529 · Investing

Playing it too safe

Recently, I spoke with a family member who decades ago, made a decision to prematurely cash out a pension plan prematurely, netting about $5k at the time. Fast forward 29 years later and the cost of undoing the earlier cash out cost $37k, an annualized rate of return around 7.1%/year.

To help frame things, if that $5k had been invested in Vanguard’s S&P 500 index fund–only two years old at the time!–that $5k would have become $67k! Not quite double, but close to it. During those 29 years, which included the dot com boom and bust, the S&P 500 averaged around 9.2%/year, only 2.1% more that the 7.1% return

There’s a serious risk of being too conservative over a long time horizon.

Triggered by this conversation, I started looking for areas where I might be playing it too safe, possibly costing me big money down the line.

College 529 Investment Options

As I’ve written before, my oldest started her university education in September. Fourteen years earlier, in 2006, I opened a 529 in her name through Ohio’s CollegeAdvantage program. I put my initial (and only!) investment 100% into equities, split between the Vanguard 500 Index and Vanguard Extended Market Index options. Then, I pretty much ignored it, occasionally checking the balance but never adjusting.

In August, I rolled over the account to Virginia529. My initial $3,500 had more than tripled, a 14.5% annualized return.

Now, maybe you’re asking, why roll it into a new account right as when she started college. Isn’t that the time to cash it out and pay tuition, right?

Three words: state tax deduction

When I made my initial contributions, I received no state tax benefit. This made me eligible to deduct the original contribution from my Virginia state income tax simply by rolling it over to Virginia529, netting a 5.75% tax savings, or about $200. Technically, I also had another four months of investing, being able to pay tuition in September out-of-pocket and waiting until the end of December to reimburse myself.

After rolling the account over, I now needed to choose an investment option. Should I keep it 100% in risky equities, 100% in the least risky fixed income, or somewhere inbetween? Remember, my investment horizon is only four months, so risky sounds like a bad option.

I decided to roll it over into the Conservative Income portfolio, which has a 80% fixed income to 20% equity mix. Additionally, I injected another $4k into the Inflation-Protected Securities portfolio, increasing my state tax savings in 2020.

But after thinking about it some more, I realized I’m being too conservative.

Parallel versus Serial

My investment horizon isn’t four months. It’s actually more than ten years!

How so? Did I find some 529 loophole that lets me pay expenses now and reimburse myself in the distant future, like you can with a HSA?

I wish.

The answer is simply that I have five other children, and I have more than ten years until the youngest enters college. And really, all the way up until she graduates. At that point, I will happily be done paying for my children’s higher education expenses.

My mistake was thinking of each child’s expenses in parallel, independent of each other. True, if I had dropped and paid all of their expenses this year, it might make sense to treat money that is going to educate my eldest with lower risk than that of my youngest.

Instead, I now see them as serial expenses. Once I’ve contributed enough to my oldest daughter’s 529 to cover all of her college expenses, all withdrawals to reimburse myself can be instead “rolled” into her younger siblings’ accounts. 

A 529 waterfall, of sorts.

What happens if the market dives and my more risky investment loses value? No biggie. By “rolling it over” into a young sibling’s account, my money stays in the market, hopefully catching the gains when the market climbs back up.

In addition, if one of my children decides to skip college or exit early, by parallelizing the 529s, I can change the beneficiary to the next sibling.

To be clear, I’m not magically reducing the amount of money that I’ll be paying out for college expenses. In that sense the expenses for each child can be considered in parallel. But by thinking of the investments in serial, I can reframe my risk concerns, potentially increasing my total return and reducing how much I pay out-of-pocket for college expenses.

Comparing Glide Paths

As with 401(k) plans, many 529 plans offer target date options. Typical of target date funds everywhere, Virginia529’s target date funds have higher fees and are pretty conservative. You’ll notice the same “glide path” of equity-to-fixed-income weighting, eventually dropping to nearly 100% fixed-income in the expected start year. Unlike retirement, which can last for years, I can see how it makes some sense to be more risk averse towards the end of the glide path. However, college tuition bills aren’t billed 100% on the first day of freshman year, instead spread out over four years, typically. Seems like a non-zero equity percentage during freshman year would make a lot of sense.

Here’s a chart comparing the glide paths of Virginia529’s target date portfolios compared to Vanguard’s. Notice that the 529 glide path is much more conservative, even as far as ten years out. Seems overly conservative to me.

Conclusion

Cleary, in order to replicate what I’m doing, you need several children to aggregate across. If you only have one or two children, your risk profile and investment horizon will be very different. But if the gap between your oldest and your youngest is big enough, your window for risk could be wider.

I’m not going to immediately switch to the Total Stock Market portfolio. Virginia529, like many 529 options, limits how many times you can exchange in and out portfolios. But all new money will probably go towards more aggressive options and at some point I’ll convert the rest as well. 

So, what am I missing? Am I thinking about this in the wrong way? I’d love to hear your thoughts in the comments.

Hasta luego!

 

4 thoughts on “Playing it too safe

  1. One word of caution about transferring 529 plans. Many states charge a “tax recapture” fee to claw back any state tax benefits they would have given you through the years. If I were to move today to another state and roll over my 529 to a lower-cost option (e.g. CA’s 0.06% ER 529), I’d have to pay a fee of about $3k in fees to my current state. Consequently, I’m leaving the 529 here no matter what happens to us in the future.

    More broadly, I agree that we have to think longer term when investing. I’m almost 40. Perhaps I’m dead at 90. So I constantly remind myself that I hopefully have 5+ decades of life left. With that appropriate investment horizon, you realize you can bear a lot more risk in your youth. The difference of a few percentage points in returns compounded over a many decade period is astounding.

    1. Great point on the rollover clawbacks. When I contributed to Ohio’s 529, we lived in Washington State with no state income tax. There is no state income tax to clawback. For curiosities sake, how does that clawback happen? It have to happen through the income tax return, not from the 529 dispersement, unless there was coordination between the 529 and the state income tax authority.

      Even though your state’s 529 fees are higher, the state income tax deduction likely makes up for the difference.

      Thanks for the comment!

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