This is a guest post by FogOfWar, who disagrees with me about 529 plans and my plan to make paying for college harder.

I’m catching up on the 529 kerfuffle. First observation: this made a massively outsized splash in public perception compared to what one would expect from a technical tax provision, which (more on this later) has a budgetary impact within a 5% confidence interval of $0.

Second observation: my good friend Cathy, who has kids mind you, is arguing against the 529 plan. Huh? When did we enter the Twilight Zone? Beating up on 529 plans is like stealing oatmeal from orphans—they’re too small to defend themselves, you don’t really get much if you win and everyone loves the soot- smudged little munchkins.

So here is what may be patient zero: this GAO Report released in 2012. The headlines read right into the talking points people are quoting. If you’re going to read it, try an interesting thought experiment: mentally substitute “401(k)” for “529” and “saving for retirement” for “saving for college” everywhere you see it. That’s not a completely fair analogy, but neither is it completely unfair…

Also, right at the beginning of the report, there’s an interesting omission. It’s in the “who did we talk with to figure out what was going on here?” section. Not that the report did a bad job, but why didn’t they talk to the AICPA (the national organization of CPAs)? These are the people who are most commonly on the ground talking to clients (rich and poor alike) about whether a 529 plan makes sense for them. I think you’d get a slightly different focus in the report with this on the ground perspective.

529 Plans Work Really Well for Everyone but the Very Rich and the Actually Poor

You can define ‘rich and poor’ in a hundred different ways, so let’s pick 4 examples in a semi-arbitrary manner. All couples are two parents and 1 kid who is 3, and all live in NYC. Couple 1 (“poor”) earned $20,000 last year; Couple 2 (“middle class”) earned $75,000 last year; Couple 3 (“mass affluent”, or “the bottom 1% of the top 1%”) earned $250,000 last year and Couple 4 (“rich”) earned $3-5m last year. Each couple has $100.00 of extra funds and is deciding what to do with it.

Important note: that’s not “$100x” as code for $100,000.00, that’s really $100.00.

Everything we’re talking about here is downwardly scalable and transaction costs are minimal (the cost of a stamp or time to set up direct deposit/withdrawal). All the couples have student loans, which are charging them 5%. Assume a stable long term low-risk portfolio also returns 5% (this is a side debate, but for those wanting to make it higher, I’d say you should consider your returns on a risk-adjusted basis).

Each couple has 3 rough choices, A: contribute the $100.00 to a 529 for kids, B: invest the $100.00 outside the 529 plan for kids, C: pay down $100.00 of student loans.

Poor Couple: Well, these guys get no state tax advantage from making the initial 529 contribution, and given their tax rate, the compounding on the 529 earnings has a negligible tax impact. Plus they’re giving up liquidity, which has more value in their hands than it does in the higher income cohort. Not only that, but I believe (chime in if you know this for sure) that moving the $100.00 from parent’s account to 529 account moves the asset from “parent asset” to “child’s asset” on many (but not all) needs-based financial aid forms. In short, the 529 plan is a terrible idea for this couple.

The real question is whether they should pay down the student loans or invest the $100.00 outside. That question is more subtle, but the availability of the student-loan interest deduction (lower after-tax return on debt paydown) and liquidity considerations makes $100.00 outside investment the likely best option.

Basically the tax code (this portion) combined with student aid gives no incentive for this couple to save and maybe a disincentive (or maybe an incentive to buy physical silver and not declare it on fin aid forms).

Middle Class Couple: At $75,000 the couple is still getting the tax shield for their student loans. So, at a combined Federal/State rate approaching 25% (NYC is a very high-tax place to live), their ROI (Return On Investment) from paying down student loan debt will be only 3.75%, compounding. So cash in pocket of $3.75 in year 1, $3.89 in year 2, etc. Their return on outside investment is sorta the same, with a big caveat. It’s all in the taxes. If middle class couple is invested in mutual funds or bonds, then yes, it’s $3.75 in year 1, $3.89 in year 2, etc. If Middle Class Couple is tax smart, they’ll invest only in low-dividend/high-growth stocks that will compound over the next 15 years before being cashed out to pay for kid’s college. In this case, the taxes are much, much lower—not zero, but much closer.

Doing some quick math: if the $5 in appreciation is going to be taxed at 20% capital gains 15 years from today, that makes the current tax cost = ($5.00*20%)/(1+0.05)^15 or $0.48. So year 1 the stock investment gains $4.52 compared to $3.75 from paying down student loans.

That’s not the full analysis, however, as (i) that difference compounds over the next 15 years, and (ii) the compounding is on $5.00, not $3.75, so it’s even more powerful. Run a quick spreadsheet and the student loan deduction compounds to $173.70 over 15 years and the stock investment runs to $186.31 after cash-out capial gains. Note that I’m assuming that student debt “savings” are reinvested in additional paydowns of student debt (somewhat for simplicity).

There’s a more subtle point as well: income is dynamic, not static, and thus tax brackets and availability of tax benefits is not locked in. If their income increases over time (as is very likely to happen statistically), they may knock themselves out of the deductibility of the student loan interest, which would cut back to paying down debt. OTOH, liquidity concerns (which are hard to reduce to a single dollar value but are extremely important) push towards the stock investment. Complicated analysis and everything above should be the starting point not the ending point if you’re looking at this choice in real life.

Now let’s add 529 Plans to the mix. Because the couple is NYC resident, they get an immediate tax advantage of $10 cash-in pocket state tax advantage (this assumes no itemizing, which is just over the cusp of reasonable given the numbers). The compounding is 100% tax free, either now or on distribution, so right away the earnings are $5.00 in year 1, compared to $4.52 and $3.75 for the other two options.

But that’s not all: the $10 in pocket is also invested—let’s assume in 5% stock investments, as above, so there’s an additional $0.45 return on that, making the 529 earnings in year one a Patriots four-time superbowl championship winner at $5.45. Not only that, but the benefit compounds over time, so the 15-year return is $226.52, all in. 30% higher than paying off student debt on an after-tax basis.

Liquidity is still a concern, although 529 plans have more liquidity than paying off student debt (b/c of ‘wrong way risk’ but that’s another discussion)—you can at least get at the money, but you have to pay a 10% penalty. Also, all of these numbers get much more dramatic if you assume investment in the stock market at a 10% rate of return over time, rather than the more conservative 5% rate of return I’ve worked with. Also, if you factor in dynamic tax rates the 529 becomes even more attractive, as the tax cut from investment income gets higher in the out years.

Takeaway? The 529 plan is an extremely powerful tool for the true working class.

Second Takeaway: running some quick numbers, about 46% of the benefit over the ‘buy and hold stocks’ strategy here is from the state tax advantage and 70% is from the federal compounding and exemption on distribution of profits. If this couple has the misfortune to move to a state that doesn’t seem to care about the middle class saving for college, like, let’s say…Massachusetts or California (neither of which give a state tax advantage for 529 contributions), the 15 year return drops down from $226.52 to $207.89. Still not bad, but the state incentives are a huge part of the practical analysis. Note also, that anyone living in a state without an income tax (Texas, Florida) gets no state income tax advantage because there ain’t any state income tax to take the deduction against!

Mass Affluent Couple: Whew, that was a lot of ink on the middle class couple, and if you’re in the Mass Affluent income cohort and reading this for practical advice, go back and read the numerical analysis of the middle class closely, because with a few modifications it’s going to apply to you as well.

Before that, though, let me say that there’s been a lot of progressive spite (not sure what adjective to use here) thrown at this couple. Cries of “they really don’t need any help—we should take this away” are there either explicitly or just below the surface. Some of my best friends are mass affluent couples in NYC, and I will tell you that the cost of college is something that gives them grey hairs. It’s enough money to be able to pay for college, yes, but not as easily as it might look from the outside.

Plus, and maybe most importantly, earnings now are not a guarantee of earnings for the next 15 years. You’re free to say “cry me a river”, but these are people, and all they want is the best for their children and to villainise them for such doesn’t sit well with me. Also, as we said before, the state tax benefit is close to ½ of the total 529 benefit, and that benefit is capped out in NY at $5,000 per parent per year, so this isn’t reducing anyone’s state tax bill to $0.

OK, here are the numbers: paying off student debt is actually more attractive for this couple because they earn too much money to get the income tax deduction, which, by the way, now stands at 43% combined state & federal (I’m assuming, not unreasonably, that this couple are AMT taxpayers). So $100.00 paying down student debt compounds at the full $5.00 ending up at a full $207.89 at the end of year 15. Not too bad, and liquidity is sacrificed, which is still important, but probably less important for this couple than the others.

Investing on the side, even if done in a tax efficient manner yields only $186.31 after 15 years (I upped the capital gains rate to 25% to reflect higher taxes—this gets a little more messy in real life but it’s a decent approximation). Hmmm…

Takeaway: Mass Affluent couple is better off paying away their student debts than investing in the stock market, given our mathematical assumptions (and, critically, on a risk-adjusted basis).

What about 529 plans? Well, the 529 plan still yields $226.52. Definitely better than paying off student debt (and that investment opportunity doesn’t even exist after all debt is paid off).

Interestingly 100% of the benefit in that comparison is now state level. Let me say that again: for well off taxpayers who still have student loans, the federal tax advantage is in some ways $0 and the advantage is all at the state level.

Interesting observation, given that many of the cries were for Obama to remove this great federal incentive in 529 plans (neither Obama nor the US Congress has any input on what states decide to do with 529 tax treatment).

Takeaway: The well-off/upper middle class/mass affluent/merely wealthy/whatever you want to label them get some advantage from 529 plans, but mostly from the state level & that really has nothing to do with Obama one way or another.

The Rich Couple: Nothing we’ve talked about matters at all. For reasons I won’t get into, anyone earning this level of income who is contributing to 529 plans should chew out their tax planner and/or financial advisor. There are a few situations where they make sense, but usually 529s are an unbelievably sub-optimal use of your annual gift tax exclusion.

Takeaway: 529 plans aren’t relevant to the rich at all. They’re glad you’re spending your time thinking about 529 taxation rather than something that matters, like carried interest or the step up in basis at death…

OK, that’s great, but what about Cathy’s point?

Oh, right. Well, yes—when you subsidize an asset the price generally increases to at least some degree (there’s all sorts of complicated analysis on relative elasticity here), and in theory that impact of the 529 is hosing the poor at the expense of the middle class and upper middle class (and the rich, sortof/maybe). Still, I feel like there are a lot of much bigger moving pieces in the overall calculus of costs of college that 529 plan tax advantages aren’t really the primary driver moving the needle.

So, for example, the total budgetary impact from 529 plans & prepaid plans is scored at around $1bn/year (page 39 here). If you’ve never worked with OMB numbers that sounds like a lot, but there’s a special phrase for a number like $1bn/year in the beltway: it’s called “a rounding error”. This is less than peanuts in the overall scope of the budget.

Which leads me full circle to an interesting question: what’s really going on here? I mean, the Obama administration is, depending upon the color of your pin, either Reed Richards or Lex Luthor—you may hear that he’s evil or a Marxist, but not usually that he’s a moron. Yet, this was an unbelievably dumb thing to propose, and honestly, it was entirely predictable that it would be not only a hideous failure, but a very public hideous failure. Again, any on-the-ground CPA could have told anyone in the administration willing to listen that these plans are one of the only reeds the government gives to parents grasping at straws to find the money to cover college and pulling it away would be…well, like stealing porridge from an orphan.

Unless there really is a brilliant “I’m thinking 3 moves ahead of you” long-game/long-con (again, depending on the color of your pin) strategy. If so, could it be this:

The left wants to win the next election. Statisticians working hard have studied the impact of the Tea Party on electoral results for the right and have determined that the optimal game-theory path is to alienate and marginalize the Elizabeth Warren/Bernie Sanders progressive wing. To do so, Obama created a straw man (the proposal to cut back 529 Plans) that pretty much most of America would hate but die-hard progressives would love. This lays the foundation for important discussions of party planks between centrists and progressives, for the centrists to say “look at what your wingnut policies cost us on that 529 debacle”, thus isolating progressives from the central discussion in formulating policy and, you know, trying to make radical change or something crazy like that…

Paranoid? Or not paranoid enough….

FoW

Cathy’s short response: nobody except the affluent middle class (and the rich) has $100 extra to begin with.