Monday, January 14, 2019

College Plan? Undeclared.

Two days after Christmas, we closed on the sale of our second, and final, rental property. We got a full price offer, too. (Minus having to give the buyers a $2k credit towards closing).

It is hard to describe how good this feels.

Though I was a bit nervous right up until the day the check cleared. A previous buyer on this property backed out at the last second, even after we agreed to fix the major items in his inspection list. So I wasn't going to declare we were officially-and-forever out of the rental business until the papers were signed.
Once check was in hand, we put Baby AF to sleep, opened a bottle of wine, and then I did a damn cabbage patch in celebration.


We've sold three properties in the past two years. We made a little profit when we sold the first rental in Indianapolis. And when we sold our prior primary residence, the first home we ever bought, we started deploying that cash to accelerate our financial independence plans.

But now that Baby AF is in the picture, Mrs. Done by Forty and I thought we'd use this rare, cash-rich opportunity to create a college fund for the little one.

I should acknowledge that we are two lucky fuckers, as these home deals could have gone sideways in a dozen different ways. For each house, we put over $20k into flipping the property, putting in new kitchen cabinets and granite, laying new flooring, hoping to make the home desirable to a family rather than another investor, and maximizing our profit on the back end. But we could have ended up losing that money had things not broke our way.

We were also ridiculously fortunate to have purchased all three properties at a low price in the first place (roughly $80k and $90k for the rentals, and our primary residence for about $130k back when the Phoenix area was giving homes away in 2010). We were also lucky to have cash available to make the deals in the first place.

We've got privilege falling out of our butts over here.


The catch is that we don't really know the best way to save for college, since I am only masquerading as someone who knows how to manage money. Given our long time frame between now and Baby AF's first college class, and our weird ass FI plan, we don't really know whether we should lump sum invest or dollar cost average, or to use a 529 or not.

That's where you smart people come in. You use your smarts and tell us what to do, and then we do it. But we don't pay you anything for your advice because we are cheap, and you are nice people.

Guiding Principles:
  • We are planning to invest $40k for Baby AF's college, and let it compound for 18 years. If we assume a 7% return each and every year (ha!) then this would grow to $135k. If we want to account for inflation and assume a 4% real return, then the $40k would grow to $81k in real terms. 
  • This will almost assuredly not cover the cost of a four year degree, and we are pretty okay with that. Mrs. Done by Forty and I both were responsible for a large part of our bachelor's, and we want Full Grown AF to have some baby soft skin in the game. The amount we're giving will still be many times more than what we received. And, who knows? Maybe we can add to the account later.
  • Lump sum investing is likely to have the best outcome, though with CAPE where it is, dollar-cost averaging sure is tempting. Still, our plan is to invest the $40k in VTSAX within a fairly short time frame.
  • Over time, we'd like the account to become more conservative, so we'd have the dividends each quarter be directed to cash, and buy the Total Bond Index (VBTLX). Over eighteen years, the mix would become more bond heavy through these dividend payments.
  • We plan to have a second little one sometime soon, so we'd want to replicate whatever plan we come up with for her.
The 529:
  • A 529 Plan seems to be the option of choice for most financially savvy folks. It allows two main tax advantages: avoiding some state income tax each year you contribute, and tax free growth for all the years the account compounds. 
  • Tax free growth is a pretty great benefit if you're going to invest all at once, since a majority of the final balance will likely be from gains 18 years down the line.
  • But a 529 has a few tricky bits for us. For one, in Arizona you can only deduct $4,000 from your taxable income each year. At our marginal tax bracket (3.32% for AZ state income tax), we would avoid $132 in taxes each year that we contribute $4,000: in effect, getting an immediate 3.32% return on that four grand. 
  • However, to maximize this tax benefit, we'd have to spread out the $40k in contributions over ten years! The opportunity costs for staying in a cash position for so long, plus the impacts of inflation, are pretty substantial.
  • Additionally, there is an outside chance that Baby AF gets a free ride to school. Or maybe he'll decide not to go to college at all, since robots took all the jobs after the SkyNet incident of 2020, and universal basic income started taking care of all our financial needs in 2021 under President Crissy Teigen. In that case, if we wanted to withdraw the funds and give the money to Baby AF to, say, start a business or for a down payment on a home, the gains in the 529 would no longer be treated as capital gains. Instead, those withdrawals would be taxed as earned income. It's hard to know what our rates will be twenty years from now, but they tend to be less attractive than capital gains tax rates.
  • There are thankfully no account maintenance fees in the Fidelity AZ 529 plan, and there are some good index options that mirror what we'd choose to invest in with Vanguard.
The Taxable Account:
  • Jeremy at GoCurryCracker has a pretty convincing take on the 529: if he's going to handcuff himself with a bunch of rules in exchange for tax avoidance, the benefits have to be pretty substantial. For early retirees who aren't going to pay a lot of taxes anyway, what's the point?
  • If we were not to use a 529, we'd invest in a boring old taxable account and try to keep the funds fairly tax efficient. 
  • Additionally, the taxable account might not be quite as bad of an option in the event that we retire early. With no earned income, we'd potentially have a 0% or a very low tax rate on the dividends, and could even do some tax-gain harvesting at 0% capital gain rates, too, depending on what Congress does with future tax laws. 
  • Which all goes to say, the benefit of tax free growth in a 529 matter less to an early retiree, who is probably paying very little in taxes on capital gains & dividends.
  • A big advantage of this plan is being able to invest as much or little of that $40k as we want right off the bat, rather than having to put it in $4,000 per year chunks if we were trying to maximize the state income tax avoidance with the 529.
  • Of course, even if we decide we want to go with the taxable account, we still have to choose between investing the $40k all at once, or dollar cost averaging over a year or three.
A Hybrid Approach:
  • As a compromise, we could do a bit of both: put $4k a year into the 529, but invest the rest into a taxable account. 
  • We hypothetically could move $4k from the taxable account into the 529 each year, but the capital gains we'd see while working (15% currently) could more than cancel out the state tax savings (only 3.32%). 
There are even more options we could consider, like throwing an Educational Savings Account in the mix, or even going with another state's 529. But this post is already running too long, and the last thing we need is to throw more options into the mix.

So here's where I put our child's education into the capable hands of my readers.

If you were in our situation, would you go with a 529, a taxable account, or a mix? And would you lump sum invest, or spread out the contributions over a year or two?

The commenter with the most convincing answer gets to pick Baby AF's major.

As always, thanks for reading.



*Undeclared photo is from Fan the Fire Magazine at Flickr Creative Commons.

20 comments:

  1. In regard to a scholarships, you're allowed to pull out the dollar equivalent of the scholarship penalty and tax free from your 529.

    A 3.3% return on the initial investment seems pretty poor. In Indiana, it's a 20% tax CREDIT on the first $5k. That makes the decision a no brainer.

    Were it me, I'd take the hybrid approach. Lump sum invest in a taxable account and contribute $4k a year into a 529. I'm not sure I'd take capital gains to fund the 529 each year though. Just out of your normal cash flow (i.e. divert money that'll be taxed anyway and you'd be investing some other place else).

    ReplyDelete
    Replies
    1. "In regard to a scholarships, you're allowed to pull out the dollar equivalent of the scholarship penalty and tax free from your 529."

      I'm not so sure about that tax bit.

      "Congratulations on your daughter's scholarship! When you take money out of a 529, earnings and contributions are withdrawn proportionately. Usually, you'd owe income taxes and a 10% penalty on earnings that aren't used for qualified education expenses. But you can withdraw money from a 529 up to the amount of a tax-free scholarship without paying the 10% penalty. You still have to pay income taxes on earnings, but contributions can always be withdrawn tax- and penalty-fee."
      https://www.kiplinger.com/article/college/T002-C001-S001-the-529-plan-scholarship-exception.html

      The switch to making the gains taxable as income, instead of more attractive capital gains rates, is a pretty significant downside in my opinion. This distinction is one of the major reasons we're wary of a 529.

      I totally agree that with the Indiana benefit of a 20% credit, it's a total no brainer. With AZ's plan, there isn't really much of a tax savings.

      As you noted, I think after year one there isn't much of a reason to move the funds from the taxable (pay 15% capital gains) to avoid state income tax (3.32%). Now, there may not be much gains in one year so there's a scenario where it makes some sense...but the max net return is 3.32% and it's probably less than that.

      Delete
  2. Most importantly....undeclared was an awesome series I need to rewatch that as I loved every episode.

    I'm in PA and here we get get 3.07% but it does have 2 different plans. One plan they call the guaranteed plan where you essentially get credits that correspond to the rise in credit price year over year. This is different that true market type investing. It's nice when the kids are in high school and you don't want to risk principal.

    I personally wouldn't single deposit it seeing how every day is so volatile for the last 2 months. I know you can't market time, but every time I hear today is the biggest whatever change (down) in history I put more money to work. So I dollar cost average, and dump slightly bigger chunks on big down days. Deposited 3 times in Dec 18

    ReplyDelete
    Replies
    1. Hey Chris! Yes, Undeclared was an awesome show. I might be looking at the library for seasons of DVDs now that I've learned it isn't streaming anywhere.

      The PA model has some attractiveness but I'm not entirely sure we want to lock in Baby AF to going to the local universities here in AZ. They're...not great.

      I think we may split the difference on the lump sum: do maybe half all at once, then DCA the rest over a year or three. It's a hedge and therefore can only be second best, but it won't come in 'last'.

      Delete
  3. We’re expecting our kiddo will have some baby soft skin in the game as well ;) My family COULD have covered all of my college costs, and while sometimes I still wish they did, I think ultimately it was a better deal to have me pay for part. I was way more incentivized to make college cost as little as possible and paying off my student loans got me involved in the personal finance community for the first time and taught me how to seriously save (pay off debt) that I’m not sure I would have learned had I come out of college with a positive net worth.

    All that said, I’m still waffling about best avenues to save those partial funds for the kiddo. I haven’t opened a 529 though because of the restrictions in place, but I keep wondering if we shouldn’t at least put a small amount in one.

    ReplyDelete
    Replies
    1. Hi Angela!

      Yeah, we're similarly on the fence. I think maybe $4k for the first year and, then, maybe no more. Though, honestly, with that small of an amount, what's even the point?

      We have the exact same philosophy with our kiddos. We want to show them this money is 'theirs' no matter what, so they hopefully use the incentive of keeping it for something else (business, home, etc.) to go out and get scholarships/grants. We'll see!

      Delete
  4. I'm not a parent. But often wonder how parents decide. Seems to me the AZ tax credit is pretty minimal. I would rather have the flexibility of a taxable brokerage account.

    Reminds of a Director who I used to work with at a previous company. He had two little ones at the time we worked together. He said he was saving up an x amount. And the direction to his kids will be you can use the x amount to go to college, start your own business, get married, or pay for a down payment for your house. That's it. His kids would get to decide to use the money in a positive way. If they used up all the money through college, they would be on their own for a wedding, etc. This way he hopes, he can create the incentive for his kids to save money and make good decisions.

    I thought this was a brilliant idea.

    ReplyDelete
    Replies
    1. Hey there, SFL!

      We're leaning towards the taxable account too. The flexibility is too choice to give up for a tiny tax benefit. If we lived in a state with a high income tax, or other tax benefits, it might be a different story.

      We're planning on doing the same thing as your Director friend: we want the money to be there for Full Grown AF, but it doesn't necessarily have to be for college if he finds a cheaper school and/or a free ride somehow.

      Delete
  5. We have a 529 through our state. It is quite literally the only nice money thing I have to say about Illinois. We use Bright Start but it's in Vanguard funds.

    I know it's a gamble that he might not go, but it's unlikely that there won't be some kind of educational cost. I assume (and I could be entirely wrong) if higher ed gets the massive overhaul that some people predict, 529s will have to change at least slightly too.

    But worst case scenarios? Mama gets her doctorate! WOOT!

    So I guess I have nothing helpful to say ;)

    ReplyDelete
    Replies
    1. Hi Penny! I think if Mrs. Done by Forty didn't already have her PhD, that other scenario might be more attractive to us because, like you said, the parent getting a degree ain't so bad!

      And I think you are probably right: there is very, very likely going to be enough costs to eat up the whole 529. I'm probably being way too optimistic for Baby AF's scholarship opportunities, but I think I'm just wired that way. Hope springs eternal. ;)

      Delete
  6. Go Hybrid, my brother. Nice that AZ offers that incentive on the 4K. Take that, then put the rest in a taxable account. Or, if you were an old fart like me, who'll be 59.5 right when the kids turn 18, you could put the other half of your dough into a straight up IRA. Good luck - I'm with Jeremy GCC on this one.

    ReplyDelete
    Replies
    1. Hey there, Cubert!

      I might do that, though the incentive (just over a hundred bucks in avoided state income tax) is pretty paltry. I suppose putting $4k in is no big commitment either.

      I'm not that far off from you. Still old fart status, as I'll be 56 when Baby AF is 18. Sheesh!

      Delete
  7. I’m typing this quickly while on a work break but FWIW, the “moneyed-class” view on this subject is generally speaking, “maximize your 529”, which means generally-speaking, $30K/year/child (2 parents, each of which can contribute $15K). You can do this all the way up to whatever each state’s plan maximum is, but you can invest in more than one state plan, so there is effectively no actual upper bound (other than 50 * $max/state).

    Why is this the view? Because if you’re going to pay most or all of your child’s education expenses anyway (assumption), then you should do it with a shit-ton of tax advantaged dollars. The state benefit is only a “nice to have”. It’s the 18 years of tax-exempt investment growth that is key here.

    After this principle of “we’re going to pay” is accepted (or rejected, that’s a fine decision too), then you’re just down to exception handling decisions:

    - What if kid gets scholarship? No problem, you only have to pay tax on the gains (10% penalty doesn’t apply) and even then you can strategize around timing. Also, don’t forget that 529 funds can also be used for housing, etc, which are ~50% of the college costs.
    - What if you have other vehicles for tax advantaged investment (e.g., IRA’s)? Those are usually capped. It’s okay to invest in them first if you prefer but they usually don’t go far enough or shelter enough. 529’s provide an almost unlimited relief valve (only capped by your expected college payout figure…$500K is probably a good number to use).
    - What if I retire early and thus don’t “really” need the tax breaks? This is where it gets hypothetical and tricky (and you’re sort of on your own to guess at this). FWIW, the “moneyed-class” don’t retire early, they keep making money in some fashion or another, money that needs tax breaks all the way until they die and give it to their kids (also in a tax-advantaged way).

    Why do I keep talking about the "moneyed-class"? Because I'm on a mission to show Trump voters that there is a whole other level in which these types of discussions take place and that they are being screwed and most of them don't even know it. They're so worried about folks coming at them from what they perceive as below (immigrants) that they are totally missing what is coming at them from above. I came from a lower-class family myself and now I'm fortunate enough to see and interact with this "moneyed-class" world.

    ReplyDelete
    Replies
    1. Hi Tin! Thanks for the very thoughtful comment!

      "Because if you’re going to pay most or all of your child’s education expenses anyway (assumption), then you should do it with a shit-ton of tax advantaged dollars. The state benefit is only a “nice to have”. It’s the 18 years of tax-exempt investment growth that is key here."

      Tax free growth is no small advantage. But early retirees do have tax free growth if their income is low, too.

      As you note, most early retirees keep earning money, it seems. I really don't plan to but I'm at least not dumb enough to think I can accurately predict my next 20 years. I indeed might work quite a lot!

      In that case, I can continue to contribute that future earned income to a 529 though, and just earmark Baby AF's "college money" to FI money easily enough: both are just taxable accounts.

      You've certainly given me something to consider though. As you noted, people who earn a lot tend to keep doing so. Maybe I will, even when 'retired'...

      Delete
  8. The "common wisdom" five years back seemed to be 529 all the way and we dumped A LOT of money in there but in the past year, I've been rethinking that strategy. There are so many unknowns - will JB go to college, which one, will ze have scholarships, etc., that make me think we'd be far better off putting future money into a taxable brokerage so we have freedom of choice. I'm penalty averse, clearly, but also if I'm going to be charged income tax on it, I'd rather be charged that without a penalty, if that makes sense.

    We get zero tax breaks here in CA so in some ways that really simplifies it for us, but I'm great at overthinking things so ... I'd go minor hybrid and mostly invest in a taxable brokerage.

    ReplyDelete
    Replies
    1. Hi there, Revanche! I also am thinking a very light hybrid with most in a taxable account. I suppose I may regret the decision later on if we get a ton of gains and are somehow in a high income tax bracket still in 2037.

      To be honest, I don't know if you'll really regret putting a lot in a 529 because the alternative is so similar: both are really just good options that might be marginally better in scenarios we can't predict. But both are still pretty sweet deals for the kiddos.

      Delete
  9. You should check with your 529 plan. I think you can contribute say $20,000 and take the tax deduction over 5 years. I could be wrong about this, though. Each state has its own rule on this.
    I'm all the way in on the 529 plan. So what if our kid doesn't go to college. One of our nephews and nieces will. An education fund will always be useful. Good luck.

    ReplyDelete
    Replies
    1. Hi Joe!

      I'll look into whether we can invest a lump sum all at once and spread out the tax benefits over multiple years. I'll admit that I'm leaning more towards skipping the 529 altogether or dipping my toe in the water for just one year's contributions. I'm just not sure that, in my low tax state and our relative closeness to FIRE, that the juice is worth the squeeze.

      Delete
  10. Congrats on the sale of your rental properties at a profit! Actually, what you did seems to be tougher than just managing rentals...which is to basically do a flip out-of-state. I may have to contact you to see who you dealt with since I might be interested in the Indy Market!
    As for the 529 plan, we just put in a small amount monthly though we never had to decide with a large lump sum. Personally, I would go with a mix. I don't want to commit that much to a 529 plan...who knows what will happen in the future. Plus, if you're FIRE, maybe you get a good amount of financial aid...isn't that Justin's (ROG) plan?

    ReplyDelete
    Replies
    1. Hi Andrew!

      Sure, let me know if you're interested though, I should state that the rentals didn't perform all that well (maybe a future post will show just how mediocre the were). The real profit was made on the flip, whatever that means. The property manager is also the real estate agent & managed the flip: much cheaper than I thought it would be, for what it's worth.

      I try not to read Root of Good, but maybe I'll make an exception to learn about this financial aid approach. ;)

      Delete