State Tax Deductions and Choosing a 529 Plan
If you spend enough time around working stiffs–at least those with kids–sooner or later you are bound to hear the lament: “I’ll never be able to retire … until my kids are through college.” I can understand the surface logic here; college costs are so out-of-control expensive that it makes senses to intuitively presume that you would have to have a big fat wage check coming in every month in order to fund this behemoth of an expense. (This feeling would only be exacerbated if you are someone that already spends nearly every bit of what you earn each month.) But this thinking is flawed. Like most of the other intimidating large expenses in life, this one can be planned around to minimize the impact on your entrapment period. Unfortunately, however, I have a suspicion that a lot of Working Joes subconsciously use the worry over college costs to justify a consumption lifestyle that ensure they will be trapped in work for decades to come. The thought goes: “Well, since I know that I can’t retire until after my kids are through college, and that’s a long way off, I’ve got plenty of time to save money. I’ll worry about that later.” But the mathematical reality is that if you begin saving early (and often) you can put yourself in a position–much earlier than age 65–to not be shackled to a paycheck in order to fund college expenses for your kids. (Note here: while this discussion starts with the presumption that we want and need to save money for our kids’ college expenses, I am a firm believer in the idea that children should bear some of the economic burden of their college education, thereby creating the incentive effect of having “skin in the game.” But that’s a discussion for another post.)
This is where so-called “529 accounts” come into the picture. Conversationally titled by reference to the section of the Internal Revenue Code that created them, 529 accounts are–at least for most long-term college savers–the superior tax-advantaged vehicle of choice. (Don’t be confused if you see the term “qualified tuition program.” That’s the technical term that the tax code uses.) They are also a strange breed of animal–in fact it may be more appropriate to think of the lot as a hodge-podge of distinct exotic animals, each with its own unique characteristics and quirks, but still sharing the same basic federal tax advantage. (Another note: 529 accounts are not the only tax-advantaged savings vehicle in the barn. Coverdell accounts are another frequently used tool, as are plain-vanilla Roth IRA accounts. Each of these have unique advantages and features that can make them more or less attractive to savers in different situations and with unique objectives.) The primary features that differentiate one 529 plan from another are:
- The Plan Manager or Administrator: Each 529 plan is sponsored by a state (e.g., New York, Nevada, Utah, etc.). The state chooses a manager or administrator to run the plan–these are often firms that you have heard of like Vanguard, Fidelity, or TIAA-CREF. (Note that some plans, such as the Nevada Vanguard 529 plan that we use, employ a manager that operates behind the scenes to take care of administrative duties, while an apparent manager such as Vanguard is used as the interface with the investor. I still refer to Vanguard as the “manager” of the plan in this type of situation, even thought that is technically incorrect.)
- The Investment Line-Up Inside the Plan: The administrator of the plan chooses the investment products or vehicles that are available to you as an investor–you don’t get to pick them yourself. Which I hate. But you do get to pick from the line-up they offer (which can be a rich buffet of options or a meager fixed menu).
- Expenses: Like other investment products such as mutual funds or ETFs, your money will be subject to expenses underlying the investments you choose as well as any expenses imposed by the 529 plan itself. Look to compare plans on the basis of an “all-in” expense figure so you are comparing apples to apples.
- State tax benefits: The primary advantage to using a 529 plan to save for college is the federal tax advantage extended to these accounts–they function like a Roth IRA for your college savings (you put in after-tax money and all the gains you pull out in the future are tax free), but with no contribution limits based on income. So the federal tax advantage is a given. But some 529 plans will also afford a state tax benefit, typically to residents of the state sponsoring the plan (note: to be clear, this is a benefit extended by state law, not by the 529 itself). The benefit is typically a deduction against your state income tax, capped at a certain amount (i.e., the deduction is capped at a certain amount but your contribution is not). My particular state allows a deduction against state income tax up to a ceiling amount per beneficiary per year for amounts contributed to my state’s 529 plan (and NOT to another state-sponsored 529 plan).
- User Interface/Client Access: I like to feel confident when I transact business over the Internet that the systems I’m using are trustworthy and intuitive. This is not a security issue–I (maybe somewhat naively) presume a minimum level of security in online financial transactions with reputable parties. What I’m referring to here is a user interface that makes very clear what I’m doing with my money and how to do it. So I care about the user interface of the plan that I interact with, and I prefer to not send my kids’ college savings money off to an administrator on the other side of a site that looks and feels like it was thrown together in 20 minutes in the basement.
On the basis of my analysis of all of these factors I have been investing our college money in the Nevada 529 plan administered by Vanguard (surprise!) since 2005 when our first child was born. It has consistently been highly rated in the reviews that I read, presumably because it offers a wide-range of low-cost Vanguard index funds and layers on very little in additional plan administrative expenses. Because it is managed by Vanguard (see disclaimer above) it also shows up as an additional account (or in my case, three accounts) on my Vanguard accounts home page, making it easy to monitor and manage along with our other Vanguard investment accounts. Way back in 2005 when I first needed to assess various 529 plans my state plan sucked so bad in terms of investment options and expenses that I did not even consider it as a remotely viable option.
Changed Circumstances Require a Review of Prior Decisions
Fast forward to this month, April 2017, and the preparation and filing of our 2016 tax returns (federal and state). Last year was an interesting tax situation for the Joe Freedom Household because I left my high-salary law job in June and declared myself semi-retired and self-employed. So we had fairly high earned income for the first six months of 2016, and … well … not so much self-employment income for the second half of the year. As a result of Schedule C losses, capital loss carry-forwards from prior years (from some tax-loss harvesting), and tax credits that were newly available to us (as self-employed individuals with lower taxable income amounts) including the child tax credit and an ACA tax credit, our federal tax liability was a negative amount (the ACA credit is a refundable credit). Our state tax liability, however, was more than $2,000! This was the result of the fact that in our state tax calculation we do not get the minimum 0% rate on long-term capital gains and qualified dividends (these amounts of taxable income are subject to essentially a low flat rate of income tax in our state), and we did not receive any of the credits that we received on the federal return (almost $5k between the child tax credit and ACA credit). The idea of having a negative federal tax liability and a $2k state tax liability really sticks in my craw, so I went looking for (valid) state tax deductions. Since it was March/April 2017 (after the 2016 calendar year had ended) my options were limited. The obvious choice was to re-evaluate my state’s 529 plan since a deduction is available for contributions made for the prior year up to the due date of the return (for 2016 this is April 18, 2017).
So I skeptically revisited the details of my state’s 529 plan, and I was initially pleasantly surprised. That is to say, it was not an immediate and automatic “no way” like it was back in 2005. First, my state had recently doubled the cap on the contribution amount that could be deducted for state tax purposes–just what I needed! The state tax deduction was introduced a few years ago after I had begun with our Nevada Vanguard plan, but the deduction caps limited the total benefit to around $350/year in state tax, which at the time was not worth the hassle of even re-evaluating the plan. But now with the increased deduction caps that effectively doubled the tax benefit and, well, my surplus of time that results from not being enclosed in an entrapment chamber (a job) for 12-14 hours a day, I took a few minutes to dig in.
Management and Investments
My state plan is currently managed by TIAA-CREF. I do have some degree of respect for TIAA as an institution but, well, it isn’t Vanguard. Nevertheless I did not rule it out on this basis–I have been forced before to keep substantial sums of money with institutions other than Vanguard (in an employer-sponsored 401(k) for example) and it was not the worst thing in the world–and I do still keep some of our investment portfolio at other custodians (Fidelity and Schwab) by choice, just for a little bit of custodial diversification. So I moved to the investment options. There were six options, including: (1) an age-based portfolio, (2) a “guaranteed income” portfolio, (3) a “balanced fund,” (4) a fixed-income fund, (5) an all-equity fund, and (6) a money market fund. I generally do not like age-based portfolios because I prefer to keep manual control over our portfolio allocation, so that was out. (I did consider it briefly but when I saw that it would put roughly 20% of the college savings for my 6-year-old in fixed income, that ended the conversation.) The “guaranteed” option guarantees an annual return between 1 and 3% based on some form of insurance contract. Out. The balanced fund holds 50% of the portfolio in fixed income. Out. The fixed-income option holds 100% in … um … fixed income. Out. The all-equity fund holds one mutual fund–the TIAA-CREF Equity Index Fund (TINRX). This doesn’t appear to be a bad option for US equities, but it’s only US equities. So if you happen to want any international equities in the portfolio (as I do), you’re out of luck. And obviously the money market fund was not an option for long-term money. At the end of the day these options were not per se awful but they did not suit my portfolio needs and preferences. With a time horizon of between 7 and 16 years for all of our college money, I’m still 100% in equities, and I want 30-40% of that in international stocks right now. While I could have built a composite portfolio comprised of more than one of the options discussed above in order to gain some international exposure, it would have been much less than my target of 30-40%, and the difference would have been put in fixed income. Not a trade I want to make right now.
The all-in expense figure for the investment options that I was considering ranged between .19% and .28% of assets per year. Not too bad, but still not as good as the .17% that I pay Vanguard for the exact portfolio that I want.
By the time I reached this factor the decision was already made. Nevertheless I noted that while the web portal for my state plan is a bit clunky, it likely would have proved serviceable if not acceptable.
In the end I simply could not bring myself to leave the warmth and comfort of the Vanguard security blanket–not even for about $750/year and what would have been a roughly 37.5% reduction of my outrageous (in my mind) 2016 state tax liability. My Nevada Vanguard plan lets me use Vanguard investment vehicles that I am intimately familiar with–VTI and VXUS (or the mutual fund equivalents)–and in the allocations that I desire. The fund allocates 40% of the assets to the Total International Equity fund, and after having ridden out a number of years now of sub-par performance from the international side of our equity portfolio, I’m certainly not going to give up now and effectively sell at (or close to) a low point. To miss out on what I fully expect to be over-performance years for international equities in the coming periods could cost us much more than the $750/year in state tax savings. The .17% all-in expense ratio is close to rock-bottom in the 529 space, and I also get the continued convenience of managing my three 529 accounts right from our existing Vanguard dashboard along with our other accounts. In sum, I concluded that to change from the Nevada plan now just for a marginal state tax break would be penny wise and pound foolish. (Oh, and for you arm-chair tax planners out there that are thinking “why not just contribute to the state plan, get the deduction, then move the assets over to the Nevada Vanguard plan?” That’s a no-go, stroker ace. My state has a claw-back feature that requires an inclusion in income for any rollover distributions from the plan equal to prior-year deductions. Damn. I tried.)
The 529 plan is a big part of the financial independence game if you have kids and want to contribute in a meaningful way to their future college costs. But you need to start early and maintain disciplined saving over your working years. I simply automated the monthly contribution amount with Vanguard and forgot about it. My rough plan is to have between $100 and $150k per child when all is said and done. (Note here: because of differences in market performance over the differing time periods, I expect that significantly different contribution levels to each of my three accounts will be able to yield substantially identical future values at the various matriculation dates. That’s my goal.) By setting up these accounts within days of each of our three kids’ births (literally as soon as I received SSNs), and then aggressively and diligently contributing during my entrapment years (at the “cost” of foregoing current consumption), I was able to largely neutralize the otherwise confining spectre of future college costs on my objective of achieving financial independence.