My 529 Plan Asset Allocation, Part 3: Final Decisions

college_shirtAfter probably too much thought, I have settled on an investment plan for our two 529 college savings plans (one per kid). My circumstances and preferences are unique and likely different than yours, but as usual I will share my process and final decision. Based on my conclusions from Part 1 and Part 2, here are the general requirements:

  • Each 529 portfolio will be similar but separate from my retirement portfolio. Similar means a low cost, balanced portfolio of roughly 60% stocks and 40% bonds.
  • I want the stocks to have a long holding period. I plan to front-load my contributions early on, and then not touch it for 10 years. After that, I will gradually shift the portfolio to short-term bonds and cash.
  • Low maintenance is good. Zero maintenance would be even better, where I wouldn’t even rebalance annually.
  • Since 529 plans are tax-deferred with tax-free qualified withdrawals, I have the ability to play a little bit with higher-turnover or higher capital-gains strategies. No tax paperwork until withdrawal time.
  • My state has no special tax benefits for 529 contributions, so I should pick from any nationally-available plan.

I narrowed it down to my top three combos:

1. Utah Educational Savings Plan and DFA Global Allocation 60/40 Portfolio (DGSIX)

Pros

  • The Utah Plan is a top rated plan, with many low-cost investment options and probably the best customization tools.
  • Dimensional Fund Advisors (DFA) applies academic research to try and capture a more “efficient” portfolio to focus in on size and value factors. More here.
  • The DFA Global Allocation 60/40 Portfolio is their all-in-one portfolio that includes domestic and international stocks as well as high-quality bonds.
  • This allows me to “scratch the itch” of investing in a DFA fund without having to deal with any tax drag on performance or additional paperwork.

Cons

  • DFA’s methods are more expensive than Vanguard’s cap-weighted indexes. The total expense ratio is 0.49% annually, vs. roughly 0.26% for a similar Vanguard portfolio. I may or may not experience enough extra return to offset the higher fees.

2. Ohio CollegeAdvantage Direct Plan and Vanguard Wellington Fund

Pros

  • The Ohio Plan is a top rated plan with many low-cost investment options, some of which are relatively hard to find like the Wellington Fund and TIPS.
  • The Vanguard Wellington Fund is an actively-managed fund that has a target allocation of roughly 65% stocks and 35% bonds. Run by Wellington Management, it has been around since 1928 and is run with a conservative, long-term view. There is plenty of information elsewhere on this fund. The stocks are usually dividend and value-oriented, and the bonds are actively picked for moderate income.
  • This allows me to “scratch the itch” of investing in the Wellington Fund without having to deal with the tax concerns of owning an actively-managed fund (higher turnover, capital gains distributions).

Cons

  • The Wellington Fund is very cheap for an actively-managed fund, but is still slightly more expensive than Vanguard’s cap-weighted indexes. The total expense ratio is 0.35% annually, vs. roughly 0.22% for a similar Vanguard portfolio. I may or may not experience enough extra return to offset the higher fees.

3. Nevada Vanguard Plan and Custom Mix of Vanguard Index Funds

30% US Total Stock Market Index
30% International Total Stock Market Index
20% US Total Bond Market Index
20% US Inflation-Protected Securities

Pros

  • The Vanguard 529 Plan is a top rated plan with many low-cost investment options, some of which are relatively hard to find like TIPS.
  • Simplicity. If you already have a Vanguard account, you wouldn’t have to add another monthly statement or online account login to your financial life.
  • This portfolio would most closely match my existing retirement portfolio.
  • The total cost would be 0.28%. This is a bit higher than other pre-made portfolios since I like to have a higher amount of international stocks and TIPS which are slightly more expensive than the traditional default options.

Cons

  • I don’t like any of their pre-made static portfolios, so I would have to make my own and rebalance periodically.

In the end, I went with the DFA 60/40 fund. My reasoning is that I have the potential for some higher returns using their strategies, and if I don’t, the passive structure prevents returns that lag too far behind the overall market. The most likely result is a slight win or slight loss. Obviously, I hope for the former but I can tolerate the latter. However, I think any of the options above (or something similar) will also work out just fine.

Comments

  1. Hi,

    Just curious on why you want to establish a 529 plan. Isn’t this plan specific for educational purposes only. What if your kids get scholarships or grants that covers college expenses and you won’t need much or any of the money at all? Is the Roth IRA approach are more versatile savings plan with fairly similar tax sheltering? At least with the Roth approach you’re not just locked with just education, if you decide to help them with other expenses in their lives.

    • I’m also maxing out the Roth IRA, but don’t plan on using that for educational expenses. If you get scholarships and/or grants, then you can then withdraw a commensurate amount from your 529 without the extra 10% penalty. You’d still be subject to ordinary income tax rates on gains, but you’d also have benefited from tax-deferred growth during all those years. With our expected asset levels, I think need-based aid will be unlikely. If we get merit-based aid, that would be a pleasant surprise and I’d be fine paying some taxes on gains. Otherwise, I’m getting a tax benefit that would otherwise not be available.

    • It sounds as if Jonathan plans to make an up-front six figure contribution to his kids’ plans. You certainly can’t do that with a Roth IRA, which is limited to $5500 in annual contributions.
      Personally if my kids get scholarships that will be a great problem to have. We can always use the 529s for graduate education, or transfer them to my children’s children at some future date. Our view is there is always going to be an excess demand for educational expenditure in our family, making a permanent surplus balance in a 529 plan a remote possibility.

      • Where did you get the idea that he “plans to make an up-front six figure contribution”? This would be ill-advised. Any beneficiary (child) that receives more than $14,000 across all accounts in a given year is subject to the federal gift tax. Only special exception that IRS allows is you can contribute up to $70,000 in one year if you then make no contributions for the next four years (so that it still averages out to $14k per year).

        • I believe it was in another article in this series that he discussed front loading. Since he is married he can double that $70K and do up to $140K per child between him and his spouse. If I recall correctly the 5 years of gifts approach requires the filing of a gift tax return to document the election, although no tax would be due.

          An option I may use is to open 529 plans for myself and my wife and transfer the beneficiary designation in a future year. I would be doing this since I live in a state where the state tax deduction is “per beneficiary” not “per taxpayer”, so I could double up my current year deduction and get the monies sheltered sooner. In the year I would transfer the beneficiary I would not expect an additional state tax deduction so it would just be an acceleration of the tax benefit. But I may have moved by then, in which case, bonus.

          • Yes, my wife and I can theoretically jointly contribute up to $140,000 per kid, but then we can’t contribute anything further for 5 years total. We are not actually contributing that much, but it may add up to a six figure amount total for both kids when we are done.

            I may have given the impression that I was maxing it out because I wrote that in my post with sample gift tax form, aka IRS Form 709:

            http://www.mymoneyblog.com/completed-sample-irs-form-709.html

    • Can someone explain how the tax sheltering of a Roth-IRA is similar to that of a 529 plan? What about making withdrawals?

  2. Hey Jonathan,

    I’m so glad you’ve brought up 529s right now! Just right now (I live in NY), I have this question:

    If I need to withdraw my contribution for some reason, can I do this without a penalty? I mean the contribution portion only, not any earnings. Normally, I wouldn’t think that’s a big deal except in my state, I can deduct up to $10K off my state income tax (6% savings), and I want to contribute the whole thing because of that. However, it will leave me a bit low in my checking (a little under $5K and usually I like to have more of a cushion). If I run into anything major during the year, do you think it would be a hassle to take the money back if necessary?

    • It’s not really meant to be used in that manner.

      If you make an unqualified withdrawal, you will be subject to both income taxes on any gains plus a 10% penalty. You cannot split between contribution and any capital gains. For example, if you put in $4,000 and it doesn’t grow and stays $4,000, if you take out any money as unqualified withdrawal you won’t have any tax due (no gains) but you’ll have to pay 10% penalty.

      If you put in $4,000 and it grows to $5,000, then any amount taken out is 80% principal and 20% gain. If you take out any money as unqualified withdrawal, you’ll have to pay income taxes on 20% of it, plus another 10% penalty.

  3. Sofaking Nuts says:

    Better to put the 529 in your (the guardian) or the child’s name?

    • It is better for financial aid purposes for the parent/guardian to be the owner and the child as the beneficiary. In this case, the 529 is treated as a parental asset. Children are expected to contribute basically all “their” assets towards college, while parental assets are expected to contribute a smaller fraction. There are plenty of calculators online for more exact numbers.

  4. Jonathan, how much you are contributing per month for each child to the DFA 60/40 fund?
    Is it possible to contribute for full 2015 to get tax benefit for current year?

  5. Sean Smith says:

    Did you compare NY’s 529 Plan? Its expense ratio is low and vanguard managed as well.

    • The NY 529 is a perfectly fine plan if you go with the low-cost Vanguard options. For a while they didn’t have any international stock exposure, but recently they fixed that I believe.

  6. Why did you decide to go with 2 separate 529 plans when the kids are so close in age? I didn’t see that anywhere in the reasoning. Why not just one plan?

  7. Jonathan,
    My state offers income tax benefits for contributing to college 529 plan. Would it make sense to contribute just sufficient ($2K) to get the tax break and contribute the rest to a different plan among the top rated plans? Is it okay to open multiple 529 plans across multiple states? Please advise.

    • Yes, it is okay to open multiple 529 plans in multiple states. You’ll have to decided if the benefit outweighs the additional complexity and paperwork. My decision would also depend on how “bad” my in-state plan was and how much I was contributing each year.

      • Thank you. I live in GA and they have pretty okay 529 plan, but I am not sure if the top rated plan offers better performance compared to the GA plan. Is there a way to estimate how the different plans are expected to perform over the next 10-15 years? Also, please help understand the “additional complexity and paperwork” you mention. Why do you think it is complex process? Thanks in advance for your assistance.

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