As university costs increase at an average inflation rate of 8% a year, how does someone try to save for a college degree? Many financial advisors and journalists preach the importance of opening a state 529 plan. However, how many parents are actually fully funding these plans to pay for all four years? I’ll explain the drawbacks of the 529 plan further and why I started the Coverdell Education Savings Account when my kids were born. I consider it superior to the 529 plan in several ways, IF it is done right.
529 Plan Background
The 529 plan is a tax-advantaged savings plan created for individuals to save for a child’s education costs. They are known as “qualified tuition plans”. There are two types of 529 plans:
· Prepaid tuition plans
· Education savings plans
Prepaid tuition plans only exist in ten states so it’s not very common. I will focus on the education savings plan where individuals can contribute dollars into an account and will have to invest the proceeds. Since they are tax advantaged, the earnings in the account grow tax-deferred. Withdrawals are tax-free as long as it’s used for qualified education expenses. Every state’s plan is slightly different and you don’t have to open up a 529 plan in your resident state. I recommend researching your particular state’s plan to see if there is an advantage. Since I live in New York state, I will focus on that 529 plan. One of the advantages of the New York state plan is that contributions up to $10,000 have a state tax benefit if you’re married filing jointly ($5,000 if you are filing as an individual). You are able to deduct that amount from your state taxes but not your federal taxes.
The New York 529 plan provides two options:
1. You can set up a Direct Plan incurring a 0.13% total annual asset fee in addition to the expense ratio fees in the mutual fund. The Vanguard mutual funds in the New York plan charge very low expense ratios. However, the annualized returns have not been spectacular.
2. You can utilize an advisor who assists you with the investment options so you would incur higher fees. The type of share class you purchase determines the fees your investment incurs.
Many of the funds in the New York plan have not performed well since inception. The Vanguard Total Stock Market Index Fund has only returned 8.52% annualized since inception.
Many financial pundits including Warren Buffett who I greatly admire and respect recommend investing in a passively managed index fund like the Vanguard Total Stock Market Index Fund. When I analyze the cost of college tuition, it has unfortunately, increased at an 8% inflation rate. Even if we assume (maybe incorrectly) that the 529 Plan can generate a 10% annualized return, we will only achieve a real return of 2%. That percentage does not provide a saver any ability to grow their investment amount to a substantial sum unless they initially started with a large balance. In theory, I would need to deposit my child’s entire cost of their four years of undergraduate study now in order to keep up with college inflation. According to US News and World Report, the average annual cost of a private university is about $41,000 which is low compared to the cost of an Ivy League school. Thus, I need to deposit $164,00 today to cover 4 years of education based on the average yearly cost.
According to the College Savings Plan Network, the average balance in a 529 plan accounts is currently $25,128. Let’s assume that you just had a child and was able to deposit that exact amount into your child’s 529 plan. Assuming return of investments of 10%, here is a chart of where that balance would be in 18 years if you started with $25,128 vs $41,000 (current cost of the first year) and you decide not to invest any more assets into the 529 plan.
In 18 years, if college inflation is growing at 8% per year annualized, you’ll need $151,700 for the first year. If you manage to invest $25,128 when your child was born, you won’t have enough to pay for the first year. To cover the entire four years of education, you’ll need a total of $683,581.
What’s the Better Alternative to the 529 Plan?
I highly recommend setting up a Coverdell Education Savings Account which can be set up at any brokerage company. Unfortunately, many people don’t talk about this account. For the finance industry, nobody makes money from the Coverdell account. For example, in the New York 529 plan, the administrator and mutual fund company generate income when you invest through their program through the fees they charge. If you use an advisor, s/he makes money from it. In the Coverdell, you have the option to invest in any security including, but not limited to stocks, bonds, and mutual funds. Your brokerage company does not make money from you when you open a Coverdell account. If you select a mutual fund to invest in the account, the fund company does make money through the expense ratio.
The Coverdell Basics
The Coverdell is a tax-advantaged education savings account where the growth is tax deferred and withdrawals are tax-free as long as they are deemed qualified expenses. The IRS clearly defines the definition of qualified expenses in Publication 970. You are required to maintain good records in case of an audit. Like the 529 plan, you can use this to pay for private school from K-12 and college education costs. The Coverdell account must be used before the child turns 30 unless they are categorized as special needs.
The Coverdell has a contribution limit of $2,000 per child per year. Also, the person who contributes to the Coverdell account must make less than the modified adjusted gross income (MAGI) of $110,000 for an individual and $220,000 in the case of a joint return. IRS Publication 970 also explains the nuances with this account and the 529 plan which they call Qualified Tuition Programs (QTPs). However, since this is not administered by the state, you do not have any tax deduction at the state or federal level. Like the 529 plan, a big drawback is that the Coverdell counts against your child’s financial aid eligibility. Here’s an article highlighting that fact. You should consult with your tax advisor to thoroughly assess if the positives outweigh the negatives for your particular situation. If you are not able to contribute due to the income limitations, other family members or friends can contribute to the Coverdell account that benefits your child.
The earlier you start, the better. If you can start contributing to this when your child is born and continue to max out the annual $2,000 limit, you can start building wealth in the account sooner. Anyone familiar with the time value of money and compound interest will tell you the importance of beginning as soon as possible. In addition, the biggest benefit is the ability to self-direct the account to invest in any available asset in your brokerage account. The selection of your investments is the most crucial aspect to grow this account and I recommend you do it cautiously. I will tell you what I have done but this is NOT investment advice. You should invest at your own risk and conduct your own due diligence before making any investments.
How Did I Select My Investment?
I am very bullish on bitcoin and believe that the current price is not reflective of the recent bitcoin halving event which I spoke about in this article. I also believe the printing of fiat currency by Central Banks around the world might accelerate the adoption of bitcoin. When my first child was born, I opened up the Coverdell and purchased bitcoin in the account. There was only one method to purchase bitcoin easily into the account. I had to purchase the Grayscale Bitcoin Trust which is publicly traded under the symbol GBTC. Any bitcoiner will inform you that purchasing GBTC is not the same as owning bitcoin as a sovereign asset. Thus, there are inherent risks owning this through Grayscale such as custodial and management risks including some others. I recommend you evaluate them on your own to determine if this is right for you.
I don’t want my child to graduate with student loans. When I opened the Coverdell, I wanted to invest it in an asset that can produce asymmetric returns. When I fell down the proverbial bitcoin rabbit hole, I devoted my life to learning about the technology. Since I understood bitcoin better than Tesla, Alphabet Inc, and Apple, I decided to invest all the funds into the Grayscale Bitcoin Trust. For this account to work for me, I needed to invest in an asset that could produce a very high return. However, there is a risk that I could lose everything in this account. When I decide on an investment, I evaluate all the risks and assign a probability for each factor. Essentially, I try to de-risk my investment. You might understand another company better than me that could produce the same type of returns. I would recommend selecting an investment that you researched thoroughly for the Coverdell.
Followers of this Trust product will note that it has historically traded at a premium to the Net Asset Value (NAV). In other words, you are paying more for the assets held in the trust. Recently, the premium has been around 20% which is fairly low but the premium has dropped to zero in March of 2017 which I discussed here. By contrast, in December 2017, the premium peaked at over 100%. Historically, I have paid the premium when it was low in order to grow the Coverdell. This is another risk factor investing in this product. If a bitcoin ETF (exchange traded fund) is approved by the SEC (Securities and Exchange Commission), then the premium will disappear. Until then, the premium might possibly hold.
A pseudo-anonymous person named Plan B has created a stock to flow model that values bitcoin based on its issuance rate. According to his different models, he believes bitcoin could reach a high of $100,000 to $300,000 during the next bull run. Hypothetically, if bitcoin can reach the low-end price of his model, GBTC could generate a 10X return. It might be possibly higher if the premiums also increase. In theory, your initial investment of $2,000 might be worth $20,000. All that growth is tax deferred and the withdrawals are tax free as long as it is used for qualified expenses as defined by the IRS.
Now the Coverdell is not your only option to invest in your child’s education. The Journal of Accountancy recently published an article on utilizing your Roth IRA versus a 529 plan. I present this here to demonstrate there are other alternatives. You need to evaluate what the best option is for you.
My Brief Perspective on College Education
Many financial gurus discuss how student loans are good loans since you are making an investment in your future. However, I would counter that all loans are bad loans. Many students are graduating with such a burden from college debt that this is now a modern-day version of indentured servitude. Unless your family is able to pay for your college costs, I think there needs to be more discussion over the cost of a four-year undergraduate degree where students need to try to graduate debt free. Considering city/state universities that offer lower tuition, and/or schools close to home to avoid room and board are some ways to reduce the overall cost of college as well.
There are many methods to achieve this such as applying for scholarships and merit-based aid. However, if you don’t believe you can receive that, there are plenty of options to obtain a solid education without graduating with a debt burden. In my own experience, I made the mistake as an undergraduate where I had a few student loans to pay for part of my room and board. I could have paid it off sooner but stuck to the payment plan. When I went to graduate school, I would not repeat the same mistake. I decided to attend Baruch College because the education quality is high and the cost was affordable generating a high return on investment. I was able to work while attending school simultaneously. When I graduated, I did not have any student loans. This was not an easy task. In 2019, Kiplinger ranked Baruch College as one of the best college values with one of the lowest average graduating debt. The school has only about 14% of students who need loans and the average debt at graduation is $12,117. According to credit.com, the average college debt in 2019 was $31,172 per student. I would prefer if the debt load is zero for Baruch College graduates but they do have an advantage over students who graduate with larger loan burdens.
I recommend students start to think about their lifetime earnings after they graduate. In other words, think about the return on investment for your college education. If you have a passion for teaching in a public school, you can easily google your annual salary. Public school teachers are unfortunately, very underpaid and incurring large amounts of student loans to obtain a degree may not be worth it. A popular argument is that the college experience is priceless. However, this burden has started to delay the younger generation from starting families. I would argue a better experience might be to follow the Western European model and take a gap year. This is where they take a year off either before or after college to visit countries and learn about other cultures. As we become a global society, this experiential learning can be very impactful for an individual. Rolf Potts wrote a book called Vagabonding- teaching people how to travel the world for a longer period of time and utilizing different ideas to stretch your budget. I had a colleague who traveled the world for a year. He met his future wife in Southeast Asia and became a reality star there. I’m sure he didn’t plan all of that to happen. No, he is not on 90 Day Fiance.
Hasan Minhaj recently focused on answering the question, “Is College Still Worth It?” The pandemic has caused many classes to move online. Parents are questioning if the cost of college is really worth all the money. Professor Scott Galloway at New York University (NYU) has publicly stated that he believes the tier 2 and tier 3 schools are going to see cost pressure and they will witness a destruction of pricing power. Many of those colleges could result in a “death march”, meaning they will have to shut down. He said “We have raised tuition rates 1,400% over the last 40 years. This is a time of year that’s supposed to be a nervous but a rewarding time of year where people figure out where they’re going to school, and instead it’s become a time of year where people try to imagine how they’re going to take several thousand dollars on in-household debt.”
I also don’t believe everyone needs to attend college. Alternatives such as trade schools provide great career opportunities but I will leave that for another discussion. The narrative that we have to attend college, obtain student loans, and get a good job probably needs to be revisited.
Is the Coverdell Right for You?
You have to make the decision to see if the Coverdell makes the most sense for your child(ren). In my opinion, the ability to select any investment available in a brokerage account is a huge advantage if you are able to select the right investment to produce outsized returns. However, if you plan to invest in an S&P 500 index fund, the Coverdell might not be the right vehicle for you. You do have the option to invest in both the 529 plan and Coverdell. You have to determine what is the best strategy for you. In the end, I can’t provide any recommendations or advice. Every person’s financial situation is different so consult with your qualified tax advisor or financial planner for your personal situation.
I own bitcoin (BTC) and the Grayscale Bitcoin Trust (GBTC). All investments involve risk of loss. Nothing said in this article should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit. Invest at your own risk. Caveat Emptor.
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