529 Account Investment Idea To Consider

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Topic Author
Markwhy
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Joined: Thu Aug 22, 2013 11:23 pm

529 Account Investment Idea To Consider

Post by Markwhy »

I wanted to float this idea to see if my idea is a good one, or if I'm missing something ...

I have saved for my kids college, about half in 529 accounts and the other half in a brokerage account. Since one is are in and the other is close to being in college, I have those funds invested in fixed income only. The remaining time horizon for the college expenses is about 8 years. I have about half of the total savings out of the 529 due to uncertainty about what the total cost of college will be (public vs private, how many years) and since there is a 10% penalty on 529 earnings when withdrawals are not used for qualifying educational purposes.

In the brokerage account, I'm barely able to get 1% interest which is less than that after-tax. I don't expect that to get much better anytime soon. But in the 529 plan, I'm in a Stable Value fund paying 2.1% and the money and earnings come out tax-free. So the 529 money is roughly keeping pace with inflation, while the brokerage money is not.

I was thinking recently, why not put 100% of it into the 529 Stable Value fund and none of it in the brokerage account? Even if I don't end up needing all of it for college, I'll be getting 2.1% compounding annually and whatever I draw out that is non-qualified will only be taxed as income with a 10% penalty on the earnings. So the penalty is 10% on 2.1% of interest, which effectively reduces the return to 1.9%. That becomes about 1.2% after-tax. Seems like this is still much better than keeping that money out of the 529 and only getting about 0.6% after-tax.

Does this logic make sense or am I missing something?

Any good insights on this would be appreciated!
Grt2bOutdoors
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Re: 529 Account Investment Idea To Consider

Post by Grt2bOutdoors »

The rate on the Stable Value fund is not set in stone. At what rate does it become ineffective for you to contemplate what you are doing? You are basing this on current tax law, should there be a change you don’t know the outcome in advance.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions
Topic Author
Markwhy
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Re: 529 Account Investment Idea To Consider

Post by Markwhy »

I've used Stable Value funds for the past 10+ years. The interest rate over that period has varied between 2.1% and 2.2% with no detectable interest rate sensitivity (effectively duration = 0). So I'm not worried about that. Even if it did change suddenly, I could withdraw the money and just pay the 10% penalty on the 2.1% I earned up to that point.
annu
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Re: 529 Account Investment Idea To Consider

Post by annu »

What 529 are you using? I use nysaves, and do not have anything like this, only stocks, bonds and tips
Pandemic Bangs
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Re: 529 Account Investment Idea To Consider

Post by Pandemic Bangs »

If your 529 is earning almost nothing, then the only benefit is the state tax deduction. You're probably only talking a few dollars here.

The benefit, as you state, is tax-free growth over many years. I can't quite parse your horizon for kid #2 but I would be more aggressive if it is 8 years out (did I read correctly)? Alternatively, if you can not afford to take any kind of hit, then you are stuck with the "savings account" model which ties up your money (restricted to education) without any real pay-off, imo.
Wait 'til I get my money right | Then you can't tell me nothing, right?
Topic Author
Markwhy
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Re: 529 Account Investment Idea To Consider

Post by Markwhy »

Annu,
I'm in the Utah 529 plan. They include a PIMCO Stable Value fund as an option.
hi_there
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Re: 529 Account Investment Idea To Consider

Post by hi_there »

I find it hard to believe that the 529 plan has a Stable Value Fund that pays that much of a higher rate compared to an external account. Have you looked at the name of the fund and researched if it is available through other brokers?
Topic Author
Markwhy
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Re: 529 Account Investment Idea To Consider

Post by Markwhy »

Pandemic Bangs,

Don't know what you mean by not being able parse the 8 year horizon. It is what it is. However, it doesn't really matter relative to my question since I wasn't looking for general advice about how to invest over an 8 year horizon. My fault for including too much "background information" as context to my question.

So to simplify my original post and help focus on the point of it, let me re-phrase my question ....

Can someone be better off investing in:
    (1) a 529 fixed income fund paying 2.1% and accepting the 10% penalty on earnings withdrawn for non-qualified (i.e. not educational) purposes, as compared to
      (2) investing in a taxable fixed income account paying at todays CD rates

      Both withdrawals (1) and (2) would be subject to Fed and State income tax. The 529 withdrawals would additionally incur a penalty of 10% (on the earnings only). It seems to me that the 529 comes out significantly ahead on an after-tax and after-penalty basis. Am I right or wrong about that?
      Pandemic Bangs
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      Re: 529 Account Investment Idea To Consider

      Post by Pandemic Bangs »

      Markwhy wrote: Thu Jan 14, 2021 11:24 am
      Can someone be better off investing in:
        (1) a 529 fixed income fund paying 2.1% and accepting the 10% penalty on earnings withdrawn for non-qualified (i.e. not educational) purposes, as compared to
          (2) investing in a taxable fixed income account paying at todays CD rates
          Considering that no one who doesn't have kids with educational-expense needs does (1), it's gotta be the loser. But you have gamed it a little by making (2) especially unappealing by limiting it to CDs at today's rate.

          For 8 years, I get the 529 account growing to $118K and after 10% penalty, being $106K. I don't know your bracket but you will be taxed on the $18K appreciation so take that off the top.

          For the same 8 years in taxable, I see CDs at 1.05 (I did not look very hard) which yields $108K at the end, less your annual tax on the interest.

          Plug in your marginal rate in 8 years and see which wins...

          I would not do 529 with these stipulations.
          Wait 'til I get my money right | Then you can't tell me nothing, right?
          Topic Author
          Markwhy
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          Re: 529 Account Investment Idea To Consider

          Post by Markwhy »

          hi_there wrote: Thu Jan 14, 2021 11:14 am I find it hard to believe that the 529 plan has a Stable Value Fund that pays that much of a higher rate compared to an external account. Have you looked at the name of the fund and researched if it is available through other brokers?
          Believe it. I've been in a Fidelity Stable Value fund in my 401K for over ten years and it has yielded about 2.2% every year. Then Utah added this PIMCO Stable Value fund in their 529 plan sometime last year and I bought it.

          I researched this years ago and learned that Stable Value funds are only allowed in 401K accounts. Apparently they are now allowed in 529 accounts as well. They aren't always available. They pay more than CDs because they buy bonds that are higher risk than CDs. The nice thing about them though is that they buy insurance derivatives that offset any effects of interest rate changes. It's a nice product. I wasted a lot of time a few years ago trying to create my own version of it in my regular brokerage accounts. It either isn't possible or it's beyond my abilities.

          But people I know who have access to them absolutely love them - especially in low interest rate environments like we've been in. You get a better yield now and if interest rates go up, there is no loss of value (i.e. duration risk).
          Topic Author
          Markwhy
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          Re: 529 Account Investment Idea To Consider

          Post by Markwhy »

          Pandemic Bangs wrote: Thu Jan 14, 2021 7:23 pm
          Markwhy wrote: Thu Jan 14, 2021 11:24 am
          Can someone be better off investing in:
            (1) a 529 fixed income fund paying 2.1% and accepting the 10% penalty on earnings withdrawn for non-qualified (i.e. not educational) purposes, as compared to
              (2) investing in a taxable fixed income account paying at todays CD rates
              Considering that no one who doesn't have kids with educational-expense needs does (1), it's gotta be the loser. But you have gamed it a little by making (2) especially unappealing by limiting it to CDs at today's rate.

              For 8 years, I get the 529 account growing to $118K and after 10% penalty, being $106K. I don't know your bracket but you will be taxed on the $18K appreciation so take that off the top.

              For the same 8 years in taxable, I see CDs at 1.05 (I did not look very hard) which yields $108K at the end, less your annual tax on the interest.

              Plug in your marginal rate in 8 years and see which wins...

              I would not do 529 with these stipulations.
              I don't see why you same I'm "gaming it" by using today's CD rates for the comparison. I have college money in my brokerage account that I want to invest at near zero risk. We know what the Stable Value fund will net after penalty and taxes. If I don't pursue the Stable Value option in the 529, what investment other than CDs would give me a better yield with near zero risk over a period of the next few years?
              Topic Author
              Markwhy
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              Re: 529 Account Investment Idea To Consider

              Post by Markwhy »

              Markwhy wrote: Thu Jan 14, 2021 7:32 pm
              hi_there wrote: Thu Jan 14, 2021 11:14 am I find it hard to believe that the 529 plan has a Stable Value Fund that pays that much of a higher rate compared to an external account. Have you looked at the name of the fund and researched if it is available through other brokers?
              Believe it. I've been in a Fidelity Stable Value fund in my 401K for over ten years and it has yielded about 2.2% every year. Then Utah added this PIMCO Stable Value fund in their 529 plan sometime last year and I bought it.

              I researched this years ago and learned that Stable Value funds are only allowed in 401K accounts. Apparently they are now allowed in 529 accounts as well. They aren't always available. They pay more than CDs because they buy bonds that are higher risk than CDs. The nice thing about them though is that they buy insurance derivatives that offset any effects of interest rate changes. It's a nice product. I wasted a lot of time a few years ago trying to create my own version of it in my regular brokerage accounts. It either isn't possible or it's beyond my abilities.

              But people I know who have access to them absolutely love them - especially in low interest rate environments like we've been in. You get a better yield now and if interest rates go up, there is no loss of value (i.e. duration risk).
              Look here for the Utah fund performance summaries:

              https://my529.org/performance-returns/

              Scroll down to PIMCO Interest Income Fund and look at the one year return and the average annual return since inception.

              Here below is a link to a brief explanation of how the fund works that was published in 2018 when they added this fund:

              https://my529.org/october-2018/stable-value-qa/
              humblecoder
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              Re: 529 Account Investment Idea To Consider

              Post by humblecoder »

              Markwhy wrote: Thu Jan 14, 2021 7:37 pm
              Pandemic Bangs wrote: Thu Jan 14, 2021 7:23 pm
              Markwhy wrote: Thu Jan 14, 2021 11:24 am
              Can someone be better off investing in:
                (1) a 529 fixed income fund paying 2.1% and accepting the 10% penalty on earnings withdrawn for non-qualified (i.e. not educational) purposes, as compared to
                  (2) investing in a taxable fixed income account paying at todays CD rates
                  Considering that no one who doesn't have kids with educational-expense needs does (1), it's gotta be the loser. But you have gamed it a little by making (2) especially unappealing by limiting it to CDs at today's rate.

                  For 8 years, I get the 529 account growing to $118K and after 10% penalty, being $106K. I don't know your bracket but you will be taxed on the $18K appreciation so take that off the top.

                  For the same 8 years in taxable, I see CDs at 1.05 (I did not look very hard) which yields $108K at the end, less your annual tax on the interest.

                  Plug in your marginal rate in 8 years and see which wins...

                  I would not do 529 with these stipulations.
                  I don't see why you same I'm "gaming it" by using today's CD rates for the comparison. I have college money in my brokerage account that I want to invest at near zero risk. We know what the Stable Value fund will net after penalty and taxes. If I don't pursue the Stable Value option in the 529, what investment other than CDs would give me a better yield with near zero risk over a period of the next few years?
                  OP:

                  Assuming your Stable Value Fund earns 2.2% or thereabouts consistently, your plan makes sense to me. People have this fear of the 10% penalty but if you do the math, it sounds like it is worth it in your case. I don't see any flaws in your logic.

                  Pandemic Bang's math is wrong by the way. He applied the 10% penalty to the principal AND earnings. It only applies to the earnings. So if your deposit $100K and it grows to $118K, the 10% penalty is only $1.8K (10% of your $18K earnings) so after the penalty, you are left with $116.2K. And you only pay taxes and the penalty if you don't use the money for educational purposes whereas you will pay taxes on the CD earnings regardless of how you use the money.
                  Pandemic Bangs
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                  Re: 529 Account Investment Idea To Consider

                  Post by Pandemic Bangs »

                  humblecoder wrote: Thu Jan 14, 2021 7:52 pm
                  Pandemic Bang's math is wrong by the way. He applied the 10% penalty to the principal AND earnings. It only applies to the earnings. So if your deposit $100K and it grows to $118K, the 10% penalty is only $1.8K (10% of your $18K earnings) so after the penalty, you are left with $116.2K. And you only pay taxes and the penalty if you don't use the money for educational purposes whereas you will pay taxes on the CD earnings regardless of how you use the money.
                  Thanks for fixing. I knew that -- too big of a hurry. :shock:

                  By "gaming" I just meant that you are making the 529 "look" better than it is simply by making the alternative particularly unappealing -- in the form of a very long CD with a dismal yield.

                  But the comparison from OP just a little upthread was not using 529 for education.
                  Wait 'til I get my money right | Then you can't tell me nothing, right?
                  hi_there
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                  Re: 529 Account Investment Idea To Consider

                  Post by hi_there »

                  Markwhy wrote: Thu Jan 14, 2021 7:32 pm
                  hi_there wrote: Thu Jan 14, 2021 11:14 am I find it hard to believe that the 529 plan has a Stable Value Fund that pays that much of a higher rate compared to an external account. Have you looked at the name of the fund and researched if it is available through other brokers?
                  Believe it. I've been in a Fidelity Stable Value fund in my 401K for over ten years and it has yielded about 2.2% every year. Then Utah added this PIMCO Stable Value fund in their 529 plan sometime last year and I bought it.

                  I researched this years ago and learned that Stable Value funds are only allowed in 401K accounts. Apparently they are now allowed in 529 accounts as well. They aren't always available. They pay more than CDs because they buy bonds that are higher risk than CDs. The nice thing about them though is that they buy insurance derivatives that offset any effects of interest rate changes. It's a nice product. I wasted a lot of time a few years ago trying to create my own version of it in my regular brokerage accounts. It either isn't possible or it's beyond my abilities.

                  But people I know who have access to them absolutely love them - especially in low interest rate environments like we've been in. You get a better yield now and if interest rates go up, there is no loss of value (i.e. duration risk).
                  "They pay more than CDs because they buy bonds that are higher risk than CDs. The nice thing about them though is that they buy insurance derivatives that offset any effects of interest rate changes."

                  Nothing about this suggests that an external fund can't replicate this system. Are you sure you're comparing this apples-to-apples with the universe of outside funds?
                  the way
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                  Re: 529 Account Investment Idea To Consider

                  Post by the way »

                  I'm interested to know how it performed this past March? Did you look at your online balance or end of the month balance at the time? I know the short duration bond funds plunged 10%+ and eventually recovered, but they were nothing like CDs. If the stable value fund held up with no dip, then it does sound like something to check out.
                  humblecoder
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                  Re: 529 Account Investment Idea To Consider

                  Post by humblecoder »

                  Pandemic Bangs wrote: Thu Jan 14, 2021 8:36 pm
                  humblecoder wrote: Thu Jan 14, 2021 7:52 pm
                  Pandemic Bang's math is wrong by the way. He applied the 10% penalty to the principal AND earnings. It only applies to the earnings. So if your deposit $100K and it grows to $118K, the 10% penalty is only $1.8K (10% of your $18K earnings) so after the penalty, you are left with $116.2K. And you only pay taxes and the penalty if you don't use the money for educational purposes whereas you will pay taxes on the CD earnings regardless of how you use the money.
                  Thanks for fixing. I knew that -- too big of a hurry. :shock:

                  By "gaming" I just meant that you are making the 529 "look" better than it is simply by making the alternative particularly unappealing -- in the form of a very long CD with a dismal yield.

                  But the comparison from OP just a little upthread was not using 529 for education.
                  Obviously I am not the OP, so I hopefully am not putting words into his/her mouth. :D

                  The way I interpreted the question was that the OP has some amount of money that he/she wants to invest "risk free" (meaning no loss of principal) intended to be used for college. One option is to put this money into a CD or similar investment (money market, HYSA) OUTSIDE of a 529 account. The other option is to use the stable value fund INSIDE of a 529 account.

                  The OP's original thought was to put the money into a risk free investment outside of 529 account, due to some uncertainty over whether the money was going to needed for education. However, the OP realized that even if he/she was subject to the penalty, using the stable value fund would come out ahead.

                  Stated another way, if the money was used for education, the stable value fund would clearly come out ahead (assuming that 2+% rate was legit of course). But even if the money wasn't used for education, the stable value fund would still come out ahead.

                  There reason why the OP was assuming that the money wasn't being used for education was to confirm that even in the worst case scenario that they didn't need the money for educational purposes, using the 529 for investing the risk free component of their education asset allocation still made sense.

                  I don't agree that the OP was "gaming the system" by comparing the stable value fund to a CD. I think it is appropriate since both investments have a similar risk profile. I do agree with your underlying premise that it may make sense to take on some risk given an 8 year time horizon. However, the OP clearly stated that the focus of the question was not on what is the appropriate AA, but given that they want to invest risk free, how should they do it. Given the narrow focus of the OP's question, the 529 stable value fund does make sense assuming that the 2+% rate is indeed guaranteed and risk free.

                  Like others, I have a natural skepticism given that this rate an order of magnitude higher than the risk free rate of most other investments, so I am wondering what the catch is. As they say, there is no such thing as a free lunch. However, if there is no catch, then the OP's thinking makes sense to me. That is a big assumption of course :-)
                  SS Rambo
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                  Re: 529 Account Investment Idea To Consider

                  Post by SS Rambo »

                  I agree with humblecoder and the math also works out from my end. Leverage the Utah 529 Stable Value fund as much as you can, if you plan to put everything in the safest options.

                  Most people confuse Stable Value Funds with income funds or bonds funds or other safe-money funds. SVFs are exclusive to 529s and employer retirement plans (I think that's it, maybe one or more) and they are constructed to keep up with inflation regardless of where interest rates are at. That is why they will outperform your safest brokerage account options.

                  With the final tuition payments 7/8 years out, you could argue for a slightly more aggressive investment for a portion of the money, but 2% today is nothing to complain about.
                  Topic Author
                  Markwhy
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                  Re: 529 Account Investment Idea To Consider

                  Post by Markwhy »

                  Thank you for an excellent clarification of my original post and your comments.

                  It does seem that Stable Value (SV) offers something too good to be true. I've checked into it a few times over the past 10+ years that I've been invested. Here are the risks that I can remember that you take on if choosing a Stable Value over a low risk fixed income alternative:

                  1. No FDIC or any other kind of insurance is provided
                  2. The SV is invested likely to be holding investment grade or maybe even lower grade bonds
                  3. SV funds do NOT have to disclose their bond holdings, so you have to trust the fund creator (e.g. Fidelity or PIMCO) - i.e. no transparency
                  4. You rely on the solvency of the "insurance wrap" writer. If the insurer fails to insure the interest rate, then you would lose the stable value characteristic of the fund. However, SV funds typically diversify this risk across multiple insurance wraps and ladder the contracts for this reason.
                  5. You've implicitly given up some of the bond yield by paying for the insurance wraps, you just don't see the details of how it was done.

                  So it isn't a free lunch, but it's a nice combination. As I said in earlier posts, I've been in my employer's Fidelity 401K SV fund for over decade. It rode through the GFC without a significant blip. I've been in the Utah 529 PIMCO SV fund for over a year now and it rode through the COVID crash earlier this year without a significant blip - though the fund performance there is only updated once at the end of each month. So I can't know if there was a temporary dip and recovery in the middle of that month.

                  Because these funds exist only in the 401K plans typically of large companies or large 529 plans, they are supposed to be conservatively managed. So I don't think they take on any reckless levels of bond risk in order to produce the net return of around 2% after paying the cost of the insurance wraps.

                  Hope this helps anyone that is interested in this topic.
                  centrifuge41
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                  Re: 529 Account Investment Idea To Consider

                  Post by centrifuge41 »

                  There's a lot of hesitant posters on Bogleheads, but it's real.
                  SEC yield on Vanguard total bond index is currently 1.08%

                  Here are some of the highest yielding stable value funds:
                  DC: 2.3%
                  CO: 2.09%

                  The rest are approximate (you can check out their share prices over time and do the math yourself):
                  UT: 2.16%
                  IN: 1.85%
                  VA: 1.8%
                  WV: 1.74%
                  IA: 1.7%
                  NV: 1.65%

                  OP is right. 529 stable values pay a lot more than CDs and the bond market nowadays, with the caveat of the risk points mentioned above. Even if someone ends up using the 529 funds for non-educational purposes, the 10% penalty is only on the interest (and the gains become taxable at your marginal rate, but you get the interest deferred in the interim. You also need to pay back the state income tax deduction, if applicable).

                  So yes, even 90% of the above rates (as a simple approximation for the interest in case of non-qualified (non-educational) use) is pretty awesome when compared to what the bond/cd market is paying nowadays.
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