Determining How Much To Contribute To A 529 Plan: Too Much No Good!

Because of the SECURE Act, the 529 plan has received a functionality boost in 2020 and beyond.

A 529 plan can now be used for:

• All college tuition and qualified expenses
• $10,000 a year for K-12 tuition and qualified expenses
• Apprenticeship programs and qualified expenses
• $10,000 to pay down a qualified education loan repayment for each of a 529 plan beneficiary’s siblings

Given these benefits, if you have kids, contributing to a 529 plan makes even more sense. Always maximize the purpose of your money by taking advantage of any benefits the government throws our way. Goodness knows they tax us hard-working citizens enough!

After a strong 2019, I decided to take a look at my son’s 529 plan. Although it underperformed the S&P 500, it still reached a level that made me question whether it’s possible to contribute too much.

Perhaps you’re wondering the same thing.

Our 529 Plan Performance Review

After superfunding my son’s plan at the end of 2017 with $70,000, my wife contributed $45,000 between 2017-2019. My mother also contributed $30,000 between 2018-2019 for a combined total contribution of $146,500.

At the end of 2019, the 529 plan finished the year at $189,911.45. Therefore, $43,411.45 has been gained tax-free to pay for education-related expenses. Too bad 2018 was a down year. But still not bad for a little over two years of contributing.

Chart one shows the graphical representation of balances.

Chart two shows the month-by-month performance changes plus corresponding deposit amounts in 2019.

Chart three shows a YTD return of 22.71% versus a 31.49% return for the S&P 500 and an 8.72% for the US Aggregate Bond Index.

Because my son’s 529 plan is 100% invested in a target date fund, it has a stock and bond allocation of roughly 75%/25% that slowly gets more conservative by the time he’s 18.

At the time, a target date fund made sense. I didn’t want to spend any effort trying to actively manage his fund while trying to keep him alive as a first-time SAHD. Further, my own investment allocation was more conservative.

In retrospect, we chose an investment that was too conservative. But this is probably just greed talking.

Too Much In The 529 Plan

Our original goal was to create a 529 plan worth at least $500,000 after 18 years. Given college tuition has been compounding at a rate of ~5% a year for decades, a $50,000 annual tuition today will grow to $120,000 in 18 years. Then there is room, board, transportation, and other expenses to pay.

The X factor is whether our son can get into a good public grade school, thereby avoiding an additional annual expense of $25,000 – $50,000 for 13 years, when he starts kindergarten. Knowing our luck, he’ll probably get rejected by our local public schools. Therefore, it might be better if we try to shoot for accumulating $1,000,000 in the 529 plan.

The other X factor is his ability to get scholarships and having the wisdom to choose an affordable university. Knowing my wife and I are of average intelligence, we assume he will not get any academic scholarships either.

But it just seems so ridiculous to accumulate $1,000,000 in a 529 plan to pay for education. Personally, I’d much rather go to public school my entire life and at the end be handed a large check after college to go invest, buy a house, or start a business instead.

At a 5% compounded rate of return, our $189,900 529 plan will grow to $415,000 in sixteen years. If we average an annual contribution of $24,000 a year plus a 5% compounded rate of return, the plan will grow to $1,010,000 in the same time frame.

Now that we have a daughter, perhaps $1,000,000 really is the number to shoot for. Ugh.

Determining How Much To Contribute To A 529 Plan

If you contribute too much to a 529 plan, you are not efficiently allocating your limited resources. Every dollar you contribute to a 529 plan is one less dollar you can contribute to your own retirement savings, your house downpayment fund, and your around-the-world adventure with friends.

My assumption is that you’ve already opened up a 529 plan or plan to open one up because you like tax-free compounding growth and want to give your children more options in the future. My other assumption is that you are happy to pay for at least part of your child’s education.

Here are some things you should consider before contributing any more to your 529 plan.

1) Identify the current and historical cost of attending select institutions. Let’s say you want your daughter to attend The College of William & Mary or UC Berkeley, two schools with excellent reputations at a great price. You should go to the respective schools’ websites and familiarize yourself with the current and historical costs of attendance.

Once you’ve calculated the historical compound growth rate, use that growth rate to make your assumption on how much the college will cost by the time your daughter is eligible to attend. Then calculate how much you will need to earn and contribute to get there.

2) Make a realistic assessment of the number of kids you will have. One of the biggest reasons why I failed early retirement was because I didn’t account for having a second child at 42 years old for me and 39 years old for my wife. After years of trying, we thought we were done after one.

After the age of 40, a woman’s chance to naturally conceive drops to around a 5% per try. Therefore, given we don’t want to go the IVF route, there’s a 95% chance we will only have to save and invest for two kids going forward.

Don’t worry. Even if you do beat the odds and are blessed with more children, you still have plenty of time to save and invest for your child’s future. It’s not like your expenses go from zero to thousands of dollars as soon as they are born.

3) Carefully observe the cognitive abilities and interests of your kids. Objectively observing your child’s attributes is almost impossible. Of course, you will think your baby is the cutest, smartest, best-looking, and kindest kid ever. But try hard to be objective by comparing the progress of your child to various milestones and examinations.

When it comes to your kids, you don’t want to suffer from Dunning-Krueger. If you do, you will give your kids a false sense of security that will be smashed to smithereens in the real world. Praise effort, not results.

Not everybody needs to or should go to college, let alone private grade school or private college. If your child dislikes learning about useless quadratic equations and would rather fix cars for a living, going to trade school is probably a much better move. Trade schools don’t take as long or cost as much as college. Therefore, you won’t have to save as much in your 529 plan.

Match your child’s education to his or her interests.

4) Pay attention to 529 plan laws and politics. Even though the SECURE Act passed, none of us are exactly sure how we’ll be able to go about extracting our 529 funds to pay for things until we actually do. I fully expect to one day try and withdraw $100,000 and can’t because I lost my password and forgot to account for some random law.

There is also an increasing chance that within the next 20 years, many more Americans will be able to attend reputable colleges for free. If the bull market continues, the wealth gap will continue to widen. As a result, a socialist might get elected President and many more socialists may be elected to Congress.

Saving and investing heavily for your child’s future is a suboptimal strategy in a more socialist regime. Think about all those parents and students from Howard University who just missed a billionaire alumni’s generosity of paying off all student debt for a graduating class.

If capitalists are in power, you should save and invest as much as possible. If socialists come to power, however, you should try to relax more and take advantage of government programs such as income-driven repayment plans with forgiveness.

5) Make sure you are saving enough for your retirement. Regardless of who comes into power, it’s always a good idea to make sure you’re financially on the right track.

Achieving financial freedom is much harder for parents because we must not only save for our own retirement, but also take care of our parents and fund our children’s education. As a result, it is extremely hard to retire early with kids. Not only is there a tremendous cost associated with kids, but there is also a motivational fire that makes you want to keep on building wealth.

Your financial well-being should come first. After all, if you can’t take care of yourself, how can you possibly take care of a child? You must be able to max out your pre-tax retirement plans and build your taxable investment accounts. Counting on the government to save you is foolhardy.

Below is a chart from my Average Net Worth For The Above Average Married Couple post, which may help keep you on track.

Think about how much better society would be if every kid grew up in a financially stable household where parents were less stressed out about their finances and had more time to spend with their kids. Perhaps there would be fewer murderers, robbers, sociopaths, and bullies.

6) Use realistic return assumptions. Nobody knows how our 529 plan investments will perform over the coming years. But we do know that stocks tend to return between 7% – 10% on average, while bonds tend to return between 3% – 5% on average since 1926.

More recently, below is an annual return chart of a 60/40 (stock/bond) portfolio since 2009. Based on the data, a wise parent with a 60/40 portfolio would assume closer to a 5% – 6% compound annual return over the next 10 years when determining how much to contribute.

Below is another chart that highlights how strong the past decade was for investors. We should logically expect a down year or two this decade.

Changing 529 Plan Beneficiaries

If you save too much in your 529 plan, you can always change its beneficiary. Surely there is a relative with a child who could use some help.

Worst case, if you remove funds for non-qualified expenses, then you’ll pay a 10% penalty on your gains. You’ll also be subject to income taxes on the gains and may even have to pay back any state income tax deductions you previously claimed.

As for us, we plan to keep contributing at least $20,000 a year into our 529 plan because we haven’t reached our minimum limit of $500,000 yet. We also expect some market declines that will cause our 529 plan to lose money.

We don’t foresee a scenario where we will have hundreds of thousands of dollars left over in our 529 plan because we’ve done our calculations. But in case we are wrong, we hope to live long enough to change the beneficiary to our grandchildren.

Readers, how do you determine whether you’ve saved too much or saved too little in your 529 plan? If you aren’t contributing to a 529 plan and have children, please share why.

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