Peter addresses a listener’s question about making 529 withdrawals while the stock market is down.
Listen now and learn:
- The best way to invest your 529 savings
- How to manage 529 withdrawals during a market downturn
- How Peter manages his own 529 plan for his two kids
Read the detailed show notes below and find links to resources.
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Show Notes
In today’s episode, I want to address a listener’s question about making 529 withdrawals in a market downturn. As a reminder, you can submit questions to me by visiting TheLongTermInvestor.com or by replying directly to my email newsletter that I send every other Wednesday.
Here is the question:
My wife and I have been saving into 529 accounts for our two kids, ages 8 and 10. We’ve always contributed up to the maximum amount we are able to deduct from our state taxes, which this year as a married couple is $16,000. The assets are invested in one of the age-based investment options offered by the plan.
Because markets have mostly gone up during our kids’ lifetimes and we’ve accumulated some fairly nice balances, we’ve gotten in the habit of paying for a portion of their private elementary school tuition from these accounts each year.
We have a tuition payment coming up, but I’m worried about making a withdrawal from my 529 account that requires selling while market prices are down. How would you think about this?
What’s really interesting to me about this question is that most 529 questions are more directly related to college expenses, but this has a few other dimensions to it.
Just to level set for everyone, a 529 savings plan is an account that allows your savings to grow tax-deferred and withdrawals are tax-free when used for qualified education costs. Many states even offer state income tax deductions on contributions to a state-sponsored plan.
A 529 account can be used to pay for qualified education expenses at eligible U.S. and non-U.S. education institutions including private elementary and high schools, trade and vocational schools, two-year and four-year colleges, and postgraduate programs. Qualified expenses include tuition, room and board, books, supplies, fees, equipment, computers, Internet access, and computer software.
Ultimately, the tax-free growth and withdrawals from a 529 for qualified expenses allows your savings to compound faster, making it easier to fund your education goals (which in turn makes it easier to fund your retirement goals).
What’s the Best Way to Invest a 529 Plan?
Now to dig into the listener question more specifically, I think we have to start by talking about what’s the appropriate investment strategy for a 529 plan.
There are typically three options you will see inside a 529 plan:
- Age-based portfolios in which the mix of stocks and bonds will automatically adjust based on the child’s age over the life of the plan. As the child gets close to college, these portfolios shift away from riskier assets like stocks and towards more conservative assets such as bonds or cash.
- Static portfolios offer a predetermined asset allocation that will not change over time unless the investor manually chooses to reallocate to another portfolio. Sometimes these portfolios will be listed according to their stock/bond mix (like 80/20 or 60/40) while other times these static portfolios will be called something Growth, Moderate, Conservative, Income, etc.
- Custom portfolios allow the user to build their own allocation using the funds available on the state plan’s platform.
Generally, I’m a fan of the age-based portfolios because they are essentially a “set it and forget it option,” which is valuable because parents are too busy with other things to regularly think about whether their 529 plan assets are invested appropriately.
They aren’t terribly different from a Target Date Retirement Fund. They’re usually low-cost and well-diversified. But most importantly, they automatically transition towards bonds and decrease the expected volatility of your portfolio as your child approaches college. That way, when the market is down like it is today, you are less likely to need to sell at a loss.
Now, this listener is using an age-based plan, but the portfolios are being used for current year private school tuition. So I would argue that this particular person does not have their 529 allocated appropriately.
Here’s what I would do instead:
You are allowed to withdraw up to $10,000 from a 529 for K-12 tuition. This couple is making contributions of $16,000 to capture the full state tax deduction.
I would suggest opening a new 529 account that is solely for the $10,000 withdrawal. Then you would make $10,000 of contributions to that account each year and have it allocated 100% to cash or money market accounts. In doing so, you are giving up the potential for growth, but you are locking in the certainty of your cash being there when you need it in the next 6-12 months – all while capturing the state tax deduction. So in many ways, this account is just a pit stop for your $10,000 K-12 tuition withdrawal that allows you to pick up a tax deduction in the process.
Then I would add the other $6,000 to the existing 529 accounts, which are intended for college, and continue allocating those accounts to age-based portfolios.
My wife and I actually do something like this ourselves. Our kids are 9 and 5 years old. With our oldest child, we started contributing a 529 when he was born and invested in an age-based portfolio that was nearly all stocks. Once he reached Kindergarten and we decided to send him to private school, we opened a second 529 to make recurring contributions that totaled to $10,000 over the course of the year.
We actually never opened a 529 for our second child until we set up this “cash 529 account” because we figured that any money left over from his brother’s account after college would be used for his tuition since you can change the beneficiary to a different family member at any time.
But now that we were funneling $10,000 to an account for his older brother’s eligible K-12 tuition withdrawal, we opened an account for our youngest and began directing the remaining $6,000 of our annual contributions into his account. In that account, we are also in an age-based option, which is almost all stocks since he is another 15 years away from college.
How to Manage 529 Plan Withdrawals During a Downturn?
So how should people think about making withdrawals from their 529 when the stock market is down?
If you’re in an age-based portfolio and you’re making withdrawals for college tuition, you’re probably in decent shape. Bonds are down this year, but most age-based options for college-aged students are a conservative mix of bonds and cash, so the losses should be minimal.
If you are in a 529 allocation with more stock exposure, then making withdrawals for college expenses is a little trickier.
One thing to note is that your 529 withdrawal doesn’t need to be made at the exact same time as your tuition payment – it only has to be made during the same tax year.
If you’re paying for college tuition and can afford to make the tuition payment using your income, then you can wait and see if the market recovers before the year is over. If it does, then you could make the withdrawal in December.
You also need to consider your future education expenses relative to the size of your 529.
If you have more than enough to fully fund all your kids’ college expenses, then I would be more inclined to say make the withdrawal now and not worry about it. On the other hand, if you have a smaller balance than what is needed to fund all of your kids’ education (including those that perhaps are still in high school or younger), then I’d wait to make a withdrawal and give the market time to recover.
My suggestion for the listener who is making K-12 tuition payments from their 529 would be to hold off using the funds unless you absolutely need to use them to make ends meet.
If you can afford to pay the tuition out of pocket, then you ought to at least wait until the end of the calendar year to see if the market recovers.
Longer term, I’d suggest that this listener should open up a new 529 that is solely for contributing $10,000 of cash each year and let the existing 529 accounts be solely for funding college expenses.
Resources
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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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