A recent conversation arose about saving for a child’s 529 college fund [or related gifting plan], and whether there is a concept one should worry about concerning overinvesting. Say losing contributions that ultimately can’t be used for the education they were designed for. Your child doesn’t see their way to an expensive college, received a scholarship, doesn’t himself or herself have another child to designate as beneficiary, etc. With great uncertainty, how should you plan?
While there are pros and cons to investing a certain amount into these programs, which ultimately will vary versus the actual eventual cost, the utility function [u] below shows how we can think about factoring those considerations to optimize our contributions.
Let’s start with a 529 risk utility function [u], which weighs [w] the tax benefits at +30% of the contribution to an optimal level. But twice weighs [2w] the tax penalty of an early withdrawal at -15% of any over-contribution [a blend of a later kicked-in penalty, post inflation]. Weights [w+2w] sum to 100%.
The equations -wrt weight versus optimal- are as follows:
u = w*30%*contribution + [2w]*-15%*contribution
u = 30%/3*contribution -15%*2/3*contribution
u = 0%*contribution > 0
Now what if you felt your utility function should have different w, for example if you have a currently high debt load and so care about that more so than the tax benefits of a future 529.
The generic equations -wrt weight versus optimal- to solve for any weight[w] level:
u = w*30%*contribution + [1-w]*-15%*contribution
u = w*30%*contribution -15%*contribution -w*-15%*contribution
u' = 30%*contribution -1*-15*contribution
u’ = 45%*contribution > 0
u’’ = 0 > 0
The story here is for linear utility functions [which it is in this case for derivatives near the optimal levels], there is only positive and thus also no decelerating utility for contributing to a 529. By definition is asked to be just a tad above target, and knowing there is inflation as well. Also regardless of how little you may care about the basic level of the tax benefit of a 529 [ie for most reasonable risk-aversion weights unique to the individual]. It is mostly prudent to save “a little more” versus "a little less" than future college expectations. Retirement design is an art in modeling uncertainty, but you plan knowing you have to spend a certain minimum. And the tax savings is there for a reason and may only improve with future benefit features, such as a $35,000/beneficiary Roth rollover.
Currently contributing close to $2,000 annually for each year of your child’s education, would equate to about the expected future cost of a high-priced college degree [we leave aside the above topic of whether this will ultimately be your liability anyway]. But with inflation at about 4%/year for example, your contributions of course should also be inflation-tracked. So if you are saving at $2,000 in your child’s first year this would mean stepping up to $2,100 in his or her 2nd year. $2,800 in 9th year, etc. Better have wages to match, or at least you can partially offset with good returns over such a long horizon!
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