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In the event of ‘financial pressure’, place the oxygen mask over your retirement before assisting children with college

The other night I was having a couple of beers with a buddy of mine (a financial planner and wealth manager) and started to tell him about an unintentional conversation my wife and I got into about 529 college savings plans.  For the record, we don’t even have kids yet, but that wasn’t going to stop my wife from having the conversation right then and there.  It was all prompted by some bank’s TV commercial.

The scene opens up with a little 5-year old girl in pigtails pretending to be a her teddy bear’s doctor.  With a Fisher Price Stethoscope around her neck, she hums softly to herself and carefully places a band-aid on the bear’s arm.   The narrator warmly chimes in, “she wants to be a doctor when she grows up…have you started your 529 plan?”  

Just as the commercial ended, my wife turned towards me and started firing away about our (future) children’s’ schooling.  How are we going to fund their education?  Should we open up a college savings plan?  How much should we contribute each month?  State schools or private schools?

I had to admit, my head immediately began to spin.  I tried to self-soothe by doing math in my head to answer such abstract questions, but no such luck.  I was quickly overwhelmed with balancing the high rents of New York City, my wife’s tuition for her new career choice, living off one income, funding our retirement – and now, allocating funds to kick-start a college education for kids we don’t even have.

Sensing that I was about to blow a fuse, my buddy handed me a fresh beer and reassured me that I am not alone, as this is one of the most contemplated dilemmas amongst couples. In an attempt to make the conversation with my wife more constructive, he advised that I need to consider one another’s personal experiences when it came to paying for your own college.  

We then did a deep dive into understanding how my wife and I had paid for our own college education.  My wife was lucky enough to have her college fully paid for upon graduation; whereas, my parents contributed what they could and co-signed a student loan for me.  (sidebar: I finally paid everything off in December 2016, a very proud moment.)  

Given our differences, it was no wonder that our conversation broke down right out of the gate.  She was all for helping our future rugrats as much as possible so they could get a head-start in life and who could argue with that?  I, on the other hand, was of the opinion that student loans were a great motivator for me to find employment and start managing money quick in life or face serious consequences (i.e. default).    

Knowing this, I was more compassionate about her feelings on the subject and asked my buddy to take me through the pros and cons of a 529 plan. After all, Happy Wife = Happy Life. Without killing me on the details, he laid out the following points:

PROS:

Tax Free Earnings. One of the best reasons to start a 529 plan is the ability to have all of your earnings tax free, provided that the distribution goes directly to the institution.

Savings Discipline.  The automatic investment option allows you to automate a savings discipline you might otherwise not have by deducting a periodic contribution directly from your bank account.  This ensures you are consistently contributing and not spending foolishly.

Easy to Start.  Low minimum balances to get started.

Other. Usually get some state tax benefits, some advantageous treatment when applying for financial aid, and professional management of your investments with stringent oversight by the states.

CONS:

Zero or Negative Earnings. What if there are no earnings? Sound ridiculous?  Just ask anyone sent their kids to college between 2007-2009.  What if all the earnings were wiped out?  Have you not just lost the number one reason to have the 529?

Let’s do some simple math.  If you put $100 into a 529 plan and the market loses 20%, your balance in the account is now $80.  Do you know how much the market would have to return in order for you to break-even?  I’ll give you a hint, 20% isn’t the correct answer.

A 20% return on your, now, $80 balance will earn you $16 bringing your total account to $96.  As anyone who has ever put money in the market, knows it’s easier to lose 20% than it is to earn it.

Penalties.  Parents are re-thinking the strategy on the parameters of funding.  One strategy parents have been employing are a results-based funding criteria.  Essentially, they may want their kids to be on the hook, and then if they do well–they will commit funds post graduation and pay off all or portions of the loan.  If this is the case, and 529 funds are used, the earnings are now taxable at ordinary income.  Bad deal.

Fees. Fees. Fees.  If you want a 529 plan, go to Vanguard.  If you purchase through an advisor sold plan, you will have commissions up front on each contribution.  Then you will have high ‘management fees. For example, let’s say you drop $1,000 to get started.  If you pay a 4% up front load and on top of that you are paying 1-1.5% in internal costs, didn’t you just lose 5.5% of your investment?  Now you need to make sure the market returns more than that threshold, good luck!

Financial Aid.  Let’s say your 529 plan does well, but with college costs trending up towards $150k-$200 for 4 years, how much is the plan really going to cover?  So you march on towards the financial aid office hoping for a miracle.  The nice lady behind the counter is going to take one look at all of your kids’ 529 plans, your joint tax return and stamp your application with a big, fat DENIED!

The best option, then becomes to  have the oldest child use the all of the 529 plans in year 1 and/or 2.  After all the plans have been exhausted, reapply for aid because there would a zero balance in the 529 accounts, thus triggering the opportunity for financial support.

No School.  Let’s face it, not all of us are going to raise the next Bill Gates kid.  Sure it all worked out in the end, but hindsight is always 20/20.  Not one hears the story about Poppa Gates rolling those 529 plan documents up in his hand and whacking little ‘ol Bill around!  Just kidding, 529 plans weren’t around back then.  

For some kids, college or any other eligible post-secondary school just isn’t in the cards for them.  You can only guide your kids the best you can, but ultimately, they wind up clearing their own path in life.  Sure, you could transfer to another child or grandchild, but with most people having their 1.5 kids these days, transferring might not be an option.  That leaves you with an income tax payment on the earnings plus a 10% penalty!

RELEASE THE OXYGEN MASK!!!

If the possibility of a perfectly timed market crash or a kid who decided against school wasn’t enough, my buddy’s final piece of advice – never sacrifice retirement for college education – really got me thinking.  He analogized it perfectly with an airline’s in-flight safety instructions – secure your own oxygen mask before assisting children or others.  It was the sad truth – What good am I to my kid if I was struggling myself?  

At this point, the beer started to kick and in I stopped trying to solve this financial crisis for the night because I know two things about myself –  1) I am and always will be a saver and 2) I started saving early.  Even if I decided to throttle back on the retirement savings and throttle up the college savings, I have momentum behind me from saving and investing early on.   

So that’s where we are at for now, continuing to do what we do best – save.  But I am curious to know how those of you with 529 plans are doing? Everything coming along as planned?  Is the growing balance a result of your contributions, earnings or both?

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