It’s that time of the year again. I need to make a new contribution to my niece’s 529 plan for her future college expenses. When I looked for a plan for her last year, I came to the conclusion that the typical age-based options don’t make sense.
The typical age-based options in a 529 plan invest too much in stocks. They are not appropriate for a 529 plan because a 529 plan has a much shorter investment lifespan than an investment portfolio for retirement. You build up the assets in 18 years (versus 40 for retirement) and you deplete them in four years (versus 20 or more for retirement).
I’m still going with the Ohio CollegeAdvantage plan because of its low cost Vanguard index fund options. Last year I put my contribution in the Vanguard Moderate Growth Index Portfolio, which invests 50% in stocks and 50% in bonds. The fund gained 10% so far in 2010.
This year, I came up with a systematic asset allocation for all future years. I start the allocation at 50% in stocks and 50% in bonds. I would reduce the allocation to stocks by 10 percentage points every three years and increase the allocation to bonds and/or CDs by the same amount.
| Age | Stocks | Bonds and/or CDs |
| 0 | 50% | 50% |
| 1 | 47% | 53% |
| 2 | 43% | 57% |
| 3 | 40% | 60% |
| 4 | 37% | 63% |
| 5 | 33% | 67% |
| 6 | 30% | 70% |
| 7 | 27% | 73% |
| 8 | 23% | 77% |
| 9 | 20% | 80% |
| 10 | 17% | 83% |
| 11 | 13% | 87% |
| 12 | 10% | 90% |
| 13 | 7% | 93% |
| 14 | 3% | 97% |
| 15 and above | 0% | 100% |
Under this allocation plan, by the time the child reaches 15, the money will be completely out of stocks. Because the money is expected to be used up in the next 3 to 7 years, it’s no longer appropriate to invest in stocks at that point. I would then divide the money into roughly equal parts and put them in CDs maturing when the money is needed.
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Phil says
Why do you believe that it will be inappropriate to hold any stocks in the 529 when the child reaches 15? Even 5-10% in stocks gives you the chance of capital appreciation while the downside risk is very low given the small allocation. Especially given the possibility of grad. school and its attendant expense, why do you believe your way is the optimal way, even if it’s only optimal for you?
Great blog and I look forward to reading your response.
Thanks, TFB.
Harry Sit says
Phil – If you have more money than you need for four years of college and some money will stay in the plan for graduate school, which doesn’t necessarily happen immediately after college, then you have more time. In my case, I expect to completely liquidate from the plan in 3 – 7 years from the time the child reaches 15. It’s a classic case for CD ladders at that point — matching assets with liability. Money I must count on in three years shouldn’t be in stocks. Five years, still a stretch for stocks. Seven years, maybe a tiny bit but it won’t make much difference either way given the small allocation, so I don’t bother.
Dylan says
I like the Vanguard plans (especially IL and NY) for younger years. Once college is funded or by the mid-teens, I look to the TIAA-CREF plans (MI has been good) for a higher fixed rate cash equivalent.
I agree that high school sophomores and up should not have college money in the stock market, but my preference is to begin avoiding bond markets that close to college too.
Carl says
Interesting take, TFB. First, I’m glad in the comments you clarified “Bonds/CDs” – it’s important to match the duration of any bonds you use to the liabilities.
I would say that there is a reasonable case for higher allocation of stocks. The size of the liability here is unknown until it almost begins, and it can be financed with borrowing. So you any losses on the stock position can be made up with higher student loan payments in the future. By avoiding stocks you are sacrificing a higher expected return / lower average cost for more certainty about the costs.
enonymous says
I know this is a bit different than your case, but if it is your child (as opposed to niece) couldn’t the investor argue more strongly for an asset allocation across all investments?
Namely, if I am going to pay for my child’s colege education, no matter what, ten it doesn’t really matter where the funds come from.
So if I am committed to 75/25 stocks/bonds (fixed income) and will adjust to about 60/40 by the time the child is ready for college, wouldn’t it make more sense to simply invest in the ‘best’ option in the ‘best’ location?
For instance, I can buy TIPS at Fidelity in tax advantaged, buy VIPSX at Vanguard, or by the Inflation Pretoected Bond option in the Ohio 529. They are all tax deferred (though the 529 is basically like a Roth 401k in that it is tax deferred growth and withdrawal for qualified education expenses). But they all have different expenses. Likewise I can buy the Extended market index fund in the 529, or buy cheaper funds at fidelity or Vanguard that do the same thing.
OTOH, I can’t find tax deferred 10yr CDs yielding 5.0% (not available at the Ohio 529 anymore), and they have no ER (but they do have really poor liquidity and essentially no put option).
If my 529 tanks, no problem, as the funds would come out of taxable investments. If it does well, that’s less from my taxabale investments/income stream that I need to kick in to pay for the education.
I’m still undecided as to which way is best (i.e., 529 as an 18 yr accumulation with a 4-8yr drawdown vs another tax deferred space where tax inefficient investments should be placed and viewed as part of the aggregate longer term portfolio, adjusting outside accounts to reflect the holdings within the 529 so that the sum total AA is the same as before, with perhaps a slightly more conservative AA since part of the portfolio is for 30-40 yrs from now and a smaller portion is for 18-25 yrs from now).
Your thoughts (different for a niece, I know)?
Harry Sit says
@Dylan – Thank you for bringing up the TIAA-CREF Principal Plus Interest Option in the Michigan plan. It’s a fixed rate, like a savings account or CD but without FDIC insurance. The rate is announced annually and guaranteed until the next announcement. Current rate is 2.50% through Sept. 30, 2011. To get that rate in the Ohio plan, you will have to get into a CD for more than 7 years. The savings account in the Ohio plan only pays 0.9% for balance above $100k.
Harry Sit says
@Carl – Basically you are saying take a chance with more stocks for their higher expected returns and use loans or other sources to cover the shortfall if the market doesn’t cooperate. That’s the age-old risk versus return question. More risk brings the potential for a higher return at the cost of more uncertainty. Everyone has to strike a balance somewhere. I chose the path I’m comfortable with.
@enonymous – If you are going to pay no matter what, I agree it doesn’t matter where the money comes from and you can invest in the “best” option in the “best” location, in theory. In practice, I find it easier with some mental accounting. Blending them together with a large looming cash outflow liability seems really hard to model, unless the college fund is insignificant to your investment portfolio. How does a forced liquidation from your taxable account mid-stream affect your retirement savings? Maybe you need some Monte Carlo. Too complicated for me if I have to do it that way.
enoynmous says
definitely easier, but whenever I hear mental accounting I think of tricks that only confuse an investor (like taxable vs tax deferred investing…)
Harry Sit says
If it’s for my own child, the mental accounting can also become actual accounting. I would be comfortable with taking a “defined contribution” approach with regard to college savings. I allocate a set budget toward a college fund. I invest it conservatively. Whatever it comes out to be, that’s the available pot for college. I’m not going to confiscate the college fund for my own use. Nor will I subsidize it from my own retirement fund.
Unless you have a lot of money, a “defined benefit” approach can be dangerous. That’s how GM bankrupted itself in funding employee benefits.
mikep says
Good idea to go more conservative than the 529 plans. I have my kid’s ESA’s in the VG TR funds.. I think they are a great glide path. TR2015 (60/40) for my 3 year old and TR2020 (68/32) for my newborn. It will ramp down to 30/70 near college years and at that point I’ll start moving it into cash. It would be nice if the 529 plans from VG included their TR funds as options
indexfundfan says
I consider the 529 account as part of my asset allocation. It behaves like a Roth IRA as long as withdrawals are qualified. It is invested entirely in EAFE large caps.
enoynmous says
@indexfundfan
how do you square your global asset allocation with the fact that the 529 has a shorter period to drawdown (and then a very short drawdown period)?
I see both TFBs point, and yours, indexfundfan.
Nevertheless, the 529 MUST be drawndown for an education, and if it happens to tank at the wrong time, you need to make sure that your taxable/liquid holdings can be drawn to complete the tuition payments (or your portion). I think this can work, but again it does require that the losses in a 529 (if they occur) be eaten, without tax benefit, while presumably gains in taxable would be used, and thus the resulting tax/location problem rears its ugly head.
I haven’t decided yet how to handle this conundrum…
indexfundfan says
You’re right enoynmous. My taxable allocation can handle the education drawdown if needed.
I have still more than 10 years to go before drawing down. Maybe at some point later in time I would switch the entire 529 allocation to become my fixed income allocation of my portfolio.
Sammy_M says
In my opinion, putting 529 proceeds entirely in bonds/CDs makes a lot of sense. Conventional wisdom is to try to put bonds in tax-advantaged accounts. In terms of tax-advantaged accounts, the time horizon on 529s is usually shorter than with 401Ks/IRAs so we should want the safer investment in there.
Why not this asset location strategy?:
529s: bonds/cds
401K/IRAs: remainder of bond/cds (if more space needed), plus domestic equities
Taxable: remainder of bonds/cds (if more space needed); plus remainder of domestic equities (if more space needed); plus foreign equities
indexfundfan – curious as to why you presently put EAFE large in your 529 rather than large domestic. Aside from the stock/bond thing, you also lose of the foreign tax credit.
indexfundfan says
>> indexfundfan – curious as to why you presently put EAFE large in your 529 rather than large domestic. Aside from the stock/bond thing, you also lose of the foreign tax credit.
At the point when I was making the decision, the dividend yield of EAFE is much higher than large domestic. I believe it was like 4% versus 2% or so. So the additional 2% in dividend yield results in a tax cost of about 0.5% (federal + state). The foreign tax credit is worth around 0.1 to 0.2% if I recall correctly.
In view of the above, holding EAFE in tax-deferred has a slightly higher priority than large domestic.
indexfundfan says
>> Conventional wisdom is to try to put bonds in tax-advantaged accounts. In terms of tax-advantaged accounts
This is only for tax-deferred accounts. For tax-free accounts like the Roth IRA, the rule of thumb is to put the asset class with the highest expected return.
The 529 behaves like a Roth IRA for me.
AD says
West Virginia 529 (Smart 529 Select) has DFA funds available, would that be better? It is directly sold. Minimum contribution $250. Can rebalance upto 4 times a year without trading cost.
Sammy_M says
>> So the additional 2% in dividend yield results in a tax cost of about 0.5% (federal + state). The foreign tax credit is worth around 0.1 to 0.2% if I recall correctly.
Makes sense.
>>This is only for tax-deferred accounts. For tax-free accounts like the Roth IRA, the rule of thumb is to put the asset class with the highest expected return.
I thought we’re supposed to look at all tax advantaged money as pretty much the same. Only with traditional, you own 1-tax rate at withdrawal. With roth, you own 100%. The only meaningful difference with Roth money is that there are no RMDs, so for that reason you put higher expected return assets into those accounts. But then you overlay the shorter time horizon, and on the other side, the “risk” of overshooting your needs for education, and bonds in 529s makes a lot of sense.
indexfundfan says
>> But then you overlay the shorter time horizon, and on the other side, the “risk” of overshooting your needs for education, and bonds in 529s makes a lot of sense.
I have not make a precise plan for the 529. But roughly, the following can be done:
Shortfall in 529 : draw money from taxable account to pay for college.
Overshoot in 529 : Before the overshoot happens, move a proportion of EAFE in the 529 to fixed income and the same amount of fixed income in my IRA or taxable to EAFE.
Remember, having EAFE in 529 does not have to be forever; I can switch without tax consequence in the 529.
Matthew says
Thanks for all the useful information everyone. I have a question about financial aide. I have two nieces. I would like to put aside some money to pay for some of their future college expenses. The 529 seems like a great vehicle to do so. Since this is also for your niece, I’m wondering if you have looked into whether or not the 529 plan will be counted towards her parent’s asset base or the child’s asset base on financial aide forms. I’ve read where if it is a dependent child, the 529 plan will be included in the parent’s asset base. Since I am not the parent, where would the 529 plan assets go? If my assets went towards the child’s asset base which is included at a much higher % in the total assets available calculation, I might consider using a different vehicle. What are your thoughts?
Harry Sit says
@Matthew – I’m not a financial aid expert. As far as I can tell, FAFSA only asks about student’s income and assets and parents’ income and assets. A 529 plan account owned by you is neither the student’s nor the parents’ assets. Therefore it’s not reported on the FAFSA and should have no impact on financial aid.
Harry Sit says
P.S. Found this FAQ for you. You should be safe if you use your 529 to pay for the final year of college.
Am I hurting my grandchild’s eligibility for financial aid by putting money into a 529 plan for him?
Financial Planner says
My research led me to low cost Vanguard funds from Utah’s college savings program, which was rated as one of the best by various magazines. However, I live in WA and I am starting to think I should have invested in the state’s pre-paid credit program! Lower risk and with rising tuition, it has easily beat various stock/bond portfolios over the past few years.
Mike says
You might like the Utah 529 – they made some recent changes to create your own age based AA as well as lowered expenses making it one of the lowest cost 529s around.
Now you can input the above AA, rounded every 3 years into the plan and it will do the work for you. With Vanguard insitutional funds low fees as well.
Ami says
Hi Harry,
I see this post is about a decade old. Are you still following this allocation system? Curious bc am about to open 529 with vanguard.
Also am a MD resident. MD tax deduction is only for investing in the state 529. I already have investments with vanguard so I like the convenience of just using vanguard 529.
I aim to invest about 4-6k for each of my 2 children per year (8-12k total per year).
I am a MD resident. By my calculation the state tax deduction doesn’t seem that much. Am I looking at this wrong? Just wanting to make sure am not overlooking a big advantage in not using my state (MD) 529.
Best,
Ami
Harry Sit says
529 plans have made great improvements in the last 10 years. Because the age-based allocations are quite good now, I don’t follow this anymore. With two children, you get up to $5,000 in tax deduction every year from Maryland income tax (and local taxes?) if you use Maryland’s plan. That’s not insignificant to me. The money doesn’t seem much in one year but it adds up every year. Maryland’s 529 plan was rated Silver by Morningstar. So was the Vanguard 529. I wouldn’t give up the tax deduction only for the convenience of having all accounts with Vanguard when the Maryland plan isn’t substantially worse.
Ami says
Thank you!
Correct. I think vanguard used to be gold star at some point but now they are silver. Not sure why they got downgraded. I was also eying Utah’s plan.
The estimate I go (copied it below) was about $200 savings on State taxes (not sure if that’s per child or combines). Does that range seem reasonable ? I know you can’t know the exact amount but Just making sure my calculation isn’t way off.
I used the vanguard calculator for MD and got this result. It’s says MD requires both spouses to have an account and contribute to the 529 plan and would each get 2500 tax deduction (state) if they file jointly.
“Your results
Based on your proposed contribution of $12,000, and taking into account Maryland’s maximum yearly tax deduction limit of $5,000, we’ve estimated your potential state tax savings for this year as follows:
Deductible contribution amount: $5,000.
State tax savings: $275.
Less federal tax on state tax not paid: ( $66**).
Total net state tax savings this year: $209.”
Harry Sit says
That Vanguard calculator is off by a factor of two. First, you have about 3% in local tax collected on the state income tax return. That makes the tax rate 8.5%, not 5.5%. Second, since 2018, state and local tax deduction for federal income tax is capped at $10,000, and that includes property tax as well. When you’re already paying way more than $15,000 in state, local, and property taxes, having a $5,000 deduction at the state level doesn’t increase your federal income tax. Altogether, the net savings is more like $425, not $209.
Ami says
Thank you very much Harry. That doubles the amount essentially.