529 Plans, Retirement Accounts

Reader Question

My wife and I are in our early twenties. we sat down the other night and talked about our goals for our life. We set some savings goals for our cash accounts, and have budgeted accordingly for our short to mid term goals. For our long term goals, we have started down the seemingly never-ending road to understanding our investment options. We are looking at Vanguard's LifeStrategy and Betterment for our retirement investments, and found your review very helpful in this regard. Our question arises when we consider our goal of college savings for our children. We know we want to have children, (2-4, but life never really goes according to plan) and we know we want a college savings account for each child. We plan to open a college savings account for each child when they are born, and invest into that account. We also plan to use the account as a teaching tool, and allow the child to make contributions as well. (I'm considering only matching the contributions of the child after a certain age) The question is where? Where do I put this account, do I use the same investment strategies as my retirement account. I'm not sure I fully understand a 529. I'm not sure I fully understand IRA's, 401k's or any other account type for that matter. Your insightful analytical approach to our dilemma would be greatly appreciated.

My Reply

Great job on starting serious financial planning this early in life! With regards to 529 plans I wish I was more knowledgeable on the subject but not having kids I never looked at it in depth. But I will share what I do know.

Before I get to 529 (or IRA or 401k), let me first repeat what you probably already know but what are the four most important points when it comes to any investing and are always worth repeating:

1. Costs are hugely important. The average mutual fund annual expense ratio of around 1.5% is effectively a death sentence to the investor's financial well-being. Seemingly tiny percentages add up to enormous amounts over decades of investing (and you do have decades of investing ahead of you). My articles about this subject include http://www.longtermreturns.com/2010/12/how-much-investment-expenses-really.html , http://www.longtermreturns.com/2012/03/why-investment-expenses-matter.html , and http://www.longtermreturns.com/2011/02/how-investment-expenses-are-ruining.html . Keeping costs as low as possible is equally important in 529, IRA, 401k, or any other investing account. This concept appies equally to stock and bond investing. Note that management costs are just one type of expenses. Trading stocks, a popular pseudo-strategy for individual investors, is just as deadly to their financial well-being because it has high costs of its own in commissions, bid-ask spreads, and taxes (which I mention below).
2. Diversification is hugely important. Putting all your money into a handful stocks is playing Russian roulette. Over time majority of companies flame out. But the minority that make it big make stock investing profitable. Nobody in the world has a clue as to which companies -- or countries, or continents -- will stumble and which will soar even just 3 years from now, let alone 30 years from now. You must diversify as widely as possible to ensure that you capture you share of the future winners. This concept applies to stocks much more so than bonds, but even with bonds it is a good idea to diversify across different bond issuers and maturities (though simple investing in highest-interest available, FDIC-insured CDs is a good non-diversified alternative to bond investing).
3. Appreciating the risk involved in investing -- especially stock investing -- and knowing how you and your wife will respond when this risk does show up is extremely important. You must believe with all your heart that at some point, sooner or later, the stock market will plunge. A LOT. 50% or maybe even more. It may happen next week or it may happen in 30 years, but it will surely happen. You must have enough intestinal fortitude and enough safe investments to not panic when it does happen. Ideally, you would even buy more stocks after they've already plunged 30+% from their peak. But at the very least you must NOT panic and sell out at the bottom or near it because you think or because everybody tells you that the end of the world is near. Stick with your plan and you should see your stock investments start to grow again. It may take years, but you should be prepared for that. Investing is a marathon, not a sprint. The rollercoaster nature of the stock market is why we invest in it in the first place -- the expected (but not guaranteed!) return is relatively high for something so risky. Over decades you can reasonably expect to make handsome profits by sticking with stocks. But because it is risky and because these high returns are not guaranteed you should never have the entirety of your wealth in stocks. When you put your savings into stocks you should be prepared to see the worst happen to them, even as you hope for and expect the best. My article on this topic is http://www.longtermreturns.com/2012/03/selecting-investment-strategy.html 
4. Last important point is maximal tax efficiency. You must avoid taxes as much as legally possible. This includes taxes on bond interest, taxes on stock dividends, and -- most important and avoidable of all -- taxes on capital gains when you sell your investments. In the ideal world, you would never sell any investments you buy, but simply live off the income stream -- dividends and interest -- that they throw off. In reality few of us will be that lucky, but you should still aim to avoid any and all capital gain taxes until your retirement! My article about the impact of taxes is http://www.longtermreturns.com/2011/10/tax-planning-for-investments.html . The best (legal) way to avoid taxes is maximizing tax-sheltered accounts such as 401k, IRA, 529 pans, and even more exotic options like HSA accounts for high-deductible health insurance plans. Any way you can avoid paying taxes either on today's earnings or on future investment gains is a VERY good thing. Unfortunately many 401k, 529, and other non-IRA plans provide less than optimal investment choices. But even then you can usually find something worthwhile when combined with the benefit of tax shelter. Note that there's one big exception to this list. Whole life or universal life insurance investments are virtually always so badly overpriced that their high costs overcome whatever tax benefits they may carry. Stay away from those.

The first two of the above points are best squared away by investing with Vanguard. As I never tire of saying Vanguard is more or less the only honest investment company in the ocean of sharks. And no, I am not being paid one penny by Vanguard nor do I have any personal or professional connection to them. It is simply the truth. Vast majority of the investment industry presents its alleged skills in the area of stock picking (i.e. going against point 2) as an excuse to charge you more in expenses (i.e. going against point 1). Vanguard wisely and honestly makes no such claims and instead does its absolute best to meet the first two points of rock bottom costs and widest diversification.

The last two points are more or less up to you. You need to know your own need and ability to take on risks and you need to maximize tax efficiency of your own investments. Not even Vanguard can do that for you -- though Vanguard does much more to educate you on their importance than an average investment company.

Now with those preliminaries out of the way, let's get down to 529 choices. Again, this is not my area of expertise, so please double-check everything I say.

The primary benefit of 529 is very simple: tax-sheltered growth of investments and tax-free distributions when they are used to pay college expenses. In other words, 529 plans help you maximize point 4 from my list above. In addition to that, only a small percent of 529 plan's value counts as part of expected family contribution (EFC) to the child's college costs which means that you won't be denying your child potentially significant grants and loans by having a well-funded 529 plan. Note that limited impact on EFC may change in the future, but chances are if it does that means that the government and colleges will be much more strapped for money and won't offer much in the way of grants or loans anyway. 529 plans also have very generous limits on who can contribute to them and how much -- total 529 account value is allowed exceed $300,000 as of today. There's also quite a bit of flexibility on who exactly is eligible to benefit from the 529 -- if one of your children doesn't go to college you can simply designate the other as the beneficiary.

The primary downside to 529, aside from the fact that the money must go toward college costs or incur penalties, is limitations on investment choices and relatively high costs (going squarely against point 1 in my list above). A few states allow you to invest with Vanguard for 529 programs directly, which is likely to be your best bet. As with their other investments Vanguard has a choice of relatively conservative to relatively aggressive investment choices with 529. Only you can decide which is right for you by analyzing yourself and your need and ability to take on risk (point 3 above). Many other states allow investments in Vanguard funds through state's own 529 program which will likely result in higher overall expenses but probably still be better than alternatives. For remaining states Vanguard will not be an option at all and you'll need to do research as to the next best available choice. You can see the state breakdown at https://personal.vanguard.com/us/whatweoffer/college/finda529?Link=getstarted&LinkLocation=college_overview . It will also provide links to your state's 529 programs. Unfortunately beyond this point my knowledge of 529 runs real dry. Besides Vanguard's site I recommend you read through http://www.bogleheads.org/wiki/529_Plans and probably give Vanguard a call (the phone number is on their site) to ask questions. I would not normally recommend doing your research by calling somebody with a conflict of interest (i.e. wanting to sell you their product) but Vanguard is one exception I am willing to make.

Wish I could be more helpful, but hopefully this still answered some of your questions and gave you pointers for further research. Above all, continue to keep the four points I listed out above in mind when it comes to any and all investing, 529 or otherwise.