Payments to Make Before Contributing to a 529

[Beltway Explorers]

Would love some input on what my financial priorities when it comes to contributing to my one year old daughter's 529 account. We are already maxing out our retirement contributions, but after that does it makes more sense to make extra mortgage payments, 529 contributions, or student loan payments? We live in a state where we can get up to $8,000 per year in state tax credits with the 529 (although I think I'm more comfortable with about half of that amount).

Any words of wisdom from those who are in the trenches with college students?

 

[Matt]

Would love some input on what my financial priorities when it comes to contributing to my one year old daughter's 529 account. We are already maxing out our retirement contributions, but after that does it makes more sense to make extra mortgage payments, 529 contributions, or student loan payments? We live in a state where we can get up to $8,000 per year in state tax credits with the 529 (although I think I'm more comfortable with about half of that amount).

Any words of wisdom from those who are in the trenches with college students?

What State? I just want to make sure we are on the same page regarding the word 'credit'.

 

[ukinny2000]

I am going to hazard a guess that from your user name you might be in Virginia? If so, it is a state deduction of $4,000 per person, not a credit

 

[Beltway Explorers]

I am going to hazard a guess that from your user name you might be in Virginia? If so, it is a state deduction of $4,000 per person, not a credit

Yes, that's correct ukinny. This is why I have a professional help me when taxes are due!

 

[Matt]

Yes, that's correct ukinny. This is why I have a professional help me when taxes are due!

Therefore the questions you need to consider:

• How much state tax credit would you get for $4000 of contribution?
• How much you are paying in APR on Mortgage, and on Student Loan?
• How much will Federal Tax increase if:
  • You don't take the State deduction
  • You pay down the mortgage
  • You pay down the student loan

The first 2 bullets aren't that hard. For the state tax in Virginia you pay 5.75% on income above $17K. $4000*5.75% = $230... that is what would be back in your pocket for getting the deduction off state. But that said, you'd also lose a bit of that because State taxes are deducted against Federal, for 'back of the napkin', I would reduce the $230 by 20%... so lets say $184. If your effective Federal tax rate is higher than that, use that instead of 20%

• Then let's divide $184 by $4000, as a percentage this is 4.6%
• Then take the mortgage rate and multiply it by 1-tax rate (I'll use 20% again, you use your real rate) so maybe 4%*.8= 3.2%
• Then tax the student loan rate and multiply it by the same (1-tax rate) so maybe 6%*.8= 4.8%

I would then look for the highest percentage, and that would be my strategy for order of payments. In this case you would save 4.6% via a rebate from taxes, but if you paid the student loan, you'd save 4.8% in interest payments kept in your pocket. The variables are rate of loan and effective tax brackets.

You'll probably find that it doesn't really matter that much from an immediate savings perspective, so you'll start thinking about the other variables:

• How you react emotionally to being debt free?
• How you feel about funding (or not) the kids?
• The value of tax free growth in the 529... but the risk that it could decline in variable investments VS the guaranteed rate you get from paying off fixed rate debt in the mortgage or loan.

You also may wish to think about how each option impacts student aid. 529s are favorably treated, but do still count towards assets when calculating FAFSA and CSS eligibility, whereas the debt is not. IE if one person had no student loans and no mortgage but no 529 they should be considered more favorably than someone with the same amount of assets spread over these three areas. This isn't huge though, as salary/income seems more important than net worth for most weighted calculations.

 

[Beltway Explorers]

Thanks for the thorough analysis Matt! It does feel counterintuitive to start investing in future education when I'm still paying off my graduate school, but I prefer to make decisions based on data, so the formulas are a big help.

 

[Matt]

Thanks for the thorough analysis Matt! It does feel counterintuitive to start investing in future education when I'm still paying off my graduate school, but I prefer to make decisions based on data, so the formulas are a big help.

As a narrative, the way I look at it is if you are saving/investing while in debt you are effectively borrowing money to fund saving, which is kinda weird. The answer needs to be in the arbitrage between the borrowing rate (including tax advantages) and the saving rate.

In the examples I showed, the loan is smarter, but you'd also only need to earn 0.2% in the 529 in order to match that, which is doable even with these rates.

It really comes down to a philosophy in the end...

 

[Sesq]

I agree with Matt's analysis, but I will add a few nitpicks.

1. Depending on income the student loans may no longer be deductible, in which case you'd compare the gross loan's interest rate to the tax benefit + expected return.

2. If you are an AMT taxpayer you can use the gross state tax rate since you lose the deduction for state/local taxes in AMT.

I am in PA and pay AMT, so 3.07% tax benefit (up to $14K per beneficiary, per earner). The per beneficiary rule varies by state,but if I had tons of cash I could open 529 plans with for my wife and I as the beneficiaries with plans to change the beneficiaries to my children at a later date. Can be helpful if your state has that rule. Some states set there limit "per tax return" or "per taxpayer" which would prevent this type of bunching up. Given PA gives a 14K per beneficiary limit I sadly can't quite fund 4 accounts (2 kids, husband, wife) on my income. I then compare my expected return + state tax benefit to my after tax mortgage rate 3.25%*.66 [AMT is about 34% while the exemption phases out] or 2.15%. Needless to say I have been squirreling most of the excess cash into the 529 over the last few years.