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Your Personal Finance Questions, Answered: Should I Play It Safe With This 529 Plan?

By Motley Fool Staff - Feb 5, 2018 at 7:55PM

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A soon-to-be mom thinks her kid might need the funds for private school before college.

At the Motley Fool Answers podcast, we can tell a lot about what's on our listeners' minds by looking into the mailbag, and no surprise, right now, the topic of interest is starting to be taxes. So for this episode, hosts Alison Southwick and Robert Brokamp recruit a special guest to help answer their queries: Megan Brinsfield, head of financial planning for Motley Fool Wealth Management. Taxes, though, are not the only subject of concern this month, but as a CFP and CPA, she's more than qualified to advise our listeners about retirement accounts, 529s, and more.

In this segment, they talk investment timelines and fund choices when you're not sure how long it's going to be before your kid needs their 529 Plan money.

A full transcript follows the video.

This video was recorded on Jan. 30, 2018.

Alison Southwick: The next question comes from Justin. "My sister recently completed her doctor of physical therapy and started her first job. Her employer offers a 401(k) plan; however, there is no employer match, and the funds within the plan are not great. A few highlights: expense ratios of 1.5, 1.34, and 1.73, and all the funds consistently underperform the S&P 500." Yay! It's expensive, but it underperforms.

"The company that administers the plan also charges 0.2% on top of the expense ratios. I know she will be throwing away a lot of money through expenses if she utilizes the dumpster fire of funds. However, I'm still working on how to think about taxes, both now and in retirement. I'm sure if she uses a 401(k) plan, she'll roll it over later to better funds with a different employer in the future. We also talked about opening a brokerage account where she can make contributions for retirement in a non-tax-advantaged account. Any pointers or tips are appreciated." Way to go, Justin. Way to be a nice brother and help your sister navigate this stuff.

Robert Brokamp: That is very nice.

Megan Brinsfield: Yes, a big brother award. I think, in general, if you're not getting a company match from your 401(k), and you're disciplined about saving -- it sounds like his sister is pretty disciplined -- then you might be better off just contributing to a taxable brokerage account.

In this case, you're paying tax at maybe 22% in order to be able to take that money and put it in a taxable account, and in general we think that if your tax rate is less than about 25%, that something like a Roth is good. But a taxable account is very comparable to a Roth in terms of just paying the tax up front and then investing.

I think that it's worth taking a look at just investing in a taxable account where you're not limited to the funds that are quite expensive. You can buy whatever you want. This would be a totally opposite recommendation for someone who doesn't otherwise have the discipline to save that money. If the 401(k) is the only way that someone is able to actually save money for themselves...

Southwick: Because the money comes out before they even know it.

Brinsfield: Exactly. And then that's the way to go.

Brokamp: If you have a lousy 401(k), you should definitely look at an IRA, maxing that out, and then looking at a taxable account. You just want to make sure that you're choosing tax-efficient investments for that. Stocks that don't pay dividends. Index funds tend to be a little more tax-efficient. They even have funds that are called tax-efficient funds. You want something that you're not going to have to pay a lot of taxes on year after year while you're holding it.

The classic example for me is Berkshire Hathaway, a stock that I own. It doesn't pay a dividend. It's a very diversified company. You can hold that for 30 years and never pay a dime of taxes on it until you sell, and then you pay long-term capital gains which, at least according to current law, are lower rates than what you'd have to pay if you took the money out of a traditional 401(k).

Southwick: And our last question comes from Liz off Twitter. Yay!

Brokamp: Yay!

Southwick: Thank God, we're on Twitter! If you want to follow us, we're at AnswersPodcast or you can follow me on Twitter, or Brokamp on Twitter, or Engdahl on Twitter. We're all there. Just search for our names. I don't know. I'm Alison Southwick. What are you on Twitter?

Brokamp: I don't know.

Southwick: Don't bother following Bro on Twitter. He's very lonely. A lonely trail. I think he came through here. I don't know. He left behind no crumbs. Liz, thanks for at least following Answers Podcast. Liz writes, "We are expecting our first child in June. A group of friends want to throw a 529 baby shower..." Which is the best thing I've ever heard of. Ever!

Brokamp: How cool is that?

Southwick: It's the coolest thing ever! Aargh!

Brinsfield: I want to be friends with all these people.

Southwick: Why didn't my friends think of this for me? Gosh! Aargh! Fine.

Rick Engdahl: The next baby, Alison!

Southwick: Yeah! Sorry, Liz. I just had to pause there, to interject my enthusiasm for this idea. "We have accounts through Vanguard. I'm drawn toward their stock portfolio, Small-Cap Index Portfolio, but I don't know if we will use for private school or college. Thoughts?"

Brokamp: So, it's very impressive. The baby isn't even born, yet, and they have the 529 account. That's pretty awesome!

Brinsfield: I don't know anyone else that's done that!

Southwick: I know. That's so great.

Brokamp: Except for Megan.

Brinsfield: Except for me.

Brokamp: Megan already has 529 accounts, in her own name, but to be used for your yet-to-be-born children.

Brinsfield: Yes.

Southwick: Yeah. Yet-to-even-be-conceived children.

Brokamp: I was going to say. Are you announcing anything here, on the Answers podcast?

Brinsfield: No, no. No breaking news.

Brokamp: Liz is highlighting a new wrinkle to the 529, thanks to the new tax law, and that is you could now use some of that money for elementary and secondary school, and not just college. In her situation, she wants to decide how to invest it, but she's not quite sure of the timeline, so it sounds to me like she's very rightly thinking, "Maybe I shouldn't do a small-cap index fund if I might need this money sooner than college."

That's a tough call. I would say generally speaking it's probably still OK to do a relatively aggressive allocation for someone who's not yet born. If you think you will be using the money for private school a few years from now, then it makes sense to be more conservative. I think it's OK to assume that most of the money will be used for college, which means you've got 18 or 19 years until this money is going to be used.

Brinsfield: I recently discovered the Gift of College gift card...

Brokamp: Yes.

Brinsfield: ... that you can give people, so if Liz doesn't have a 529 already set up and selected, that's a good way for people to buy the gift card, and she can put it in whatever 529 ends up being her choice.

Southwick: And in the meantime, Liz, if you're ever in town, I think we could all be friends. Not just for the 529 benefits, but we just seem to be cut from the same cloth, especially you and Megan. Let's get drinks! Let's make it happen!

Brinsfield: Totally!

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