The day my daughter was born was the day I stopped saving for her college education. Yup, you read that right. She wasn’t even a day old and under some conservative assumptions, her 529 College Savings Plan was fully funded. I started investing in this tax-exempt account long before the iPhone came out without the help of a fancy 529 calculator. In fact, the entire thing was an accident of sorts. And if you’re single and have some extra savings, this could be your gateway to FIRE.
Single and ready to … invest
Yes, I was saving for an unborn child’s college fund as a 23 year old single guy. (And I was the extremely fortunate position to do so, since my dad’s employer had covered the lion’s share of my own college tuition.) But it wasn’t intentional. I thought I was saving to get an MBA. And in changing course, I fortuitously unleashed a long term compounding machine that helped check off one of adulthood’s biggest expenses.
529s have juicy tax benefits
Opening my 529 plan was the result of hating my first job out of college and setting into motion a backup plan: getting an MBA. And as someone always looking for legal tax loopholes, I stumbled upon the 529 plan and its two juicy benefits: tax-exempt growth (for the future) and a tax deduction (for today).
Benefit 1: Tax-exempt growth
In a nutshell, a 529 plan is a tax-exempt investment account for future higher education expenses. You put in after-tax dollars, but you don’t pay any taxes on the growth or dividends (as long as they go to “qualifying” higher education expenses such as tuition, room and board, and books). It’s like a Roth IRA for college savings.
Benefit 2: Tax deductions
Furthermore, thirty states offer you an additional benefit: contributions into the 529 plans can reduce your tax bill via state-level tax deductions or credits.
This presented a unique opportunity for my 23 year old self: Open a 529 account in my name to take advantage of the current year’s tax deduction. If I got an MBA, I’d use those savings towards the tuition; if not, I’d transfer the account to my future child. I didn’t even have a girlfriend, but hoped (and found it reasonable to believe) that I’d have a child one day.
But what if my soulmate never came along?
Or circumstances beyond our control prevented us from having a child? There was an out for this low-probability (but possible) risk: I’d pay the taxes on the gains (i.e. as if I’d invested them in a regular taxable account) and an additional 10% penalty. That felt like a risk worth taking.
The 529 calculator: compounding at its best
The plan began in 2003. I invested $5k a year (to capture the NY State and City tax deduction) raising that amount to $10k once we got married in 2012. (And in 2006 I realized I wasn’t getting an MBA.)
And fast forward twelve years later, here’s what the account when our first child was born (1):
Plugging that balance into this 529 calculator (Google Sheets) showed that with 18 years of additional compounding, there’d be a good chance of covering her four year tuition expense.
But I know what you’re thinking – with so much time on your side, you’re going to end up ahead. And while that’s true, the psychological side ain’t always easy. My test came five years after opening the account, when the 2008 financial crisis hit us all (and the S&P 500 was down nearly 50%).
Thankfully, I stayed the course – and (as is usually the case) we’re being retested again with the 2018 bear market.
There’s more: The annual tax deduction
This wasn’t just an exercise in delayed gratification; it was one of cold hard cash. Since I lived (until recently) in a state (NY) that provided a tax deduction, my annual contribution also put dollars in my pocket each year. To the tune of $5,457 over the 13 year period.
Here’s how a tax deduction works: Multiply the deduction by the your effective tax rate. The result is how much you save in taxes that current year (2). Using Vanguard’s tax deduction worksheet, as a single guy I saved $325 in taxes (on a $5k contribution) and $633 once married (on $10k of contributions).
I now live in California, a state without a tax benefit. I am also saving now for a second child. Nevertheless, I still plan on contributing: as you saw in the tables above, the tax-free compounding of growth makes the best way to save for college.
Any blind spots?
First, if you’re single it’s impossible to determine the probability that you’ll get married and have a child (who will go to college). But that feels like a fairly safe bet for most people. But more importantly, there’s an opportunity cost to prioritizing saving for college this early: it comes at the expense of home ownership. And home ownership usually comes well before college tuition. It would suck to not be able to buy a home because you had too much money tied up in the 529 of an unborn child. Notwithstanding my general preference for renting, I always felt that in the worst case, I’d just delay home ownership for a few years.
The biggest risk, might be in the opposite direction – the elimination of certain 529 benefits. In fact, in his 2015 State of the Union speech, President Obama proposed eliminating the tax-free nature of the distributions. This was met with heavy opposition, but this shows that even the federal government might think that we’re getting too sweet of a deal. So get in while the going is good… even if you’re 23 years old and single.
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- You Need A Budget, Jesse Meachem – A RadReader favorite on shifting your money habits and budgeting via @canthardywait.
Dollars and Sense: How we Misthink Money and how to Spend Better, Dan Ariely – The behavioral scientist on how emotions shape our spending decision
- Your Money or Your Life, Vicki Robin – The 1970s book that serves as FIRE’s bible via @mikekarnj
- The Soul of Money: Transforming your Relationship with Money and Life, Lynne Twist – The definitive guide on shaking “scarcity thinking” – the belief that we don’t have enough via Oliver Guinness
(1): It’s not my style to share my actual financial information. I’m doing it here because it was entirely rules-based ($5k/year when single, $10k/year when married).
(2): Tax rates are highly sensitive to a long list of variables, making it hard to generalize their impact. Consult your tax adviser to fully understand your own situation.