Dear Parents: Follow The 50/50 Rule for College Saving

After a few real-life conversations and my running the math, I’ve decided that a “50/50” rule for college saving achieves the best of both worlds.

The rule is:

• ~50% of your college savings goals should be saved via a 529 plan.
• The other ~50% should be saved via a taxable brokerage account.

Why is that the case? Let’s discuss what we do and don’t want from our college savings plan.

PS – if you want further background reading on 529 plans, here are some other useful articles…

• 529 Plans: A Complete Guide
• The Important Details Behind 529-to-Roth Conversions

What We Do and Don’t Want from College Savings

• We do want to save for college. Ground-breaking stuff.
• We do want to reduce our income taxes.
• We do want our investments to grow tax-free.
• We do want flexibility while we save, in case life throws us a curveball.
• We don’t want to end up with permanently frozen assets. We don’t want “leftover” 529 dollars.

529 College Savings Plans offer some of these ideals. But not all.

In fact, 529 plans are terrible at achieving some of the abovementioned goals.

Reducing Income Taxes

Many states offer income tax deductions on 529 contributions. In New York, for example, the first $10,000 contributed to 529s per year is exempt from state tax. That’s a ~$600 annual savings (depending on tax bracket).

Tax-Free Growth

529 investments grow tax-free, just like 401(k) or IRA assets. There’s no annual tax on dividends and interest. This leaves more dollars behind to compound.

Let’s Measure That Tax Savings

If we apply these two tax advantages to a reasonable scenario**, it’s realistic to expect a 529 account to result in 15-20% more dollars for college than a taxable brokerage account.

**see this Google sheet for detail.

But taxable brokerage accounts have distinct advantages on our other ideals.

Flexibility & “Frozen” Assets

Taxable accounts are very flexible. You can withdraw from them anytime (e.g. during an unexpected emergency). 529 dollars, on the other hand, must be spent on educational expenses and cannot be withdrawn for other reasons.

What if your kid decides to skip college? Unused funds in a 529 can be impossible to withdraw without taxes and penalties. Taxable accounts avoid this situation.

What’s the 529 Withdrawal Penalty?

Every 529 withdrawal—whether for education purposes or not—is made pro rata between your contributions and your earnings. The contributions are never taxed and never penalized, but the earnings can be if your withdrawal is not for a qualified educational expense.

For example:

• Your 529 plan has $100,000 of contributions and $50,000 of earnings. (Two-thirds and one-third)
• You make a $30,000 withdrawal. You have no choice in that $20,000 will come from contributions and $10,000 will come from earnings (Two-thirds and one-third)
• If your withdrawal is not for qualified education expenses, the $10,000 earnings portion will be taxed as income (more marginal tax dollars, ouch!) and will suffer a 10% penalty.

If you run the math, you’ll see this penalty eats away at all the 529’s tax benefits. You do not want to suffer this penalty.

Finding Balance Between 529 and Taxable

The question is how to balance these various pros and cons. The 50/50 Rule does so!

Let’s say you aim to gift your children $100,000 over their four years of college. How generous! I submit you should aim to have:

• $50,000 of that gift coming from a 529
• And $50,000 from a taxable brokerage

You know it won’t be a perfectly ideal scenario. Whatever reality throws at you, you’ll wish you had decided to go all-in on the 529 or all-in on the taxable.

But you don’t know the future! This fact – that we’re more mortals without a crystal ball – is one of the fundamental frustrations in financial planning. If we knew the future, we could make a perfect financial plan. But we don’t, so we can’t. Our best solutions, therefore, involve hedging our bets. We’d rather know we’re 50% correct than be surprised later we’re 100% wrong.

The 50/50 Rule guarantees a middle-of-the-road solution. You’ll capture tax benefits and retain flexibility.

If Johnny gets a little scholarship and only needs 70% of your saved money, great! Use the 529 dollars completely. Dip into the taxable account when needed, and keep the remaining taxable dollars for other goals in life. You’ll be confident your 529 account will be completely drained, avoiding frustrating taxes and penalties.

But FAFSA!?

An anonymous person wrote in after I first published and said,

This doesn’t factor in how FAFSA treats these accounts differently.

That person, unfortunately, is wrong. FAFSA (the Free Application for Federal Student Aid) treats 529 assets and the parents’ taxable assets precisely the same.

FAFSA’s goal is to understand a family’s income and assets and appropriately calculate how much a family should be expected to contribute to college costs (this is called the expected family contribution, or EFC).

The FAFSA treats 529 accounts and taxable accounts precisely the same. Up to 5.64% of those accounts go directly to calculating the family’s EFC.

Does It Have to Be 50/50?

I’ll admit: dividing the two accounts down the middle, 50/50, is an easy shorthand. You can choose a different fraction. But when thinking it through, my primary concerns are:

1. You need to be confident you’ll drain the 529s. If Johnny’s college will cost $200,000 and you aim to have all $200,000 in a 529, I don’t like that. There’s no margin for error.
2. You want to have a large enough portion in the taxable account to provide “just in case” flexibility.

Maybe 75/25 makes more sense for you. I can get on board with that. But I wouldn’t go much higher than 75% from the 529.

Working Backward

You can work backward from your future goal to discover what today’s saving rates need to be. In our hypothetical scenario of $50K in a 529 and $50K in a taxable (for college in ~15 years, we’ll say), a reasonable starting point is to put $2000 per year (or ~$170 per month) into each account. That’s how the math shakes out.

Depending on your timeline and assumed rate of compound growth, a simple spreadsheet or question to your financial planner will inform what your savings plan should be.

Thank you for reading! If you enjoyed this article, join 8000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.

-Jesse

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