Some time-sensitive thoughts on fall higher education enrollment

Become a Patron!Long-time readers know that one of my earliest recurring themes here on the blog was techniques to bring down the cost of higher education. Not by "applying for scholarships" or "getting good grades," but by manipulating the machinery of the financial aid system.With colleges and universities around the country announcing their decisions about whether students will be allowed to return to campus and attend classes in-person this fall, it's become fashionable to joke about "whether it's worth enrolling" at Harvard if you'll miss out on the excitement of going to parties with the most annoying people in the world, sorry, scratch that, I mean The Future Leaders of Tomorrow.I think this is a very boring question. It's July, so you already know if you've been admitted to Harvard, or Stanford, or even Dartmouth, and there's no reason at all to enroll in "virtual" classes this fall. Dostoevsky will be waiting for you next year. Write the admissions committee a nice letter asking if you can instead join them in 2021. If nothing else, you'll be a year older, your facial hair won't look so scruffy, and maybe you'll have learned to dress yourself a bit better in the interim.Let me frame the boring question as precisely as possible: if you (or, more realistically if you're reading this blog, one or more of your kids) have already been admitted to the higher education institution they want to attend, and that institution is not operating as expected this fall, you should defer admission to next fall.But the existence of a boring question suggests the existence of an interesting question.

What should a high school graduate do instead?

To understand the answer to this question you need to know two things:

• most four-year colleges and universities do not allow students to apply as freshmen (the most common and easiest form of admission) if they have received any college credits after the summer following their senior year of high school.
• most states do not allow students to establish residency for the purposes of in-state tuition if they move to the state "exclusively" in order to enroll in higher education.

The logic behind the first bullet point is that many high schools now allow students to directly enroll at local colleges and receive college credits while they're still in high school. These programs have different names, but they're fairly common and they're all basically ways to offload students who are bored with secondary school work. This immediately created a problem for university admissions, however: systems that are set up to admit students into 4-year programs directly out of high school were suddenly looking at students who might have 50 or 60 college credits between AP tests and community college classes. To square that circle, most top-tier public and private colleges and universities introduced the rule that freshman could bring in college credits, but only college credits earned in high school (or the summer after graduation). If you earn college credits in the fall after graduation or later, then you're shunted into the much narrower "transfer" admissions pipeline.The logic behind the second point is a bit harder to understand, but if you squint just right you can see the idea. States with high-quality public institutions like California, Wisconsin, or Michigan offer lower tuition to in-state residents. You can conceptualize this in different ways: perhaps parents "pay up front" for their children's tuition through income and sales taxes, or perhaps the higher tuition of out-of-state students "subsidizes" the education of state residents. However you choose to explain it, the consequence is obvious: people to want to move to those states and establish residency! But if establishing residency were easy, then the mechanism wouldn't work. Everyone would get the in-state tuition rate, and there would be no discount (or no subsidy). So, through laws, court cases, and rule-making, most states have arrived at a kind of equilibrium: to receive in-state tuition you need to only reside in the state for one year — but you must not have moved to the state for the primary purpose of enrolling in higher education. You can move to California for a year and lay bricks, then receive in-state tuition and a full scholarship to the University of California, but you can't move to California and enroll at Santa Monica College for a year before transferring to the University of California.Once you get your head around these two principles, the interesting answer presents itself: the last thing any high school graduate should do this year is enroll in higher education!

Move wherever you want to go to college, work, and file taxes

Once you understand all of the above, the solution presents itself cleanly. It's July, and you've already graduated from high school. If you've already been admitted to your preferred institution, then you have nothing to worry about, just defer admission for a year. But if you're unsatisfied with your current opportunities, the good news is there has never been a better time to reset them. Just remember, when establishing residency in a new state, documentation is your friend. The day you arrive:

• register to vote;
• get a new driver's license, ID card, hunter's license, gun license, or whatever else suits your fancy;
• sign a lease, and keep a copy;
• switch your bank and credit card statements to your new address;
• file taxes in your new state, even if you don't owe anything (some states may not allow you to file $0 returns online, but you can still mail them a physical return).

Conclusion

A strange thing about the American psyche is the way it is premised on categories that do not survive even the briefest encounter with reality, and one of the best examples of that is state "residency." Residency isn't where you live, it isn't where you work, and it isn't where you study. Residency is a vibe.Establishing residency means getting on the same wavelength as the overworked, underpaid residency cop who has to make 90 residency decisions per hour. So make it as easy as humanly possible for your residency cop to decide in your favor.Become a Patron!

The (weird) optionality of Series EE savings bonds

Become a Patron!There's a cliche at least as old as I am, that while ATM's were expected to reduce the demand for bank tellers, banks actually increased the number of tellers they employed, for the counter-intuitive reason that a bank branch was much easier to administer once simple deposits and withdrawals were handled by machines. Instead of wiping out the retail branch, they instead exploded, with one or two human tellers handling all the business that endless brass windows used to be required for.I mentioned this to my partner today in the context of seeing a teller redeem a US savings bond, something that I guessed any given bank employee was only asked to do once or twice a year; even with a computer's assistance, I remarked, it must be a struggle to remember training they use so infrequently.Then, to my amazement, my partner replied: "US savings bonds? I think I've got some of them around here somewhere."The documents she dug up were so strange and so old even the Treasury Department only reluctantly acknowledges their validity. But I couldn't help but investigate what on Earth these faded documents were for.

Some unique features of Series EE savings bonds

So-called "Series EE" savings bonds have three strange features:

• their value is guaranteed to double within a specified time frame (currently 20 years);
• the owner may choose to report the taxable interest on the bonds upon redemption;
• and the interest may be excluded from federal income taxes if the entire value of the bond is used for certain higher education expenses.

Like most federal debt instruments, the interest on the bonds is entirely excluded from state income taxes.My partner's bonds, in some cases dating back to 1993, were purchased at half of face value, while Series EE bonds today are purchased at face value, but let's set aside that technical nuance for now. I'm more interested in the question, what role could Series EE bonds play in an investment allocation?

A binary interest rate

If you hold a $50 Series EE savings bond for 20 years, it is guaranteed to be redeemable for $100, with the $50 in interest taxable at the federal level but exempted from state and local taxes, which my trusty financial calculator tells me works out to a 3.53% annual interest rate.If you hold the bond for any period of time less than 20 years, it will earn interest at a preposterously low interest rate (0.10% as of this writing, and for many years prior).

Annual interest rate resets

Series EE savings bonds can be cashed in, with accrued interest, after 1 year (with a 3-month interest penalty), or 5 years (with no interest penalty). That means every year you have the opportunity to recalculate whether you are better off holding onto the bond and getting closer to your 20-year 3.53% payout, or resetting the 20-year holding period at higher prevailing rates.These breakeven points are trivial to calculate (these values aren't quite right because for simplicity I'm rounding 0.10% APY down to 0%):

• after one year, if interest rates shoot up from 0.10% to 3.72%, make the exchange;
• after 5 years, they must reach 4.73%;
• 10 years in, they must be 7.18% per year;
• and with 5 years left to go, you'll need to earn 14.87%.

Another way of expressing this is that the closer your bonds get to maturity, the higher the interest rate you should think of them as earning: 3.53% may not be impressive 20 years out, but a 100% interest rate one year out should convince you to hang onto them almost no matter what, when their value jumps from $50.96 to $100.

Series EE bonds could be risk-free complements to 529 plans

Besides a nominal allocation to high-yield corporate debt, I own essentially no bonds, for the simple reason that I'm not smart enough to pick individual bonds, and investment-grade mutual funds don't pay enough interest to merit my attention. I prefer instead to put my "stable" savings into high-yield accounts like the ones I discussed last week.In tax-advantaged accounts like 529 college savings plans, where investments compound tax free and can be withdrawn tax and penalty free for eligible expenses, owning "safe" low-yield bonds makes even less sense. But 529 plans designated for actual education expenses pose a conundrum: what if your stock holdings happen to drop in value the very year you need them?Series EE bonds offer one kind of solution: making a bond allocation to Series EE bonds gives half the tax protection of a 529 account (state, but not federal, income tax exclusion). If the stock investments in your 529 account are shooting out the lights, you can make withdrawals tax and penalty free when your beneficiary enrolls.On the other hand, if your beneficiary happens to enter college during a stock market slowdown, cash out the Series EE bonds and let the stocks in your 529 plan ride. Subject to income limits, potentially all the interest on your bonds could be exempt from both state and federal taxes.

Just a few more complications

This is a modestly interesting idea, and I'm glad I looked into it, but there are a few major problems with actually pursuing this as a college financing strategy.First, the required holding period for Series EE bonds in order to trigger the special interest rate is 20 years. Since most Americans enter college between 17 and 19, you'd have to start planning awfully early, like, zygote-early, in order to make a Series EE investment part of your college financing plan.Second, purchases of Series EE bonds are limited to $10,000 per Social Security number, per year. In light of the above, you'd need to load up on bonds to the maximum immediately if you wanted to be sure to meet the requirements for both the full interest rate and, potentially, the federal income tax exemption.

Conclusion

When I visited the Jefferson County Museum in Charles Town, West Virginia, there was a lovely exhibit on the financing of World War II, with carefully preserved books of "War Stamps" and posters exhorting those on the home front to buy War Bonds. But I've never read a good account of exactly how these confusing documents worked.Series EE savings bonds seem to be somewhat similar to those War Stamps: purchased by relatives, forgotten by recipients, stuffed in drawers and safe deposit boxes, and offering random windfalls when discovered years or decades later.Become a Patron!

What to watch for as the Senate panics over the SECURE Act

Become a Patron!My readers know that the SECURE Act, passed unanimously out of its House committee and overwhelmingly on the floor of the House, was conjured into existence by the insurance industry in order to increase the distribution of expensive, opaque annuity products in 401(k) retirement plans. It incidentally also includes a few other provisions designed to reduce the taxes paid by the extremely wealthy, like the SECURE backdoor into 529 assets. Throughout 2019 the Act has been held up in the Senate by Ted Cruz, who wants to open the backdoor even further by allowing tax-free distributions from 529 accounts for "homeschooling" expenses.The SECURE Act is back in the news since, with impeachment looming, the Senate's legislative calendar is looking increasingly time-constrained, and the insurance industry's senators are panicking to make sure their masters get what they paid for.Since some version of the Act will likely be folded into end-of-year budget negotiations, here's what to watch for as that process plays out.

What won't change: annuities and RMD's

The core of the SECURE Act, and its companion measure in the Senate, has always been to increase the distribution of annuities in employer-provided 401(k) plans by shielding employers from liability when those plans are unable to make their promised payments. The sop to individual savers to "balance out" that giveaway is an increase in the age, from 70 1/2 to 72, at which minimum distributions are required from pre-tax individual retirement accounts and 401(k)'s.Those two giveaways are the reason the Act exists, and are unlikely to change substantially since they've already been frozen in carbonite by their respective lobbyists.

The 529 backdoor

The House version of the SECURE Act includes the SECURE backdoor into 529 assets, allowing account owners to double dip into their account balance, once by taking a tax-free distribution for higher education expenses covered by a student loan, and then a second tax-free distribution of up to $10,000 in order to repay that loan.The Senate version did not contain that provision, so it remains to be seen whether the final measure will include the backdoor, and if so, whether the House's $10,000 limit will be kept, raised, or lowered.

The "homeschooling" loophole

In the smash-and-grab tax act of 2017, a private schooling loophole was added to 529 plans, allowing for up to $10,000 in tax-free distributions for certain private primary and secondary education expenses. Ted Cruz wants to blow that loophole wide open by allowing for the same tax-free distributions for "homeschooling" expenses, and has blocked passage of the Act in the Senate until he gets his way.Upon even a moment's reflection, this is simply open-ended permission for the wealthy to shield their investments from capital gains taxation. After all, education takes place throughout the year. Who is to say that tennis lessons aren't a form of homeschooled "physical education?" Who is to say that a laptop isn't necessary for homeschooled "computer science?" Who's to say that a month in France isn't a "foreign language" field trip?So far the Senate has had the good sense not to bend on this point, but in the flurry of year-end negotiations, Cruz may end up getting his way.

Changes to "stretch" IRA's

For technical reasons, it's much easier to pass legislation that does not have a budgetary cost than legislation which does, so in addition to its handouts to the very wealthy, the House version of the SECURE Act also included a measure to increase revenue: drastically shortening the period over which withdrawals from inherited IRA's and 401(k) accounts must be taken.Under current law, required distributions from an inherited IRA can be calculated based on the heir's life expectancy, rather than the original account owner's. This allows an heir to both reduce required distributions and strategically time distributions for low-tax years. Under the SECURE Act, all inherited IRA's must be completely distributed within 10 years.This is an extremely important change in the world of tax planning, but obviously not of much interest to the overwhelming majority of people: most people do not inherit anything; most people who do inherit something don't inherit IRA's; and most people who inherit IRA's just withdraw the money immediately, they don't strategically time withdrawals for the next 60, 70, or 80 years.If the SECURE student loan backdoor limit is raised, or the "homeschooling" loophole is added, the budgetary cost of the Act will soar. That may mean the stretch IRA period will be shortened further: a 7-year window raises less money than a 10-year window, since it mechanically reduces the opportunities for strategic withdrawals.It's also possible the necessary revenue will be raised elsewhere in the final bill, or the procedural point of order will be simply be waived.

Conclusion

The SECURE Act is a bad law that should not be passed: the benefits go overwhelmingly to the wealthy in the form of tax savings, and the costs, particularly the ability of annuity marketers to target employers for inclusion in 401(k) plans, will be borne exclusively by the working and middle classes.But since it likely will be passed in some form, eventually, now you know what to watch for.Become a Patron!

Are there 529 plans so bad they aren't worth their state's income tax benefits?

Become a Patron!A lot of financial planning and advice can start to seem pretty routine over time: maximize contributions to tax-advantaged savings vehicles, invest in a basket of diversified, low-cost assets, and periodically (but not too often!) rebalance.I'm always interested in identifying places where that kind of routine advice breaks down, and the other day, I got to thinking: many states allow certain state income tax deductions for 529 college savings plan contributions, but only when contributions are made to plans sponsored by the state where you take the deduction. Since the fees and expenses of 529 plans can vary considerably, I wondered if there are states where the costs of using the in-state plan instead of a cheaper alternative exceed the value of the state income tax benefits.

Deductions, credits, and rates

To investigate this question, I had to isolate several different dimensions:

• Does a state offer a tax deduction or a tax credit? Four of the 35 states offering state income tax benefits offer a tax credit for contributions: Indiana, Utah, Vermont, and Minnesota. The rest allow for contributions to be deducted from state income instead.
• What are the limits on the state tax benefit? Colorado, New Mexico, and West Virginia allow taxpayers to completely eliminate their state income tax liability through 529 contributions. The remaining states place a cap on the amount that can be deducted.
• What are the state income tax rates? A deduction is more valuable in a state with high income tax rates than in a state with low ones. I used the lowest and highest non-zero income tax brackets for each state to identify the range of potential values of a state income tax deduction.
• Does the state only allow deductions for in-state plan contributions? Seven states allow income tax deductions for contributions to out-of-state plans: Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania.
• And finally, what is the cheapest appropriate investment option in each plan? For this comparison, I selected the lowest-cost broad US equity option in each plan, which was typically a US large cap, S&P 500, or total stock market fund.

Whether or not you're interested in my particular research question, you might find the resulting spreadsheet useful on its own, and you can find it here.

Reminder: state tax benefits are worth less to federal itemizers

Before I go on, I want to remind folks who choose to itemize their federal deductions that state tax credits and deductions are worth less to them, since reducing their state income taxes mechanically reduces their state and local tax deduction and increases their federal income taxes.Take, for example, a South Carolina resident in the 7% state income tax bracket who owed exactly $10,000 in state income tax and no other state or local taxes in 2018. If they chose to itemize their federal deductions, for example due to a large deductible charitable contribution in 2018, then the $10,000 is also deductible from their taxable federal income.Since South Carolina allows 529 plan contributions to be deducted against an unlimited amount of state income, the taxpayer can save $10,000 in state taxes by contributing a bit over $100,000 to a South Carolina 529 plan. But this will reduce their state and local tax deduction by the same $10,000, increasing their federal income tax liability by up to $3,700.Such corner cases cover only a tiny number of taxpayers, but it's something to be aware of in case you happen to be one of them.

First impressions

Taking a look at the spreadsheet, the first thing that should jump out at you is that these plans are all over the place. Investment costs start as low as 0.035% (for Rhode Island residents to invest the "U.S. Stock Portfolio"), and run as high as 0.65% (for Mississippi's "U.S. Large-Cap Stock Index Fund Option"). Note that these are the lowest-cost equity investment options in each plan — fees for other investment options can run much, much higher than this.The second noteworthy observation is that some of these supposed tax benefits are trifling. Rhode Island will give a married couple with over $145,600 in taxable income a deduction worth a little less than $60 for contributing $1,000 to their in-state plan. For a low-income single filer, the deduction is worth less than $20. What exactly is the point supposed to be?At the high end, the state tax benefits can be considerable. In addition to the states with unlimited deductions I mentioned above, high-income married taxpayers in Alabama, Connecticut, Idaho, Illinois, Indiana, Iowa, Mississippi, Nebraska, New York, Oklahoma, and Vermont can all save $500 or more by making contributions to in-state plans. Single filers have it tougher, but can still save more $500 or more in Mississippi and Oklahoma state income taxes.

If you're just maximizing state tax benefits, don't diversify!

This is a corollary of what I wrote above: since I chose the lowest-cost equity option in each plan as my benchmark, if you don't use that option, you will likely end up paying more in fees. For your primary 529 account, you should have an appropriately diversified portfolio that scales back risk as your beneficiary nears enrollment. For your tax-scam 529 account, just put however much money you need to maximize the state tax benefits into the cheapest equity fund and forget about it.If you're lucky enough that your primary account is also your tax-scam account (Utah, I'm looking at you), then feel free to disregard this warning.

It's almost always worthwhile for non-zero rate payers to maximize their in-state tax benefits

Remember the original question we started with: are there states where the cheapest investment option is so expensive it outweighs the state income tax benefits?And the answer, to a first approximation, is no. What I was looking for is a state with a very low income tax benefit, like Rhode Island, and very high investment costs, like Mississippi or North Dakota. But those states mostly don't exist: for taxpayers with any state income tax liability at all, making the maximum deductible contribution to the cheapest in-state 529 investment option will almost always create a greater reduction in state income taxes than the increased expenses compared to the cheapest 529 plans available.There are two exceptions: in states with fixed account maintenance fees in addition to investment costs, low balances may incur much higher proportional expenses, in the same way that fixed fees on origination can increase a loan's APR far above the stated interest rate.The second exception is folks without state income tax liability. If you aren't taking advantage of your state's tax benefits for in-state plan contributions, don't feel compelled to make in-state plan contributions: find the cheapest plan with the best investment options and use that instead.Become a Patron!

The wealthy Illinois degenerates were good and right for getting their kids a free education

Become a Patron!Last week, the nonprofit journalism enterprise ProPublica wrote a breathless expose about a number of wealthy Illinois families, and their law firm collaborator, who were able to secure generous financial aid awards for their children to attend certain Illinois public universities.The article served as a brilliant kind of Rorschach test for how readers feel about public services, means-testing, and the administrative state. If you haven't read it yet, go check it out first, then head back here.

What happened in Illinois

Unfortunately, the ProPublica authors didn't consult me or anyone else who understands how financial aid works, so the article is missing some important details.How financial aid works in the United States is that there is a single, federal application called the Free Application for Federal Student Aid, or FAFSA, which is used by the federal government to determine statutory eligibility for certain federal programs, including Pell Grants, subsidized and unsubsidized federal student loans, and some smaller programs like SEOG. The FAFSA produces an aid eligibility determination based on family size, income, assets, and a few other variables.One of those variables is "dependent status." In general, all undergraduates are considered dependent unless they meet any one of several tests:

• Will you be 24 or older by Dec. 31 of the school year for which you are applying for financial aid?
• Are you married or separated but not divorced?
• Do you have children who receive more than half of their support from you?
• Do you have dependents (other than children or a spouse) who live with you and receive more than half of their support from you?
• At any time since you turned age 13, were both of your parents deceased, were you in foster care, or were you a ward or dependent of the court?
• Are you an emancipated minor or are you in a legal guardianship as determined by a court?
• Are you an unaccompanied youth who is homeless or self-supporting and at risk of being homeless?
• Are you currently serving on active duty in the U.S. armed forces for purposes other than training?
• Are you a veteran of the U.S. armed forces?

If an undergraduate applicant meets any one of those tests, they're considered "independent," and only their own income and assets are used to determine federal financial aid eligibility. This means, for most independent undergraduates, that they're entitled to the maximum amount of federal student aid.Above, I've bolded the test used by the Illinois families in the ProPublica story to trigger maximum financial aid eligibility: by asking a court to grant legal guardianship of their progeny to a friend or relative, they were able to remove their own income and assets from the federal financial aid determination of their children at Illinois public universities.

Why it worked

So far so good, right? Not quite. there are two important additional reasons why these Illinois families were able to maximize their financial aid awards.First, Illinois has a low/nonexistent requirement for guardianship orders. While the federal FAFSA condition for independence is obviously meant to identify students who are escaping abusive or inadequate living situations, guardianship orders are handled by state courts, and as ProPublica explains:

The Illinois Probate Act, the law that governs guardianship, does not specify circumstances in which guardianship should be denied. According to Illinois law, a court can appoint a guardian if the parents consent, the minor agrees and the court determines it is in the minor’s best interest. Even if a parent is able to care for the child, the court can approve the guardianship if the parents voluntarily relinquish custody of the child.

The federal government doesn't have a mechanism to overrule state guardianship orders because family law is exclusively a state competency.The second advantage these Illinois families had is that the universities their children applied to rely entirely on the FAFSA for student aid eligibility decisions. As I've explained in the past, many public and virtually all elite private universities rely on a second screening tool, the College Board's CSS Profile. This application requires parental information regardless of FAFSA dependency determinations.While federal financial aid determinations are based entirely on the FAFSA, in order to receive generous in-state and institutional aid, the Illinois families needed to send their kids to a school that doesn't use that additional information.

The Utopia of Rules

The anthropologist David Graeber's 2015 book "The Utopia of Rules: On Technology, Stupidity, and the Secret Joys of Bureaucracy" describes a key reason why, despite its frustrations and absurdities, we're attracted to bureaucracy: it gives us some confidence that, no matter how annoying we might find our interactions with the system, that the system is not targeting us or singling us out for persecution. In that way, the impersonality of the bureaucracy puts everyone on a level playing field, with rules defined in advance. You can't plead with your sister who works at the DMV to give you a drivers license because no one can plead with your sister.Rules are rules — and the Illinois families followed the rules.

The problem is means-testing and more rules won't help

Whenever these "scandals" come along there are immediately calls to "tighten up," "strengthen," and "fortify" the rules governing means-tested programs. But even if that's what you think you want, it's not true. What you want is to live in a just society, and the idea of people "exploiting loopholes" in the rules pisses you off because you think it makes society less just.The problem is, means-testing also makes society less just. It discourages people from applying for the food, health, and housing benefits they need. It discourages people from going to college. It discourages people from starting businesses. There's nothing just about a society full of hungry, sick, homeless, unemployed people.To condemn the Illinois families for taking advantage of the rules, as written, is to say the rules were wrong. But that only gets you halfway home. Were the rules too loose, and need to be tightened, so that every Illinois family needs to jump through even more hoops if they want to send their kids to college? Or were the rules too tight, too carefully constructed, too delicately balanced, and what we really need is public education free to all without the increasingly tortuous barrier of means-testing?

Conclusion

The reason I love the Illinois case as a test is that it demands we answer two, equally important questions:

• what should the rules be?
• and how should we feel about people we don't like following the rules?

Most wealthy people have no problem accepting deferred compensation in their 401(k) accounts, or making "backdoor" Roth IRA contributions, or squirreling away tens or hundreds of thousands of dollars into HSA accounts. Those are the rules, and they're maximizing the benefits of them, as they're written.Now how do they feel about a single parent of 3 who reports exactly $14,250 in earned income and claims a refundable credit of $6,431? Are those parents still "just following the rules" or are they "exploiting a loophole?"If you want to make the rules stricter on low-income parents, but looser on high-income investors, you're making an important point, but the point you're making is about you and your values, not about the rules.Become a Patron!

Why I just changed my 529 asset allocation

Become a Patron!I've written before about what I consider the two best 529 college savings plans: the Nevada-sponsored Vanguard 529 plan and the Utah-sponsored my529 (formerly UESP). In general, most people making contributions in excess of their in-state tax deduction for 529 plan contributions (if any) should consider using one of those two plans, thanks to their broad range of low-cost, passively-indexed investment options.On July 11, I received an interesting e-mail from my529, where I keep my own 529 assets, which contained references to the following program changes:

• "Reduction of the Administrative Asset Fee for all investment options
• "Elimination of the Public Treasurers’ Investment Fund investment option
• "Increase in the Utah state income tax credit/deduction
• "Update of year-end deadlines
• "Reduction in some underlying operating expense ratios"

Obviously any reference to "reductions in fees" gets my attention, so I opened up the new Plan Description and dug into the details.

My529 introduced variable administrative asset fees

When I wrote in February, 2018, my529 charged a flat 0.20% administrative asset fee in addition to the expense ratios of your underlying investment options. As their e-mail states, that fee has fallen for all investment options, but it is also no longer constant: their pre-packaged investment options now charge between 0.10% ("Fixed Income") and 0.13% (all others), while customized investment options now charge 0.18%.To be clear: no one is paying more under the new fee regime. However, those who invested their my529 assets in pre-packaged options saw a bigger fee cut than those of us in customized investment options.

Consider simplifying your my529 asset allocation

Since I don't have any children yet, my 529 assets are invested for the very long term, i.e., entirely in stocks. When my529 charged a flat 0.20% asset allocation fee, I used the "customized static" option to allocate 65% of my account to the "Institutional Total Stock Market Index Fund" and 35% to the "Total International Stock Index Fund."Under the new variable fee regime, that asset allocation cost a total of 0.218%: a weighted 0.038% fund expense ratio and a flat 0.18% asset allocation fee.Meanwhile, the pre-packaged "Equity—30% International" investment option has a total cost of 0.156%: a weighted 0.026% fund expense ratio and a flat 0.13% asset allocation fee.I want to stress that these options are not exactly identical: the pre-packaged portfolio has a slightly smaller allocation to international stocks, and the international component is invested only in developed markets, while the Total International Stock Index Fund I had been using includes some exposure to emerging markets. Nonetheless, those differences struck me as minor enough to happily make the switch, on the basic premise that the fewer fees I pay, the more money I get to keep, no matter what the stock market does.

How do the new my529 fees stack up against Vanguard?

Of course, these changes weren't made in a vacuum: Vanguard has also been aggressively reducing the cost of their investment options. Vanguard uses a slightly different method to calculate expenses, but their "Vanguard Total Stock Market Index Portfolio" costs a total of 0.15% and their "Vanguard Total International Stock Index Portfolio" costs a total of 0.195%," which means (almost) replicating the my529 "Equity—30% International" allocation would have a weighted all-in cost of 0.1635%.

Conclusion

Most people don't have 529 college savings plans, and most people who have 529 college savings plans don't have more than a few hundred dollars in them. They were conceived, birthed, expanded, and are passionately defended by the wealthiest people in the country, those willing to do absolutely anything to minimize the taxes they pay on their investment income.If that describes you, make sure you're not overpaying for your investment allocation, and don't be afraid to switch between plans if lower-cost investment options become available (however, note that under some circumstances rolling 529 assets from one plan to another may require you to repay any in-state tax deduction you took for your contributions in prior years).Become a Patron!

The SECURE backdoor into 529 assets

Become a Patron!I've written extensively in the past about 529 College Savings Plans, an extremely tax-advantaged method of saving for higher education expenses. Contributions are made after federal and state taxes (although many states offer in-state tax deductions for contributions), compound internally tax-free, and are withdrawn tax-free for "qualified higher education expenses."In the Smash-and-Grab Tax Act of 2017, Republicans expanded those eligible tax-free withdrawals to $10,000 per year in elementary and secondary education expenses as well. Increasing the expenses that are eligible for tax-and-penalty-free withdrawals mechanically increases the value of the 529 tax shelter since it decreases the risk of saving "too much" in an account and being forced to pay taxes and penalties on any withdrawals.A bill is being rushed through Congress that will create a new, even more cavernous loophole to avoid taxes and penalties on 529 plan assets.

The SECURE Act Double Dip

H.R. 1994, hilariously titled the "Setting Every Community Up For Retirement Enhancement Act of 2019" (SECURE, get it?), passed the House Ways & Means Committee early last month with bipartisan support, and is being fast-tracked through the House alongside a companion measure in the Senate.The House bill makes an unprecedented change to what expenses are eligible for tax-and-penalty-free withdrawals of 529 assets.As a refresher, there are three kinds of withdrawals from 529 College Savings Plans:

• withdrawals for qualified higher education expenses paid out of pocket or with student loans are completely tax-free;
• withdrawals for qualified higher education expenses covered by grants and scholarships are penalty-free, but subject to income tax on the earnings portion of the withdrawal;
• and withdrawals for non-qualified higher education expenses are subject to income tax on the earnings portion of the withdrawal and a 10% penalty on the earnings portion of the withdrawal.

All withdrawals are made proportionately from contributions and earnings, so it's not possible to designate withdrawals as coming first from contributions or first from earnings.Section 302(c)(1) of the SECURE Act is simple: "Any reference in this subsection to the term ‘qualified higher education expense’ shall include a reference to amounts paid as principal or interest on any qualified education loan...of the designated beneficiary or a sibling of the designated beneficiary."The tax-and-penalty-free student loan withdrawals are capped at $10,000 per individual.Attentive readers have no doubt already noticed the problem: the SECURE act would allow tax-free withdrawals for higher education expenses financed with student loans and for the repayment of those student loans!

The double dip, illustrated

To see how this would work in practice, take the example of someone who contributes $10,500 to a 529 plan the day their child is born, which compounds at 6% annually for 18 years, reaching a final value of $30,000 on the child's 18th birthday, when the 529 plan account is reallocated to an FDIC-insured money market fund. On that date, the child also enrolls in a higher education institution with a total annual cost of attendance of $5,000, and receives a $2,500 annual scholarship. The student takes out $2,500 in federal Stafford loans to cover the remaining balance.Under current law, the 529 plan owner can make a $2,500 tax-free withdrawal (the amount of qualified higher education expenses paid for with student loans) and a $2,500 penalty-free withdrawal (the amount of qualified higher education expenses paid for with grants and scholarships). They would owe ordinary income taxes on the earnings portion of the second $2,500 (roughly 65% of it, or $1,625).After four years, the account owner would have withdrawn $20,000 of the $30,000 balance, with $10,000 in completely tax-free withdrawals and $6,500 taxed as ordinary income. The remaining balance in the account would be $10,000. To withdraw that balance, the account owner would have to pay ordinary income taxes plus a 10% penalty on the earnings portion, which comes to roughly $1,788. A high-income account owner in a high-income state might pay as much as 50% of that in income taxes, or $894.Under the SECURE Act, if that withdrawal is used to repay the student's $10,000 student loan balance, it is also completely tax-free.

Conclusion: the system is breaking down

There are a few foundational principles of American tax law. You can't deduct an expense incurred by someone else. You can't claim a deduction and a credit for the same expense. What we are seeing right now is that system breaking down in real time.When the second Bush administration eliminated the estate tax, they also eliminated the stepped-up basis rule, so that appreciated assets would be taxed as capital gains when sold instead. When the Trump administration all-but-eliminated the estate tax, they left the stepped-up basis rule intact, so that appreciated assets would never be taxed.Today, so many assets have been sheltered from taxation for so long, and appreciated by so much, that their value looms over the entire system, with the tiniest changes to tax law having enormous downstream effects on those sheltered assets.Pre-tax contributions to accounts like IRA's and 401(k)'s were justified with the promise that they would eventually be taxed when withdrawn in retirement. Now that the wealthiest generation in human history is in retirement and being forced to make those withdrawals and tax payments, it seems they've found that they would prefer not to. And unlike poor Bartleby, the Boomers vote.Become a Patron!

Three bad and one good way to think about public higher education and tuition

Become a Patron!Elizabeth Warren made a splash this week with her plan to both ensure public higher education is tuition-free and forgive up to $50,000 per student of the existing stock of federal student debt.I already offered my hottest takes on Twitter, but I think a lot of the disagreements surrounding public tuition and student debt revolve around fundamentally different conceptions of the nature and purpose of higher education. As often happens in politics, that means people who think they are disagreeing about one thing (the appropriate level of tuition at public universities), are actually disagreeing about something else (what is education, who owns it, and who benefits from it?).I think there are basically four ways to look at the issue, and it's these competing perspectives that lie at the heart of the disagreement.

Education as a Private Capital Good

In this view, education is literally treated as an investment, made by the student, in a combination of individual "capital" (knowledge, experience, and credentials) and social "capital" (meeting friends, spouses, and business partners). Like many investments, the upfront cost is large, but since it yields an even higher time-weighted and risk-weighted return, it's still an investment worth making.Since education is a purely private capital good, purely private commercial loans are an obvious way of financing that investment. In a rationalized educational system, students would simply be charged for the appropriate fraction of their instructors' time, controlled for salary, enrollment, and overhead, and then borrow the necessary amount semester-by-semester at a market rate of interest.While this perspective has been beaten into Americans by the Reagan-Clinton neoliberal revolution, it's important to understand how completely novel it is, and what its real-world implications would be.First, what is the cost of overhead? If we are to completely rationalize the charge on the student's side of the equation, it seems necessary to likewise rationalize the expenses on the university's side of the equation. If they are to charge the entire cost of providing education, then the federal government should also capitalize the cost incurred through the Morrill Land-Grant Acts. Profitable universities, of course, would be able to take out long-term loans to finance the one-time cost of reimbursing the federal government for their land, but some institutions would no doubt fall into default and the federal government would have to seize and auction them off.Second, what is the market rate for an unsecured debt by a 17-or-18-year-old borrower? If the payoff to higher education has a barbell distribution, with a high percentage of low-income dropouts and an above-average income to graduates, the market interest rate would have to be astronomical: low-income dropouts and graduates will declare bankruptcy, while high-income graduates will repay their loans early.If higher education is a purely private capital good, obviously there's no reason for the federal government to get involved with loan guarantees or financing, and without them, it's unfathomable that private sector financing will be available at all.

Education as Intergenerational Wealth Transfer

Until 2015, this was the unspoken premise of a lot of opposition to universal tuition-free public higher education. And then in 2015, the unspoken became spoken, when Hillary Clinton insisted that "I am not in favor of making college free for Donald Trump's kids" (Interestingly, she did not insist on means-tested co-payments at public libraries, swimming pools, parks, museums, or elementary and secondary schools, so I gather the Trump clan is free to visit them at will without furnishing their tax returns).The logic here is simple: since we refuse to appropriately tax high incomes, and we refuse to tax estate transfers, and we refuse to treat capital income the same as earned income, the only mechanism we have left to tax the wealthy is through our system of public higher education, where we charge them full tuition. If tuition were low or non-existent at our public universities, we would lose our last remaining option to share any part of the largest private fortunes in the world.Hillary Clinton is a savvy politician, and she made this argument for a reason: it has immediate, emotional appeal. The trouble is, it begs the question. If we taxed high incomes properly, why would we need to single out high-income parents for additional tuition charges? If we taxed estate transfers properly, why would we need to finance universities with levies on high-net-worth parents? If we taxed capital income properly, why would we need to single out high-capital-income parents for special tuition fees?

Education as Class War

If "stick it to the rich" is one version of the argument for public higher education tuition, "stick it to the poor" is its mirror image, helpfully illustrated on Twitter. In this version of the story, public higher education is not a public or private investment, it's an ordinary consumption good. The poor buy cheap public higher education for less money, and the rich buy expensive public higher education for more money; the poor go to technical colleges, the rich go to flagship universities.I appreciate the fact that this view has resurfaced precisely because it disputes the entire premise of American meritocracy. College graduates do not become more qualified because of anything that takes place during the course of their education; rather, they're more qualified because of their starting wealth.However, if anyone really believed this was true (and I think almost no one does), the consequences would be radical. Graduates of elite universities would not receive more consideration during job applications, they would receive less, since such a large percentage of their education is attributable to their starting wealth, rather than any accrued qualifications.Needless to say, almost no one explicitly professes this belief. Rather, you end up with just-so stories wherein the well-genetically-endowed accumulate their wealth through hard work and intelligence, their children inherit their hard work and intelligence genes, and so the people who "deserve" to attend elite universities (thanks to the genes) also happen to be able to afford it (thanks to the wealth). There's even a term for it in the eugenics literature: "mismatch theory," whereby it's downright dangerous to admit the poor to elite universities where they are destined to underperform.

Conclusion: Student Debt as Aggregate Demand Management

It would be unfair to conclude without sharing my own view of the student debt crisis, which is simple: the experiment has failed.Federal student loans (and other federal programs like Pell and FSEOG grants) were intended to address a particular problem: if Baumol's cost disease causes the cost of public education provision to accelerate faster than the increase in productivity in the higher education sector, then the states (which are constrained by balanced budget rules) will be forced to radically reduce the quality of education they offer or radically increase their taxes to finance it, and over time gradually but permanently reduce the education level of the American people.Instead, the federal government decided to print money in order to finance those public education services. But this decision created a different problem: if the federal government had simply assumed the cost of operating the nation's public universities, the entire cost of that operation would be brought "on-budget," creating an expense that would have to be matched with increased taxes or debt.Instead, we went a different route. Rather than simply operating, and paying for, a system of nationwide free public universities, we created a system of federally-backed student loans. This has the great technical advantage of creating an entry on the asset side of the federal ledger. Indeed, the federal student loan program is "profitable," in the specific, bizarre sense that the money it earns in principle and interest payments exceeds the amount it loses in loans discharged due to death, disability, or other reasons.President Obama made important changes to the system again with the introduction of Income-Based Repayment, which allows the remaining balance of federal student loans to be discharged after 20 years of payments.The question remains, however: why assign the cost of a publicly-financed system of colleges and universities to the people who happen to attend them? If graduates earn higher incomes, then we can easily impose a progressive income tax that captures a share of their increased income over that of non-graduates. If graduates accumulate more lifetime wealth, then we can easily impose an estate tax that reclaims far more than the cost of their attendance at a public university. If graduates earn an unusually high share of income from capital, we can easily equalize the tax treatment of income and capital gains (as we did it as recently as the 1980's).The experiment was simple: if college attendees really exerted a unique upward pressure on wages and prices by earning and spending much more money than non-attendees, then isolating them for specific surcharges might have made sense, in order to prevent overall price inflation. But the experiment failed. In the very worst cases, it turned into just another bullshit means-tested program that no one qualifies for.The fact is, we already operate a system of publicly-financed colleges and universities, because we know as a country we rely on the graduates of that system. All that's left is to admit it.Become a Patron!

The Indy Finance guide to why, where, and how to seek higher education

Become a Patron!I've written many times before about higher education, mainly from the perspective of financing it. Thanks to Aunt Becky, for the last few weeks the national spotlight has focused on much more fundamental questions: what is post-secondary education for? Who should pursue it, and why? What should they study, and where?Fortunately, the definitive answers to all these questions and more are below.

True credentialing

It has become a cliche to say that the middle class obsession with higher education is an example of "credentialism," whereby people go to college "just to collect a piece of paper." Evidence for this typically includes the fact that many jobs which required a high school diploma 25 years ago require a bachelor's degree today. I want to distinguish that process, which we can call false credentialing, from true credentialing.True credentialing describes the fact that, for a variety of historical reasons, certain work can only be performed by people who have specific credentials. If you want to become a nurse, you can't just hang out around nurses until you pick up the tricks of the trade. If you want to become a doctor, you can't just read a bunch of medical textbooks. If you want to become an architect, you can't just practice drawing blueprints until you get really good at it.In many states, everyone from hairdressers to ear piercers need a credential of some kind. Depending on the line of work you desire, you should look into what credentials are required to pursue that profession.Now, it's also true that these credentials can be very difficult and expensive to acquire, and many people who start off wanting to become nurses, doctors, and architects fail to complete the required credentials, either because they discover the work is worse than they hoped (blood, gore, sawdust), or they lack the interest or ability to finish.This is an important reason to pay as little as possible for higher education, and to maintain a very high willingness to drop out. People who complete their medical, dental, or engineering education do not usually struggle to pay their higher education expenses. But since you don't know in advance whether you will succeed at acquiring a credential or not, you should always prefer to pay less rather than more. If you succeed, there's no harm done in having below-average educational debt, and if you fail there's an enormous advantage to having below-average educational debt!

High-wage employment

Another good reason to get a post-secondary degree is if you are interested in pursuing high-wage employment. I've had enough jobs over the years that I don't particularly recommend it, but if you're the kind of person who wants to work for someone else, it's almost always better to be paid more rather than less, and better-paid jobs typically require some kind of post-secondary education, whether it's a formal degree, a vocational diploma, or even something as simple as a commercial driver's license.Note that I am distinguishing high-wage employment from having a high income. If you want a high income, you should figure out something you're good at, then charge people to do it for them. If you're not good at anything, you should get good at something, then charge people to do it for them.It might cost a few thousand dollars in art supplies to get good at screen-printing, or a few thousand dollars in gym memberships to get good at weight lifting, or a few thousand dollars in running shoes to get good at training for marathons, but if you want to work for yourself, you don't need a degree. You don't even need a resume (as long as you promise not to ask for it).This is a good time to mention a common misunderstanding people have about higher education. It's become a cliche to say that so-called "STEM" fields pay well, so students should be encouraged to study science, technology, engineering, and math in college. But this advice is only relevant if you want to seek wage employment. You do not need a college degree to own a tree nursery ("science"), Apple doesn't ask you to upload a resume before submitting apps to the App Store ("technology"), Chinese factories don't ask to see your degree before shipping you drone parts ("engineering"), and anybody can upload mathematical proofs to the internet (although I don't think there's very much money in that one).In other words, acquiring a degree in a STEM field may make sense if you want to turn your degree into high-wage employment; it's totally unnecessary if you want to work for yourself.

An advanced education

Another important reason you might pursue post-secondary education is to achieve a more comprehensive understanding of one or more subjects. Fortunately, this can usually be done for very little cost if you're able to do any planning at all. The key insight is that the cost of American higher education has a horseshoe shape: tuition at community colleges and in-state public universities is extremely cheap or free, mid-tier private universities and out-of-state public universities are extremely expensive, and tuition at elite private universities is again cheap or free due to large endowments and generous financial aid (ignore the sticker price; nobody pays that except aging 90's TV stars).Here you might object that "thanks to the Internet," information is free. Why would you pay anything to sit in a classroom and listen to a lecture when you can watch thousands of hours of lectures on any topic from the comfort of your own home.The answer, of course, is that regardless of what information costs, information is different than an education. Out of curiosity, I pulled up the requirements for an undergraduate degree in history at Yale University. Eyeballing it, students need to take about 10 classes in the Department of History to meet the degree requirements. Here's a description of a semester-long, freshman class selected at random from the Yale Spring semester course catalog:

"This course introduces students to the myth-making processes involved in the creation of nation-states in the post-Ottoman Middle East, including Iraq, Palestine, Israel, Lebanon, Turkey, as well as in Iran and Egypt. It explores the ways in which national identities and nation-states formed—in ways both organic and forced—around certain myths and ideologies. It examines the impact of these national/nationalist myths on revolutions and uprisings in the late Ottoman and post-Ottoman Middle East. The course readings, sources, and discussions examine the relationship between myths of national origin, revolution, and state-making. The class also addresses the ways in which the control over the creation of myths of origin and ethnic, racial, national, and religious identity shaped society and politics in nation-states, republics, and monarchies especially after 1918. The course focuses partly on the theoretical underpinnings of national myth-making and ideologies of nationalism in order to offer historical understandings as to how states, majority and minority groups, and different national movements in post-Ottoman society created and re-made ‘imagined communities’ of nationals and citizens, sometimes through violence. The course surveys the ways in which new identities became manifested in a number of often-revolutionary ideologies including pan-Arab nationalism, Zionism, Kemalism, Phoenicianism, Baathist socialism, and various anti-imperial and anti-colonial movements."

By contrast, Khan Academy, the most famous of the "free online universities," appears to have about an hour of video explaining the history of the Middle East in the 20th century. PragerU, the creepy conservative alternative education site, has four videos about the Middle East, including the 5-minute-long, iconic video starring the dead-eyed master of ceremonies, Dennis Prager himself: "The Middle East Problem."Look: I love Wikipedia as much as anybody, but even at its best, Wikipedia can only provide you with information, not an education.

Post-secondary education advice roundup

We're going a little bit long here, so I want to add a bunch of quick hits that will be available in the same place:

• Whenever you move between states, immediately change your voter registration, apply for a new state ID or driver's license, and file taxes in the new state (even if you don't owe any state taxes). State residency for tuition purposes is seen by amateurs as an intrinsic fact about your identity, but this is false. It's a composite of what you can and can't prove. The more facts you can prove about your presence in the state, the more likely you are to receive in-state tuition.
• If you decide to go the elite-private-school route, do not take any post-secondary classes after the summer after you graduate high school. At most elite private universities, if you take any classes after that summer, you will not be eligible for "freshman" admission, and you'll be required to meet the much stricter "transfer" admission requirements.
• On the other hand, if you decide to go the in-state public university route, you should aim to meet as many of your general education or distribution requirements as possible before enrolling, so you can focus on getting as specialized a university education as possible. The way this works is that "lower-division" courses are typically large lectures, often taught by over-worked lecturers and offering little or no personal attention, while "upper-division" courses are more often smaller classes taught by tenure-track professors. The more you can tilt your course load towards the latter, the more bang for the buck you'll get.
• Many people say the only way to gain fluency in a foreign language is to live for an extended period in a country where that language is spoken. This is false. The only way to gain fluency in a foreign language is to attend the Middlebury Language School for that language.
• Never pay for non-professional graduate school. I don't think you should pay for professional graduate school either, but I understand the world needs doctors, so I'm not going to fight that battle here. But if you are considering attending a graduate program in the humanities or sciences, only enroll if you are provided health insurance, a tuition waiver and a stipend. Do not borrow money for non-professional graduate school. Do not pay for non-professional graduate school. If you can't get admitted to a program that provides a tuition waiver and a living stipend, go do something else and apply again the next year.

Conclusion

I think college is terrific. That (and a certain global financial crisis) is why I spent a decade floating around between institutions of higher learning before I found my calling. But it's also a system that in many ways preys upon people who are, by design, too young and ignorant to know what they're doing.If there's somebody like that in your life, send them this post!Become a Patron! 

The least-understood benefit of the 529 scam

I have written a lot about 529 college savings plans, the grotesque transfer of millions of dollars of additional wealth to the richest people in the country, which were expanded and made even more valuable in the Smash-and-Grab Tax Act of 2017 when qualified "higher education" expenses were expanded to include up to $10,000 per year in tuition at private elementary and secondary schools.In an exchange with reader calwatch in the comments to an earlier post, I touched on one of the most misunderstood elements of 529 plans, and realized it really deserved its own post.

The difference between tax-free and penalty-free withdrawals

I've gone over the basic conceit of 529 plans many times before: contributions are made with after-tax income (although some states allow tax deductions if you contribute to the plan in your state of residence), compound internally tax-free, and can be withdrawn tax-free for qualified "higher education" expenses (now including up to $10,000 in private elementary and secondary school tuition, as I mentioned above).It's essential to understand three types of withdrawals that can be made from a 529 plan:

• withdrawals for qualified higher education expenses paid out of pocket or with student loans are completely tax-free;
• withdrawals for qualified higher education expenses covered by grants and scholarships are penalty-free, but subject to income tax on the earnings portion of the withdrawal;
• and withdrawals for non-qualified higher education expenses are subject to income tax on the earnings portion of the withdrawal and a 10% penalty on the earnings portion of the withdrawal.

The key difference between tax-free and penalty-free withdrawals is this: tax-free withdrawals must be made in the year the qualified educational expenses are paid (or billed), while penalty-free withdrawals can be made at any time and "attributed" retroactively to the grant or scholarship.For folks who choose to enroll in high-deductible health plans eligible for tax-free health savings accounts, this should sound familiar: withdrawals from HSA's must be "attributed" to a qualified health expense, but they don't have to be made in the same year the health expense is incurred. Indeed, they can be made years or decades later, as long as you keep good records.

A well-timed penalty-free withdrawal is a tax-free withdrawal

What this allows you to do is time penalty-free, taxable withdrawals for years when you have low taxable income, for example if you stop working before age 70 but want to take advantage of the Social Security magic trick. During years in which you don't earn any ordinary income, you can "fill up" the bucket of your $12,000 or $24,000 standard deduction with 529 plan withdrawals attributed to decades-earlier grants and scholarships, and then meet any additional income needs with withdrawals from Roth accounts or taxable capital gains in the separate 0% capital gains tax bracket for those transactions.

Conclusion: yes, I'm trying to kill this loophole

Tax-advantaged programs like 529 accounts, while offering hilariously small benefits to the middle class and no benefits at all to the poor and working classes (who for obvious reasons are not saving anything at all) offer preposterous tax incentives to the rich, the very rich, and the ultra-rich.The answer is waiting for us whenever we're ready for it: shut down the 529 scam once and for all.

Why I like tax-free internal compounding, and why you might (and might not)

Last month I wrote about a range of available non-retirement investment accounts and broke down some advantages and disadvantages of each. When it came to 529 college savings accounts, reader flyernick had some objections to my math:

"On one hand, you’re arguing that at withdrawal, you get to exempt $12000 in gains because of the std. deduction. Then you compare that, 'In a taxable account, meanwhile, you’d owe taxes annually on every dividend and capital gain distribution'. But, you get that same $12000 exemption every year on annual distributions. And of course, 'taxes on the sale of the asset itself' would only apply to (un-distributed) cap gains. Your example here fails to convince me that paying an additional 10% tax 20+ years down the road is a useful strategy."

I want to address flyernick's specific objection and also expand on my logic to show why I think tax-free internal compounding is valuable enough that it's worth paying some amount for under the right circumstances.

529 accounts are uniquely valuable because of the option of tax-free withdrawals

I know my readers have heard this a thousand times already, but let's do a quick rundown of the benefits of 529 plans again:

1. limited, state-dependent tax benefits;
2. unlimited tax-free internal compounding;
3. unlimited tax-free qualified withdrawals.

The state tax benefits are typically not very interesting, but high-income folks in high-tax states should certainly maximize their home-state benefits before contributing to a low-cost plan like Utah's My529 (formerly UESP) or Vanguard's Nevada-based plan.The tax-free internal compounding is a feature shared by 401(k)'s, 403(b)'s, IRA's, and even variable annuities — more on this in a moment.But the ability to make tax-free qualified withdrawals of both your contributions and your earnings turns 529 plans into super-charged Roth accounts for anyone who may ever spend money on anyone's higher education expenses: they have preposterously high contribution limits, no income limits, tax-free dividends and capital gains, and tax-free withdrawals.This is a crime against the American taxpayer, but as long as the crime is being committed for the benefit of the wealthiest people in the country, it would be irresponsible for the rest of us not to join in.

What is the value of tax-free internal compounding?

With that out of the way, we can focus on nickflyer's specific question: what is the value of tax-free internal compounding, and how much should you be willing to pay for it? Let's take two stylized, but true, historical examples.

• Between July 1, 2009, and June 30, 2018, Vanguard Total Stock Market Investor Shares had a price appreciation of about 200%: $100,000 invested at the beginning of the period would have turned into $301,900 at the end of the period, and this appreciation would be tax free under any circumstances, as long as you held your shares for the entire period, since we don't tax capital gains until they're realized. But you also would have received $32,212 in dividends and capital gains distributions, and those would have been taxed along the way. Capital gains tax rates have bounced around a little bit but if you were in the highest capital gains tax bracket (23.8%) for the entire period, you would have owed a total of $7,667 in taxes over the 10-year period. In the lowest long-term capital gains tax brackets, you would have owed nothing on those distributions.
• Between July 1, 2000 and June 30, 2009, Vanguard Total Stock Market Investor Shares had a price appreciation of negative 32%: $100,000 invested at the beginning of the period would have turned into $68,639 at the end of the period. During the same period, you would have received $12,349 in dividends and capital gains distributions, and paid a top federal tax rate of 20%, or $2,470.

Importantly, in these examples it doesn't matter if you reinvest your dividends and capital gains; the taxes are owed no matter what you do with the money.Using the same two time periods, with the same $100,000 invested in the same mutual fund, but with dividends and capital gains reinvested and allowed to compound tax-free, the corresponding final values would be $356,174 and $79,522, respectively. With the investment made in a 529 plan or other account with tax-free internal compounding, the investor has so far saved $7,667 or $2,470 in federal taxes owed, plus whatever rate their state levies on capital gains and dividends.What happens when we try to get the money out of the 529 plan? For the 2000-2009 investor, this is not a problem at all: they're allowed to withdraw their entire balance, including dividends and including capital gains, tax- and penalty-free, because the amount of the withdrawal is lower than the amount of their contribution. The 529 plan "wrapper" has saved them $2,470 in federal taxes with no downside at all (except the opportunity to harvest capital losses). Obviously they'd prefer if their decade of investing had a positive, instead of a negative, return, but that's what you get when you invest at the peak of a stock market bubble and sell at the bottom of a global financial crisis.What about the investor who put $100,000 to work in July, 2009? Sure, they've saved $7,667 in taxes along the way, but now they're facing an account balance that is 72% gains ($256,174 of their $356,174 balance). For simplicity, say they convert their Vanguard Total Stock Market Investor Shares to cash at the end of the period, so they'll face a total of $25,617 in penalties whenever they withdraw that balance: 10% of the gains on the account, plus of course their ordinary income tax rate on the share of the gains they withdraw.Based on our stylized example, we can now easily see four possible outcomes:

• The account falls in value, and non-qualified withdrawals are completely tax- and penalty-free;
• The account maintains its value, and withdrawals are completely tax- and penalty-free regardless of whether they are qualified or non-qualified;
• The account increases in value, and non-qualified withdrawals are taxed and penalized;
• The account increases in value, and qualified withdrawals are tax- and penalty-free.

Only in one of the four cases, where you have an appreciated account with non-qualified withdrawals, does the 529 account have any downside compared to the same investment in a taxable account. In the case of accounts that fall in value or maintain their value, withdrawals remain tax- and penalty-free while dividends and capital gains compound internally tax-free, and in appreciated accounts used for qualifying expenses dividends, capital gains, and price appreciation are permanently tax-free.

Conclusion

I've assembled these facts not to give nickflyer a definitive answer to his question, but to reframe it slightly.A person who has certain knowledge about the future trajectory of the stock market should invest in the stocks that are going to go up the most. In that case, tax loss harvesting, tax-deferred accounts, and other opportunities to game the tax code are a sideshow compared to the business of buying the stocks that are going to go up and selling the ones that are going to go down.But if you have no idea which stocks are going to go up and which are going to go down, then 529 plans give you the opportunity to make lop-sided bets: if they go down, you're allowed to withdraw your principle, your dividends, and your capital gains tax-free. If they go up, you only have to pay taxes and penalties on your earnings, and only for non-qualified distributions. And if you're able to make qualified distributions, your earnings, dividends, and capital gains are permanently tax-free.The 10% penalty and ordinary income taxes levied on non-qualified distributions has to be weighted by the likelihood and magnitude of non-qualified distributions of gains. And as I mentioned in the original post, you can make those odds even more lop-sided by opening multiple accounts and horse-racing them against each other: make qualified withdrawals from the most appreciated accounts, and non-qualified withdrawals from accounts that have fallen in value, maintained their value, or appreciated the least, while all your accounts compound internally tax-free.

Differences between non-retirement investment options

If you're in the right mood, there's something a little bit depressing about the subject of investing: how boring it is. An easy way to think about this is that if you make the maximum contribution to a 401(k) and IRA every year, for 20 years, at the end of that 20 years, you'll be rich. How rich you'll be depends on a lot of factors, but the fact you'll be rich doesn't depend on anything except the steadiness of your contributions and the amount of time they're allowed to compound.$24,000 in annual contributions for 20 years turns into a million dollars at 6.6% APY. If you can only manage 6% APY, it takes a year longer, and at 7% APY a few months less. But all anyone has to do to become a millionaire is max out their 401(k) and IRA contributions for around 20 years.I don't mean to say that's easy. You can't contribute more than 100% of your income to a 401(k) or IRA, so if you make less than $18,500 you can't maximize that contribution (although you can contribute your first $5,500 in income towards both accounts). I'm just saying it's boring. Max out your contributions, wait 20 years, and you'll fall somewhere in the top 10% of households by net worth.The flip side of that fact is that as long as you make your retirement accounts as boring as possible (my solo 401(k) is invested in a single Vanguard mutual fund), you can do almost anything you like with the rest of your money without posing much if any risk to your chances of ending up rich. I've written a lot in separate posts about different kinds of non-retirement investments, so I thought I'd pull those different pieces together in one place.

Taxable brokerage accounts

Pros: no withdrawal penalties, opportunities to manipulate income, cheap or free, $11.2 million estate tax exemption and stepped-up basisCons: taxable (at preferential rates), may affect financial aid eligibility, limited control over dividends and capital gains distributionsTaxable brokerage accounts have two huge advantages and a slew of disadvantages.On the plus side, you can access your money at any time for any reason. It's true you may owe taxes on any appreciated assets, but as I like to say, if you're afraid of paying taxes you're afraid of making money — you only owe capital gains taxes on capital gains, after all. Additionally, simply having a bunch of uncorrelated assets in a taxable account is a tool for managing your tax liability, since you're able to top up your income with long term capital gains in low-income years ("capital gain harvesting"), and sell losers in high-income years to reduce your taxable income by up to $3,000 in losses per year ("capital loss harvesting").The disadvantages are important to consider, however: mutual funds that are forced to pass along capital gains can trigger tax bills even if you don't sell your own shares. Unpredictable dividends can make it difficult to dial in your income precisely, for example if you intend to qualify for premium subsidies on the Affordable Care Act exchanges. If you or your kids are applying for federal financial aid using the FAFSA, you don't need to report qualified retirement savings, while assets in taxable brokerage accounts will reduce your assessed financial need (under some circumstances).One other thing taxable brokerage accounts are perfect for is gambling. If you walk into a Vegas casino and lose $500 playing roulette, you're out $500. If you buy $500 of Enron stock and it drops to $0, you might be out as little as $250, depending on your federal and state income tax situation.

Variable Annuities

Pros: tax-free internal compounding, asset protectionCons: gains taxable as ordinary income, inherited assets fully taxable, very expensive, early withdrawal penaltyI wrote relatively recently about variable annuities so I won't belabor the point here, but one point that reader Justin brought up in the comments to that post is that depending on your precise situation, annuity assets may be protected from creditors in a civil judgment or bankruptcy filing. This is, obviously, not protection afforded to taxable brokerage assets, and I think in certain circumstances an annuity might be worth considering for this reason alone.However, if your primary goal is asset protection, you should first consider shopping around for an umbrella insurance policy, since the management fees and tax consequences of a variable annuity might be substantially higher than the annual cost of comprehensive liability insurance. However, this would not apply if you're contemplating bankruptcy in a state that protects annuity assets from creditors.

529 College Savings Plans

Pros: low-cost, state-dependent tax benefits, tax-free internal compounding, flexible beneficiary designation, tax-free qualified withdrawalsCons: non-qualified withdrawal penalty, contribution limitsLong-time readers know that 529 plans are a crime committed in broad daylight against the American people. But that doesn't mean they can't still be useful. It's useful to think of 529 plans in two ways:

• qualified withdrawals are completely tax-free;
• pro-rated gains on non-qualified withdrawals are taxed as ordinary income with a 10% penalty.

While my main problem with 529 plans is the tax-free transmission of wealth between generations, it's trivial to conceive of an even simpler hack to achieve both tax-free internal compounding and tax-free withdrawals. Since 529 plan beneficiaries can be changed without any tax consequence to immediate (and not-so-immediate) relatives of the current beneficiary, who does not need to be related to the account owner, all you need to do is find a family with a bunch of kids and designate the oldest (or smartest) as the beneficiary of the account.Whenever they have any qualified educational expenses (which, thanks to Zodiac Killer and Republican Senator Ted Cruz, now include up to $10,000 in private and religious K-12 expenses per year), you can issue a qualified, tax-free distribution to the school and be reimbursed by whoever would otherwise pay their tuition.To be clear, this is completely illegal. But if you think that's stopping our plutocrats from doing it, I've got a tax-advantaged infrastructure investment in Brooklyn to sell you.The other reason to consider 529 plans as an alternative savings vehicle is that the penalty on non-qualified withdrawals just isn't that harsh. Here's an example using the 20-year investment horizon I described earlier:

1. Contribute $100,000 to the Vanguard Total Stock Market Portfolio in Vanguard's (Nevada-sponsored) 529 plan;
2. Using a 5% APY average return after fees, in 20 years the account's value will be about $265,000, representing $165,000 in gains, or roughly 62% of the account's value.
3. Assuming a standard deduction of $12,000, you can withdraw $19,354 per year without owing any income tax: 62% of the withdrawal will be taxable as ordinary income and 38% will be a tax- and penalty-free withdrawal of your original contribution. You will, however, owe a 10% penalty on the gains, or $1,200.

In a taxable account, meanwhile, you'd owe taxes annually on every dividend and capital gain distribution as well as taxes on the sale of the asset itself. Under the right circumstances, the 10% "penalty" can be lower than the taxes you've avoided on internal compounding, and over even longer time horizons that's even more likely to be the case.In other words, over long enough time horizons, 529 college savings plans function like variable annuities with substantially lower management fees and expenses, and the opportunity for completely tax-free withdrawals. In Vanguard's case, compare the 0.18% all-in fee for their 529 Total Stock Market Portfolio to the 0.42% for the same portfolio in their variable annuity product. The key point is that the higher management fees and expenses are charged on the entire variable annuity portfolio, while the 10% withdrawal penalty is only charged on the gains in the 529 portfolio.This technique even allows you to replicate the old "horse race" strategy of IRA recharacterizations. Since the gains in each 529 account are calculated separately for the purpose of non-qualified withdrawals, you could open one Vanguard 529 plan invested entirely in the Total Stock Market Portfolio, and one My529 plan invested entirely in the Vanguard Total International Stock Index Fund (and another state's plan invested in the domestic bond market, and another state's plan invested in the international bond market, etc.). Since non-qualified distributions are taxed and penalized on an individual account basis, you would always have the option of making non-qualified withdrawals from the account with the most (or least) gains, depending on your tax situation in a given year.And this, unlike the "sell your 529 plan assets" strategy mentioned earlier, is 100% legal. Hell, it's practically encouraged.

Non-traded investment scams

Pros: high "expected returns"Cons: expensive, illiquid, obviously doomedToday there are a million crowd-funded investment options, from old-school players like Prosper and LendingClub to newfangled bill brokers like Kickfurther. But the investment that most naturally lends itself to crowdfunding is real estate. Real estate is expensive (so you can raise a lot of money), it's illiquid (so you can lock investors' money up for years), and it's opaque (so no one has any idea if you're getting a "good" or "bad" price on the real estate you acquire or the management fees you charge).I have a lot of respect for these scams. They charge huge upfront fees and huge management fees for an investment they have no control over the performance of. Fundrise is one of my favorite examples: one thing you could do if you identified a promising piece of real estate is to take out a loan and buy it. Alternately, you could raise money from a group of investors who would then share ownership of it. But Fundrise has an even better idea: collect money from strangers, issue them unsecured claims on a future stream of revenue, charge your expenses against that stream of revenue, then return their money minus your own healthy share of any eventual profit.If you want to invest in a mutual fund, you ought to invest in a mutual fund. If you want to invest in real estate, you ought to invest in real estate. But if you want to get ripped off by some Silicon Valley dweebs who paid $300 for a graphic artist to design a sleek website, Fundrise is for you.

Rental real estate

Pros: generous tax treatment, stepped-up basisCons: expensive, illiquid, volatileAs a leveraged bet on the cost of housing, owning rental real estate doesn't have any advantages over simply buying a residential REIT on margin. You have all the risks of declining real estate prices, rising vacancy rates, and property damage, and none of the benefits of spreading that risk across hundreds or thousands of properties.All the advantages come from the special tax treatment real estate receives. While you own a rental property, you're allowed to deduct the interest on any mortgage you took out to buy it. You're allowed to deduct the property's depreciation. And you're allowed to sell the property and make a "like-kind" exchange for another property (in the US) without triggering taxes on the sale. Finally, like other taxable assets, your heirs will receive the property with a stepped-up basis, meaning they won't owe taxes on the appreciation of the property during your lifetime.This is especially valuable in the case of real estate if the original owner was deducting depreciation and reducing their own basis in the property: a property purchased for $200,000 whose owner deducted $100,000 in depreciation, but is worth $400,000 when inherited and sold, avoids capital gains taxes on $300,000 that would have been owed if sold during the original owner's lifetime.

Collectibles

Pros: interesting conversation piecesCons: losing all your moneySome people think the problem with "greater fool" assets, whether it's bitcoin, Beanie Babies, or Hummel figurines, is that you'll run out of fools, but I don't think that's quite right. If you try hard enough, you'll likely always be able to find someone, at some price, to take your junk off your hands. The problem isn't finding a fool, it's finding a greater fool — someone willing to pay more for your trinkets than you did.Note that there are strict rules on the tax treatment of hobby losses, so consult a lawyer and/or CPA  (again, I am neither) before starting to gamble in any of this stuff.

Start a business

Pros: preposterous tax advantages, higher Social Security benefits, larger 401(k) contributionsCons: unknownI'm here to promote entrepreneurs and entrepreneurship, so obviously I'm a bit biased. Nonetheless, the advantages of starting a business are undeniable, whether or not you also work as an employee elsewhere.First, if you don't hit the Social Security earnings cap through any other work you do, self-employment allows you to raise your annual contribution and increase the old age and disability payments you're entitled to. For folks who spent a long time unemployed or in higher education due to the late-2000's breakdown in global capitalism, the only way to make up for those missing years is higher contributions during the remaining years before retirement.Second, while your voluntary employee-side 401(k) contributions are capped at $18,500 in 2018 across all your employers and your self-employment, each employer — including yourself — has a separate cap on the amount they're able to contribute to an employer-side 401(k). That means you can take advantage of any employer matching program at your day job and make additional employer-side contributions into a solo 401(k) subject to a totally separate cap.Finally, the 2017 Republican tax heist added an additional 20% discount on the taxable income of many small businesses. This is an extremely confusing topic so, again, consult a CPA if you have any questions about whether your small business qualifies, since certain industries and legal structures are excluded under certain circumstances.

Prepaid tuition plan roundup

This week I wrote about the prepaid tuition plans offered by Washington state and Virginia. To close out the week I wanted to share a brief roundup of the other prepaid tuition programs still out there.First, take a look at the overview, then I'll offer some brief commentary:

State	Plan	Premium (discount) to current tuition	In-state public benefit	In-state private benefit	Out-of-state benefit
Washington	Guaranteed Education Tuition	8.80%	Tuition and mandatory fees at most expensive Washington public college or university	Tuition and mandatory fees at most expensive Washington public college or university	Tuition and mandatory fees at most expensive Washington public college or university
Virginia	Prepaid529	0%	Tuition and mandatory fees	Payments made plus the actual rate of return	Payments made plus a reasonable rate of return
Florida	Prepaid	6.5%	Tuition, tuition differential fee and other specified fees	Average rate payable to in-state public institution	Average rate payable to in-state public institution
Mississippi	MPACT	6.5%	Public in-state standard undergraduate tuition rates and mandatory fees	Weighted-average tuition and mandatory fees at Mississippi public colleges and universities	Weighted-average tuition and mandatory fees at Mississippi public colleges and universities
Maryland	Prepaid College Trust	(20.4%)	In-state or in-county tuition and mandatory fees	Tuition and mandatory fees up to the Weighted Average Tuition	Tuition and mandatory fees up to the Weighted Average Tuition
Massachusetts	U.Plan Prepaid Tuition Program	0%	Lock in a percentage of current tuition and fees at participating public and private schools in Massachusetts	Return of investment plus CPI	Return of investment plus CPI
Nevada	Prepaid Tuition Program	(6.1%)	Tuition at rate selected on contract	Paid at rate selected on contract	Paid at rate selected on contract

For each plan, I calculated the cost based on the most comprehensive plan available (usually a four-year university plan) for someone born this year (most of the plans get more expensive the closer your beneficiary is to graduation). I then calculated the premium or discount paid compared to the amount paid for someone using their benefits this year at the most expensive in-state institution.The prepaid tuition plans follow three basic models.

Fixed payout rate

This is the model used by Washington and Nevada. You buy a certain number of investment units at a fixed price today, and then are paid out at a different, hopefully higher value in the future. In Washington the payout rate is based on the most expensive public university in the state, while in Nevada it's based on the "credit hour cost" set by the Nevada Board of Regents.Washington charges a premium of 8.8%, meaning tuition and fees at the University of Washington would need to rise that much before a contract would start to show a profit.Nevada, on the other hand, charges less per credit hour than the current payout rate: you can buy 120 university credit hours for $24,285, or $202.38 per credit, while the current payout rate is $215.50 per credit hour.Both programs allow you to receive the same benefit at in-state public, private and out-of-state schools, making them by far the most flexible prepaid tuition programs.

Tuition and fees

Virginia, Florida, Mississippi, and Maryland allow you to use your prepaid tuition plan to cover in-state tuition and fees at public schools. Mississippi and Florida have the additional cool benefit of guaranteeing beneficiaries in-state tuition, even if they're not residents of the state when they enroll.The premium I show above is the difference between the cost of a prepaid tuition contract and the current value at the most expensive public institution. If your beneficiary attends a less expensive school, the premium goes up, since contracts cost the same whether you attend the University of Virginia or the College of William & Mary (the latter is more expensive).The discount shown for Maryland's plan is an artifact of my methodology, due to the outlier expense of attending St. Mary's College of Maryland, where tuition and fees for four years cost $57,984 and a four-year university plan costs just $46,135. At the University of Maryland Baltimore County, the second-priciest public university in the state, four years costs just $46,072, leaving the Prepaid College Trust with a small premium.One final thing to point out here: the weighted averages used by Florida, Mississippi, and Maryland to calculate the benefits payable to beneficiaries attending private and out-of-state schools will be much lower than the maximum benefits I used to calculate the premium and discount rates. In Maryland, the weighted average tuition for four-year colleges is $10,033, giving the Prepaid College Trust a premium of 14.8% (the amount the weighted average tuition would have to rise before your contract broke even).

Massachusetts

The Massachusetts model is fascinating. Instead of only applying to in-state tuition at public universities, the U.Plan Prepaid Tuition Program has a long list of participating Massachusetts public and private schools.Accounts owners make a dollar-denominated contribution to their account and then that contribution is converted into a percentage of tuition and fees at the prevailing rates at every participating school.So, to use this year's table, a $1,500 contribution today buys 2.86% of tuition and fees at the (expensive) Amherst College and 29.94% at the (cheap) Berkshire Community College. Next year, if Amhert's tuition rises by more than Berkshire's, the same $1,500 contribution might buy 2.5% at Amherst and 29.5% at Berkshire.The two contributions together, then, buy a total of 5.36% at Amherst or 59.44% at Berkshire — whichever one you end up enrolling in.This plan has one big advantage: it lets you lock in today's tuition prices, and at a wider range of schools than just the public institutions available in the other plans, including premier institutions like Amherst, Wellesley, Smith, and Mount Holyoke.But that advantage comes paired with a big downside: if you attend a non-participating institution, you get nothing. Well, not exactly nothing; you get your money back, but without any investment returns at all.That creates an obvious bind: the earlier you contribute, the lower the tuition rate you're able to lock in, so if you anticipate that Baumol's cost disease will continue to ravage the higher education sector, you should accelerate contributions early on. On the other hand, the earlier you contribute, the more years of investment returns you sacrifice if your beneficiary ends up attending a non-participating school!

Conclusion

Now you know everything I know about prepaid tuition plans. A few closing thoughts:

• A sufficiently wealthy resident of Washington or Nevada, with sufficiently young kids, should consider buying the maximum contract if they want to place a bet on the trajectory of public higher education costs. Both programs are fully funded (Washington at 135% and Nevada at 132% of liabilities), so I don't see any reason to worry about the programs being unable to pay the promised benefits.
• Residents of Florida, Mississippi, or Maryland with young enough children might consider combining a prepaid tuition plan with a 529 college savings plan. If their children attend private or out-of-state schools, then the weighted average tuition paid by the prepaid tuition plan should have steady, bond-like returns, allowing them to take more investment risk in their college savings plan. If the beneficiaries do end up attending an in-state public institution, then they'll receive a bonus payoff in the form of discounted tuition. Note that the beneficiary should be young enough to give rising tuition plenty of time to overcome the premium paid.
• Residents of Massachusetts or Virginia with enough children may consider opening a prepaid tuition plan in order to lock in today's tuition rates, since the ability to change the account's beneficiary from one child to the next increases your odds of being able to claim the benefit, by attending a participating school in Massachusetts or a public university in Virginia.

How to think about prepaid tuition plans: Virginia Prepaid529

Yesterday I described the best prepaid tuition plan I know of, Washington state's Guaranteed Education Tuition plan, which allows you to place a tax-free bet on the trajectory of tuition inflation at Washington public universities. It's a weird investment vehicle, but you could see how it might play a speculative role in the portfolio of a sufficiently wealthy person, especially because it comes with all the tax advantages of a 529 college savings plan.By way of comparison, today I want to describe the wrong way to invest in a prepaid tuition plan: the Virginia Prepaid529 plan.

Virginia Prepaid529

The Virginia Prepaid529 plan differs in important ways from Washington's GET program:

• Prepaid529 uses "semesters" as the unit of investment, rather than GET's "units." A "semester" is equal to the cost of one semester at a Virginia public 4-year university or 2.6084 semesters at a Virginia 2-year college.
• The price paid per semester varies depending on the age of the beneficiary. While GET allows all enrollees to buy units for the same price, set somewhat above the current payout value of a unit, Prepaid529 charges less for semesters purchased closer to the beneficiary's enrollment. For example, a newborn beneficiary is charged $8,825 per semester, while a 9th-grade beneficiary is charged $8,145 per semester. By way of reference, mandatory tuition and fees for undergraduates enrolling at the University of Virginia in 2017 are about $8,390 per semester (this information is remarkably difficult to find).
• Accounts must be opened by the end of the enrollment period during the beneficiary’s ninth grade year (as far as I can tell — Virginians feel free to correct me if I'm wrong).

So far, the plan looks pretty similar to GET. In-state tuition and fees at the University of Virginia are somewhat more expensive than at the University of Washington, so prepaying tuition is somewhat more expensive, but not radically so. The difference comes in when it's time to redeem your prepaid semesters:

• At Virginia public colleges and universities, you can redeem one semester investment unit for one semester of mandatory tuition and fees (2.6084 semesters at two-year and community colleges).
• At Virginia private colleges and universities, you can redeem one semester investment unit for the lesser of the payments you made plus the actual rate of return Prepaid529 earned on those payments or the highest Virginia public institution tuition and mandatory fees.
• At colleges and universities outside Virginia, you can redeem one semester for the lesser of your payments plus a "reasonable rate of return" or the average Virginia public institution tuition and mandatory fees. I can't find any record of that average on Prepaid529's site, but it will always be much lower than the highest tuition and fees used in the above calculation.

What is a "reasonable rate of return?" Prepaid529 helpfully defines it as "the quarterly performance of the Institutional Money Funds Index as reported in the Money Fund MonitorTM by iMoneyNet." As far as I can tell that's essentially 0%. Reasonable!

Do not invest in Virginia's Prepaid529 plan...

Virginia has essentially set up a three-tiered outcome structure:

• Some number of Prepaid529 beneficiaries will attend Virginia public colleges and universities. They'll receive the number of semesters of tuition and fees they paid for, at the price they paid for them. In exchange, Prepaid529 gets to invest their money during the intervening period. If Prepaid529's investments outperform tuition inflation, Prepaid529 gets to keep the difference. If they underperform, they (hopefully) still pay out as promised. This is a traditional single-premium annuity or insurance contract.
• Some number of Prepaid529 beneficiaries will attend Virginia private colleges and universities. If Prepaid529's investments underperform tuition inflation, they'll receive a lower payout amount based on that performance. If Prepaid529's investment outperform tuition inflation, the beneficiary doesn't participate in that outperformance; instead they receive an amount based on the highest Virginia public university tuition and fees. In other words, you participate fully in the downside and only partially in the upside, like a twisted variable indexed annuity contract.
• Some number of Prepaid529 beneficiaries will attend out-of-state colleges and universities, and receive their money back, plus a nominal return.

The one thing I'll give Prepaid529 is that this structure allows them to charge lower prices per semester compared to Washington's GET. You can buy 10 semesters of in-state tuition and fees for a newborn today for $88,250, about a 5.2% premium over current tuition and fees, while 500 GET units would cost $56,500, a premium of about 8.8% over the current $51,930 payout value. That's not nothing.But in exchange for the relatively low Prepaid529 premium, you are buying into the three-tier payout structure I described, in which the investment returns on the payments of students attending private and out-of-state schools subsidize the guaranteed tuition of students attending in-state public schools. Meanwhile, the higher GET premium buys you a return based on Washington state public tuition inflation regardless of where you decide to enroll.For an older student with their heart set on attending the University of Virginia, that might make sense. But for a younger beneficiary who may or may not even decide to enroll in higher education, investing using a 529 college savings plan offers all the benefits of internal tax-free compounding without the larcenous payout structure of Virginia's prepaid plan.

...with one exception

If you or your beneficiary is a Virginia resident in the 9th grade year of your beneficiary and you think there's even a chance the beneficiary will attend a Virginia public college or university, you might consider rolling over a 529 college savings plan into the Prepaid529 plan. Why? Because if you plan on spending your 529 assets for higher education (instead of for estate planning), those assets should be mainly in cash and bonds anyway by the time your beneficiary reaches high school, in order to preserve their value against stock market volatility. If you're going to earn a low rate of return on 529 assets anyway, you may as well get a cheap hedge against tuition inflation.The same logic doesn't apply to Washington state's GET program because the purchase price of investment units is too high compared to the near-term payout value of those units.In other words, the best course is to invest your 529 assets in GET as early as possible, and invest them in Prepaid529 as late as possible.

How to think about prepaid tuition plans: Washington's Guaranteed Education Tuition plan

I've written extensively about 529 college savings plans, which are a way for the wealthy to permanently shield intergenerational transfers of appreciated assets from taxation while also allowing those assets to internally compound tax-free. However, there's a second kind of investment vehicle conceived of by section 529 of the Internal Revenue Code: prepaid tuition plans.While every state, the District of Columbia, and Puerto Rico all offer 529 college savings plans, only a few states took section 529 seriously and endeavored to set up prepaid tuition plans.

Washington State's Guaranteed Education Tuition (GET) plan

Washington's GET plan has a simple structure:

• At any time, you can buy any number of "units" at a purchase price determined by GET's actuaries each year, until the total number of units purchased per beneficiary has reached 600.
• When the beneficiary enrolls in a qualified educational institution, you can request disbursement of up to 150 units per year at a unit payout value equal to 1% of the tuition and mandatory fees charged by the most expensive public university in Washington state.

A few things to note here:

• In any given year, the unit purchase price will be higher than the unit payout value. This year, the unit purchase price is $113, while the unit payout value is $103.86. That's because they're not selling this year's tuition and fees, they're selling tuition and fees at an unknown point in the future.
• 600 units is equal to 6 years of tuition and fees at the most expensive Washington public university, but you can redeem up to 150 units per year, so if you bought 600 units, you could be reimbursed for 150% of that amount against the tuition and fees at a more expensive four-year college (like all 529 plans, you can only request tax-free distributions for qualified expenses).

To give an extreme example, you could purchase 600 units today for $67,800. You would break even when tuition and fees in Washington rose to $11,300 per year, about 8.8% higher than they are today. As tuition and fees rose still further, you'd experience the same tax-free appreciation of your investment seen in 529 college savings plans, except instead of depending on stock or bond market performance, your returns would depend on the trajectory of Washington state education funding.This is, needless to say, a curious investment. It combines a credit risk (will Washington state honor the terms of the program in 10, 20, or 50 years?), an inflation hedge (the "purchasing power" of your investment is protected from tuition increases as long as you attend a Washington public college or university), and a speculative bet (Washington state tuition inflation will outpace the performance of your public market investments).

What happens if tuition and fees go down?

I'm glad you asked, since that very thing happened in 2015!In that year, the Washington legislature passed the "College Affordability Plan" which reduced tuition and fees from $11,782 to $11,245, and then to $10,171. By rights, this should have reduced the unit payout value of accounts from $117.82 to $101.71, a decrease of 13.7%.But it didn't. By special dispensation from the state legislature, GET was allowed to maintain the higher unit payout value, and then when they finally reset the unit payout value to match the new, lower tuition and fees, they compensated account holders by increasing the number of units in their accounts by a corresponding amount!Look: I'm not a Washington state taxpayer. I don't own and am not the beneficiary of a GET account. But this kind of "heads-I-win-tails-I-win" policymaking is a textbook example of moral hazard. If GET investors participate fully in the upside of tuition inflation and are protected from the downside of tuition deflation they're going to be the beneficiaries of huge wealth transfers from their fellow citizens of Washington state, and the country as a whole.

Should you invest in a prepaid tuition plan?

A few years back I learned about the story of Bert Fingerhut, who, as a wealthy and successful Wall Street investment banker, criss-crossed the country opening accounts in his own name and the names of anybody else he could think of at so-called "mutual savings banks," so that if they ever reorganized as publicly traded entities he would be entitled to pre-IPO shares. What he was doing was perfectly legal, he just wasn't satisfied with only claiming shares for himself, so he fraudulently opened accounts of which he was the beneficial owner.When researching the Washington state GET plan, I was reminded of poor old Bert, whose only crime was that he got greedy. I think if I were a sufficiently wealthy Washington resident, with a sufficiently young child, I'd buy my 600 GET units, not because such an investment is guaranteed to outperform the public markets, but because it's an investment different enough from the public markets that it's likely to perform differently from the low-cost stocks and bonds in a 529 college savings account like the ones offered by Vanguard and others.After all, the most you can lose in a $67,800 investment is $67,800. If tuition and fees at the most expensive Washington public universities rises at the same rate as median hourly wages, the maximum rate currently allowed by law, then based on data between 1990 and 2016, you'd expect your investment to return an average of 2.9% per year. If that cap is lifted and tuition and fees rise faster, you'd do even better, and if tuition and fees are cut again, there's precedent for being made whole by the state legislature.And all these returns are, of course, completely tax-free.

Should you use the Vanguard 529 Plan?

State-sponsored 529 savings plans are tax-advantaged estate planning tools that can also be used to save for "higher education" expenses, a category which was recently expanded to include private and religious K-12 tuition.I've had an account with the Utah Educational Savings Plan, which was recently rebranded as My529, for years and have been very satisfied with their selection of very low-cost Vanguard investment funds and low account maintenance fee of 0.2%.My brother recently asked me about the Vanguard 529 Plan, and after doing a little bit of research, I thought I'd share what I found.

How to select a 529 plan

There are three factors that should go into your decision of which 529 plan or plans to choose:

1. Tax benefits. Check every state where you earn taxable income and find out whether there are deductions or credits available for contributions to 529 plans. Some states, like Pennsylvania, allow residents to take the deduction for contributions to any state's 529 plan, while others, like Arkansas, only allow deductions for contributions made to in-state plans. Credits and deductions may only be available to residents; check with your tax professional.
2. Investment options. While I would look for low-cost Vanguard index funds, it's not the end of the world if you have to choose low-cost index funds from another provider, but stay away from plans that only offer high-cost, actively-managed, or more complex investment vehicles. Washington State, for example, has a prepaid tuition savings plan that, as far as I can tell, is a way to make a tax-advantaged bet on public higher education tuition outpacing the stock market (and Washington State not going bankrupt).
3. Fees. In addition to the underlying expense ratio of the mutual funds you invest in, 529 plans also charge account maintenance fees, which you should also attempt to minimize.

The key thing to realize is that since you can open multiple 529 plans, you can optimize these factors in multiple ways. For example, an Arkansan can contribute $5,000 per year ($10,000 for married couples) to Arkansas's relatively expensive 529 plan in order to secure the maximum state income tax deduction, then direct additional contributions to lower-cost, out-of-state plans.

How does Vanguard compare to My529?

When it comes to state tax benefits, the plans are identical except for residents of Utah, who can claim an annual 5% state income tax credit on up to $1,920 ($3,840 for married couples) in contributions per beneficiary to My529 plans. That $192 per year, per beneficiary, may not seem like much, but it swamps the differences in fees between the two plans.What are those differences? Unlike My529, Vanguard somewhat annoyingly rolls the asset-based account maintenance fee into the expense ratio for each investment option. So while My529 offers the "Vanguard Total Stock Market Index" with a 0.02% expense ratio and 0.2% "Administrative Asset Fee" for a total of 0.22%, Vanguard offers the "Total Stock Market Portfolio" which charges 0.18%, including both the underlying expense ratio and the account maintenance fee.The spread isn't a constant 0.04%, unfortunately, so the actual difference in fees will depend on your weighted asset allocation. For international stocks, My529 charges a total (including Administrative Asset Fee) of 0.27% while Vanguard charges 0.25%.So basically, for non-Utah residents, Vanguard is the clear, if slight, favorite. For Utahns, the question is how much hassle you're willing to go through managing two 529 accounts. If that exceeds your hassle threshold, then using My529 exclusively is a perfectly reasonable, low-cost choice. If your hassle threshold is higher, stick $1,920 per beneficiary, per year, into My529 and use Vanguard for the remainder of your contributions.

Vanguard 529 balances count towards Voyager status

Unrelated to the tax and cost advantages of 529 savings plans, Vanguard has one additional slight advantage: your 529 balances count towards your qualification for Voyager, Voyager Select, and Flagship services. Vanguard "elite status" doesn't have very many advantages, but if you have any account types, like a solo 401(k), that charge annual account maintenance fees, those fees are waived once your total Vanguard balance across all account types reaches $50,000. That can take a long time if you're just saving $5,500 per year in an IRA, so the ability to goose your overall Vanguard balance with 529 contributions may help you save money on fees in addition to the lower cost of the investments themselves.

The effect of estate tax repeal on the 529 scam

One of the first posts I wrote here was about the 529 scam. I explained that 529 plans are a way for wealthy individuals to permanently shield an almost unlimited amount of assets from taxation, and that the scam was made sustainable by the very large number of middle class people saving a very small amount of money who are absolutely convinced that 529 plans are a way to save money for college, rather than a way for the wealthy to shield their assets from taxation.Like the mortgage interest, the state and local tax, and charitable contribution deductions, the actual benefits of 529 plans accrue to a tiny population of wealthy heirs and heiresses, who are protected from blowback by a large population of earnest upper-middle-class professionals.

What are the benefits of 529 college savings plans?

There is so much nonsense out there about 529 college savings plans that it's important to understand what the actual benefits of the plans are. There are only three:

• Internal tax-free compounding. Dividends and capital gains from the underlying investments are untaxed as long as they remain in the account, while they would be taxed if held in a taxable brokerage account.
• Tax-free withdrawals. Under certain conditions, withdrawals from the accounts are tax-free, while they would be taxable if the securities were instead held in a taxable brokerage account.
• Transfer of ownership of a 529 account is not a taxable event at the death of the account's owner, while it might be if the owner of a taxable brokerage account dies (although in that case the heir would benefit from the stepped up basis rule).

What are the limits on 529 college savings plans?

It is commonly believed that there is a limit of $14,000 in annual contributions to 529 college savings plans, or $70,000 if contributions are made upfront and reported over a 5-year period. This is precisely false.$14,000 ($70,000) is the annual (quinquennial) amount you can contribute without filing a "Gift (and Generation-Skipping Transfer) Tax Return."The actual limit on the amount you can contribute to a 529 college savings plan is the plan's maximum contribution balance. For my preferred 529 plan, the Utah Educational Savings Plan, the maximum contribution is $430,000. You can't contribute any more to the plan as long as your balance is at least that amount, but in case of a decline in the value of the account, you can "top up" the account to $430,000 again. As UESP helpfully explains:

"UESP will accept contributions for a beneficiary until all UESP account balances for that beneficiary reach $430,000. It is possible that balances may exceed $430,000 because of market performance. Contributions or portions of contributions that exceed this maximum will be returned to the contributor."

How would repeal of the estate tax affect the 529 scam?

In the absence of the estate tax, there would be no reason for our beloved oligarchs not to contribute the maximum account value to every 529 plan in the country. Without an estate tax, there would be no estate tax exclusion that such contributions could count against, and there would be no return that would need to be filed to record such transactions.To use UESP as an example again, in the absence of the estate tax, at birth every wealthy child in the country could receive a $430,000 transfer, invested in the stock market, that would compound tax-free forever, and with tax-free withdrawals when spent on eligible expenses.

About those eligible expenses

Here readers think they have caught me in some kind of trap. "A-ha," you say, "what good is an enormous tax-free inheritance that can only be spent on certain eligible expenses?"Don't worry, Ted Cruz is on the case. Senator Cruz included in the Senate version of the Republican tax reform bill a provision allowing $130,000 to be withdrawn for K-12 private school expenses, in addition to the undergraduate and graduate school withdrawals that were already allowed tax-free.Even if you're a responsible middle class professional, think about the logic of this provision. A diligent middle class saver starts investing money at the birth of their child and starts withdrawing it a few years later for private kindergarten expenses, so it's had perhaps 2 or 3 years of tax-free internal compounding. A wealthy person inherits a multi-million dollar 529 plan and is able to withdraw $10,000 per year for 13 years that has never been and will never be taxed. Then they can withdraw an unlimited additional amount, also tax-free, up to the total cost of attendance at their kid's private college and graduate school.Finally, as I mentioned in my original post, it's important to understand that a huge portion of the intergenerational transfer of wealth is precisely the transfer of educational opportunities and credentials. Far from being a "restricted" or "limited" form of inheritance, "forcing" your heirs to use a portion of their inheritance on the best private schools is far from a drawback of the 529 plan scam. For many of our oligarchs, it's the whole point.

Fish for scholarships in the deepest pools of money

One of Charlie Munger's beloved aphorisms is to "fish where the fish are." It doesn't mean you're guaranteed to succeed, but you're much more likely to succeed than trying to fish anywhere else.When it comes to college scholarships, there's a cliche so old it's practically an antique: apply for as many scholarships as possible, no matter the amount, because every little bit helps to make college affordable.I don't know the origin of this conventional wisdom, but it's so banal I'm not even going to bother to disagree with it (though I think high school students have better things to be doing than applying for $50 scholarships from their local credit union). Instead, I'm going to suggest an alternate approach.

Think like a grant applicant

When the federal government wants to research the causes of diabetes, it sends out a request for proposals for research into the causes of diabetes. All the nation's diabetes researchers submit their proposals, and the federal government selects the most promising proposals to fund.There's nothing you can do about the amount of money appropriated for diabetes research, which determines the number of proposals accepted. What you can focus on is the one thing you can control: being a diabetes researcher with a compelling research proposal. That's because no matter how much money is appropriated, only diabetes researchers are going to be approved to receive it.The same logic applies to receiving student aid: become the kind of person who receives student aid, and you're much more likely to receive it.

Research government funded educational programs: that's where the money is

Let's start with an easy one. Everyone knows that low-income college students are eligible for federal Pell grants. But did you know there's a second low-income college scholarship program, the Supplemental Education Opportunity Grant? The catch is, not every institution participates in SEOG — to receive a grant, you need to attend a participating institution. Unfortunately, 20 minutes of searching didn't yield an official list of participating programs, which means you'll need to check each institution you're interested in individually. Searching for the institution's name and "FSEOG" or "SEOG" typically works, although you can also call the financial aid office and ask directly.Now let's take it one step further. The Department of Education also runs a competition to award Foreign Language and Area Studies, or FLAS, grants to undergraduates studying "modern foreign languages and related area or international studies." To receive a FLAS grant, you need to be studying a foreign language at a school that receives FLAS funding. It's no good to study foreign language anywhere else, and it's no good to study anything else at a FLAS school. Fortunately, a list of 2014-2018 FLAS schools is available online.Finally, there are entire educational programs funded by the federal government. To continue the example of foreign language training, the federal government, at great expense, has created undergraduate language fluency programs in Arabic, Chinese, Hindi Urdu, Korean, Persian, Portugese, Russian, Swahili and Turkish. Note that while the programs are generously federally funded, they don't include scholarships for undergraduate students. That brings me back to the first point above: think like a grant recipient. The programs themselves don't have to include undergraduate scholarships, but if you can enter a language flagship program suddenly you become the work product of the grant applicants, which means they have an incentive to see you succeed, whether that means writing letters of recommendation, finding scholarship funding, or providing work-study opportunities.I've been using examples from foreign language studies since that's my own background, but opportunities exist in other fields as well: do you know about the Ronald E. McNair Postbaccalaureate Achievement Program? You have to attend one of the 151 participating institutions to participate.

Conclusion

My readers already know that you don't need "scholarships" to go to college for free: you just need to have a low enough income and attend a school that promises to meet your full financial need with grant aid. If you've decided to have a high income, or decide to attend a school that expects you to contribute to the cost of your tuition, then it may make sense to pursue scholarships. But if you're going to do so, you're going to have much more luck going from big to small than vice versa. And when it comes to "big," there are no deeper pockets than Uncle Sam's. Start there.

You can go to college for free (but you won't)

This is a subject I've written about before on the Saverocity Forum, but now that I've got this whole finance blog I can share it with a bigger, smaller, or at least different audience than regular Forum visitors.Anyone can get a tuition-free higher education in the United States. I'm going to show you how, and tell you why you won't believe me, even after I spell it out for you.

Identify colleges and universities that accept only the FAFSA

There are two primary sets of documents prospective college students complete in order to determine their eligibility for financial aid:

• the Free Application for Federal Student Aid, or FAFSA, is a form developed by the federal government to establish eligibility for federal student aid programs;
• the CollegeBoard CSS/Financial Aid PROFILE is a private application used by some colleges and universities to establish eligibility for institutional financial aid.

In order to receive federal or institutional financial aid, all colleges and universities require students to fill out the FAFSA. A subset of those colleges and universities require students to complete the PROFILE in order to be eligible for institutional aid.Unfortunately, I don't know of a comprehensive list of colleges and universities that don't require the PROFILE. However, CollegeBoard does helpfully provide a list of colleges and universities that do require it.Your goal in this step is to identify colleges and universities that you're interested in attending that are not on that CollegeBoard list of PROFILE institutions.

Select institutions that promise to meet full demonstrated financial need

Once you've identified a group of colleges and universities that accept only the FAFSA, and don't require the PROFILE, visit the financial aid website of each institution to determine whether and how they promise to meet the full demonstrated financial need of admitted students. You can usually find this promise advertised fairly prominently, and additional details about how it works, for example on Harvard's financial aid website.

Establish residency (optional)

If you've selected a public college or university to attend, you'll likely need to establish in-state residency in order to take advantage of in-state tuition and any financial aid guarantee. This typically takes a year or more of living and working in the state without taking classes, in order to prove that you didn't move to the state exclusively to establish residency for education purposes. By way of example, here are the residency requirements for the University of California system.

Establish independence

In order to establish independence for purposes of federal student aid, you have to answer yes to one of the following questions:

• Will you be 24 or older by Dec. 31 of the school year for which you are applying for financial aid?
• Will you be working toward a master’s or doctorate degree?
• Are you married or separated but not divorced?
• Do you have children who receive more than half of their support from you?
• Do you have dependents (other than children or a spouse) who live with you and receive more than half of their support from you?
• At any time since you turned age 13, were both of your parents deceased, were you in foster care, or were you a ward or dependent of the court?
• Are you an emancipated minor or are you in a legal guardianship as determined by a court?
• Are you an unaccompanied youth who is homeless or self-supporting and at risk of being homeless?
• Are you currently serving on active duty in the U.S. armed forces for purposes other than training?
• Are you a veteran of the U.S. armed forces?

Establishing independence is key to tuition-free higher education because once the FAFSA has determined you are independent, it does not require any financial information from your parents.If Tagg Romney waited to turn 24 before going to college he could have applied for financial aid from the University of Utah without submitting any information about his dad's income or assets (he went to BYU instead, which also doesn't require the PROFILE, although they may have their own financial aid forms).

Take out only federal student loans

Federal student loans, besides their attractive interest rates, allow you to repay them using "income-based repayment," which caps your monthly payments at a certain percentage of your disposable income, and allows you to discharge the loans after 20 years of repayment (10 years if you work in the public sector).This ensures that whatever career you embark on after college, you'll never be financially crippled by student loan payments, no matter how much you borrow — as long as you borrow exclusively from the federal government.Every story you have read in the past 10 years about people being hobbled by their student loans is a story about someone who didn't follow this one simple rule.

There is no crisis of college affordability

Public higher education for those of limited means in the United States is very reasonably priced. It's heavily subsidized by taxpayers, alumni, and endowment income, and it's sold far below cost. By following the steps in this post you can make it even more reasonably priced by excluding your parent's income and assets from your financial need calculation.The crisis of higher education affordability is one of class anxiety and economic insecurity. Parents, even parents who themselves may not have graduated from college, understand perfectly well that higher education is an essential class identifier and the surest path to a semblance of economic security.I can find no more telling indicator of this than the polls we've been bombarded with by the news media for the past two years in which "working class" was a shorthand reference to adults without a college degree — regardless of their income or profession! In this world your humble blogger is "middle class" while a unionized UPS driver making $70,000 a year is "working class," just because he didn't graduate from college.And that is why you will not wait until you establish independence before attending college and why you'll pressure your kids to attend college immediately after high school or, at most, after taking a "gap year" doing something expensive. The fact is you're much more anxious about how your peers and your children's peers will view the decision to put off college than you are about the cost of college.We can fix that crisis, but only by creating a society and economy of plenty, where the desperate struggle for middle-class respectability and a semblance of economic security doesn't shape every decision we make. Until then, nothing in this post will be of the slightest help to you.