategy
 
If it seems daunting to even attempt to fully fund the high cost of higher education, we recommend starting here instead - the 1/3, 1/3, 1/3 plan:

  • 1/3 of the education funding goal is saved by the parents in a 529 plan before college
  • 1/3 is paid by the parents from normal monthly income during college
  • 1/3 is paid by the student through part-time work, scholarships and student loans (total amount of student loan debt should be less than their starting salary after graduation, ideally a lot less)

We recommend this education funding strategy as a starting point for a few reasons. This strategy makes saving for college somewhat manageable, given the high (and rising) cost of higher education. This strategy puts some of the education funding responsibility on the student, which we feel is healthy and, related, this strategy ensures that saving for college does not take priority over saving for one’s own retirement. Finally, this strategy could prevent the (although, unlikely) possibility of over-funding of education savings, if college is not what is best for the child in the future (sometimes referred to as “enrollment risk”). 

Functionally, we recommend either saving into a 529 College Savings Plan or simply a taxable investment account, depending on your situation. While a taxable investment account provides tremendous flexibility, a 529 account provides two main benefits:

  1. A State of Kansas income tax deduction
  2. Tax-free investment growth (if spent on qualified education expenses)

529 Benefit #1
 
If you're willing and able to save more for college, we typically recommend maxing out your State of Kansas tax benefit by contributing $6k/child first, then saving anything on top of that in a given year into a more flexible (e.g. taxable investment) account ear-marked for education.

The maximum amount you can actually contribute to a 529 account PER child PER year is something north of $300,000.  However, you can only take a deduction on your Sate of Kansas taxes of up to $6,000 PER child if married filing jointly (or $3,000 PER child if filing single or separate).

529 Benefit #2
 
The other benefit, tax-free investment growth, is dependent on two things: 1) actually spending it on qualified education expenses when withdrawn and 2) the age of your child.  If your kid is 0-5 years old and you have 15+ years for the account to experience compound interest, a 529 account is going to provide a huge benefit in the realm of never having to pay income taxes on that investment growth.

If your kid is 16 years old and you have 2 years to go, the benefit from tax-free investment growth is going to be minimal compared to the benefit of the annual state tax deduction.

For example:

Jimmy was born yesterday and Jimmy’s parents immediately began contributing $6,000/year to his 529 plan.  Straight math of $6,000/year multiplied by 18 years until college says Jimmy will have $108,000 if the money is in cash and not invested.   However, Jimmy’s parents selected an age-based portfolio that averaged 7% interest over that 18 years, and Jimmy actually has $203,994 saved in his 529.

When Jimmy goes to Med school (because what other set of degrees should cost $200k) and starts withdrawing to pay for expenses, NONE of the distribution is taxable to him or to his parents, even though almost half of it has never been taxed.

If Jimmy was 16 when his parents decided to contribute, he’d have $12,400 total ($12k from contributions, $400 of investment growth at 7%) on the first day of college.  Though his parents benefited from the annual $6k state deduction, the benefit of spending $400 tax-free is much less significant than spending $100,000 tax-free.

Be on the lookout for our next blog about Spending During College (529 Plans Part II).