Thanks to the SECURE 2.0 bill, it’s time for the FI community to reexamine 529 plans. This post shares my two cents on 529s in general, and specifically as applied to the FI community. The next post, dropping February 15, 2023, addresses in detail the new 529-to-Roth IRA rollover enacted in SECURE 2.0.
Financial Independence
Before we talk about 529s, we have to talk about the primary goal of financial independence. For young parents, the primary goal is to secure Mom & Dad’s financial independence.
Achieving the parents’ primary goal has an incredible secondary effect. Mom and Dad buy Junior an incredible gift by securing their own financial independence. That gift is that Junior will never have to worry about Mom and Dad’s financial security as an adult. The greatest financial gift parents can ever give their children is the parents’ own financial stability.
Second, where possible, money and financial assets should be able to support multiple financial goals. We should be at least somewhat hesitant before locking up money such that it can only support one highly specific goal without incurring a penalty.
529s
529s are tax-advantaged savings accounts generally run by states to facilitate college savings. 529s are best understood as a Roth IRA for college education with far greater contribution limits. Sure, that is an overstatement of how they work, but that gives us a good conceptual framework from which to start the analysis.
A quick note on terminology: The IRS often refers to 529 plans as “Qualified Tuition Programs” or “QTPs.” I will use the more commonly used colloquialisms, 529 and 529s.
Contributions to a 529 are not tax deductible for federal income tax purposes. At least initially, there’s no federal income tax benefit to making a 529 contribution. However, money inside a 529 grows federal and state tax-free and can be withdrawn tax-free for qualified education expenses (such as college tuition).
Contributions are generally not limited by federal tax law, though contributions above the annual exclusion gift tax limit ($17,000 per donor per beneficiary per year in 2023) generally trigger Form 709 reporting requirements (though in 99.99% of cases there should not be a gift tax liability). States generally have lifetime contribution limits per beneficiary. Usually these limits are far in excess of what one would normally need for undergraduate college tuition.
Very generally speaking, qualified education expenses can be directly paid from the 529 to the educational institution or such expenses can be reimbursed from a 529 in the year the expenses are incurred. Payments for qualified educational expenses are generally tax and penalty free. 529s do not enjoy the rather unlimited reimbursement deadline that HSAs enjoy.
529s get similar tax treatment to the federal income tax treatment in most states. However, there can be an additional benefit: an annual state tax deduction or credit for some 529 contributions to the state’s own 529 plan (note 8 states allow a 529 tax deduction or credit for contributions to other states’ 529 plans). However, for many readers this will either be irrelevant or only of minor importance. Of the four most populous states (CA, TX, FL, NY), only residents of New York can obtain an up-to $5,000 per person per year state tax deduction for contributions to a home-state 529. California has no 529 tax deduction and Texas and Florida do not have an income tax.
Okay, sounds great! Clearly there are tax benefits for 529 money used for qualified education expenses. But what about distributions that are used for anything other than qualified education expenses? Well, they are going to be subject to an income tax and likely a 10 percent penalty, in the following manner. A non-qualified distribution is deemed to come ratably out of the contributions to the 529 (tax and penalty free) and earnings of the 529 (subject to income tax and the 10 percent penalty, some penalty exceptions may apply).
Here’s an example illustrating the application of the nonqualified distribution rules:
Hal, the owner of a 529 account, takes $1,000 out of the 529 to help pay for vacation expenses. Previously, he had made $60,000 of contributions to the 529, and it had grown to $100,000 ($40,000 of earnings) prior to making the $1,000 non qualified distribution. Sixty percent of the distribution ($600) is a nontaxable return of contributions and 40 percent ($400) is subject to both income tax and a 10 percent penalty.
The taxation of non-qualified distributions is a significant drawback of using 529s.
529s and the FI Community
Let’s remember what is going on with a 529. It is a gift to the next generation. It comes with very modest tax benefits.
My thesis on the 529 is this: for most parents, including most of those in the FI community, the tax benefits offered by 529s are not sufficient to compensate for the use restrictions on 529s. Thus, my view is that 529s should generally be deployed once Mom and Dad are financially independent (or close to it), not when they are on the path to financial independence.
The idea behind the 529 is to provide tax-free growth for college savings. It solves for something that, frankly, isn’t much of a problem. Taxes are not why college is unaffordable for many Americans. College tends to be unaffordable not because investment taxes are high, but because tuition and fees are out of control.
One thing in parents’ favor when thinking about funding college educations is that income taxes on investments are relatively modest over a child’s childhood due to low long term capital gains rates and qualified dividend income rates. Hopefully, by age 22 or 23, the child’s undergraduate education is completed, providing a relatively modest investment time horizon (i.e., a modest tax exposure horizon), even if the parents start saving for college at birth.
Contrast that to the retirement time horizon of a 20-, 30- or 40-something parent saving for his or her own retirement. The money invested for retirement at age 25 might be accessed at age 60, 70, 80, or 90. Compared to educational savings, retirement savings (which are usually far greater than educational savings) are much more vulnerable to income taxes for a much longer time frame. Even at long term capital gains and qualified dividend income rates, exposing retirement savings to decades of taxation could be very expensive. Retirement savings are also exposed to tax law change risk for a much longer period of time. For example, there’s no guarantee that there will be favored long term capital gains and qualified dividend tax rates 30 years from now.
The tax risk profiles on educational savings and retirement savings are much different. Based on those risk profiles, for most I believe aggressive retirement tax planning makes sense. But I don’t see educational tax planning making as much sense, for the reasons discussed below.
Of course, tax-advantaged retirement savings can come with a juicy up-front federal income tax deduction. 529s do not offer the possibility of a federal income tax deduction, making them less impactful than tax-advantaged retirement savings regardless of the time frame involved.
Young Parents and 529s
Let’s consider young parents. Say Junior is born when Mom & Dad are age 30 and have saved 10 times their annual expenses in financial assets. Many, myself included, would say Mom and Dad are doing well with their finances. Here’s where I diverge from some others in the personal finance space: I would not recommend Mom & Dad save in a 529 shortly after Junior’s birth.
Notice I’m not saying Mom & Dad should not pay for Junior’s college. What I’m saying is Mom and Dad should stay flexible for their own financial future.
What’s so horrible about Mom & Dad starting to save for Junior’s college in a taxable brokerage account under their own names? At birth, they have no idea if Junior will get a scholarship, go to trade school, how Mom & Dad’s finances will be when Junior is ready to go to college, etc. By saving in financial assets that are in their own names–perhaps mentally segregated as potentially being for Junior’s college–Mom & Dad maintain great flexibility without sacrificing too much tax benefit.
If Junior gets a scholarship, great, the financial assets stay with Mom & Dad. If Mom & Dad are not financially successful when Junior goes to college, great, the financial assets can support Mom & Dad and Junior can figure out other ways to pay for college.
The Value of the 529’s Tax Benefits
How bad is the tax hit on holding investments for a child’s college education? Imagine owning a 60 / 40 equity to bond portfolio of $100,000 for a child’s college education. If held in the parents’ taxable brokerage account, how much taxable income might that generate annually? Very roughly, if dividend yields are 2 percent, the $60,000 in equities would produce $1,200 of dividend income, most of which is likely to qualify for qualified dividend income tax rates. The $40,000 of bonds would produce $1,800 of ordinary income at a 4.5 percent yield.
Is it desirable to add $3,000 of income to Mom and Dad’s tax return? Surely not. Cataclysmic? Also surely not.
Consider what a small amount of additional taxable income buys. If the money is held in the parents’ names, it can be used for anything without penalty. Perhaps Mom and Dad have not been financially successful. That $100,000 could help the parents achieve their own financial goals and retirement. What if the child gets a scholarship and does not need much in the way of tuition assistance from his or her parents? What if the child doesn’t go to college?
In exchange for paying tax on $3,000 of income annually (some of it at tax-favored QDI rates), and some long term capital gains when used to pay tuition, Mom and Dad have incredible flexibility with the $100,000. Maybe $50,000 goes for Junior’s college tuition, and $50,000 goes for Mom and Dad’s retirement. Further, for many it won’t be $3,000 of income annually. It will take most parents years before they could accumulate the sort of balance that would generate $3,000 of taxable income from educational savings. Thus, the tax hit for not using the 529 is likely to be that much less in the years well before the child is close to college age.
Outside of the handcuffs of the 529, assets can support multiple financial goals. Even better, as one financial goal is met, the money can be shifted to support another financial goal. Perhaps Mom and Dad are behind in their own savings when Junior is age 10. But things go well, and when Junior turns 16 Mom and Dad have wealth in excess of their FI number. In that case, money that might have been needed for the parents’ retirement now can be used for college tuition.
Use Restrictions
We need to consider the use restrictions on 529s. If not used for qualified education expenses, the growth is subject to both ordinary income tax and usually the 10 percent penalty.
Compare the tight use restrictions on 529s to the use restrictions on the other most prevalent tax baskets: taxable accounts, traditional retirement accounts, Roth accounts, and health savings accounts. Generally speaking, all of them (even HSAs) are not use-restricted or only partially use-restricted. All four of those tax baskets have a significant advantage over 529s in terms of use restrictions.
In many cases, I believe that the 529’s significant use restrictions are not adequately compensated by its tax advantages.
The 529 has rather onerous time restrictions, as distributions of earnings are generally subject to tax and the 10 percent penalty in those years there are no qualified education expenses.
Feeding the Beast
As much as we might want to, we can’t turn a blind eye towards hyperinflation in college tuition. With that in mind, shouldn’t we ask: Isn’t a hyperfocus on college savings feeding the beast?
It’s time to scrutinize American higher education. It’s not good for the country to have students graduating with mountains of debt. This is happening for many reasons, including significant administrative bloat in higher education. Clearly, American higher education is failing too many of its students. Is now the time to set aside money to pay American colleges and universities?
I get it: no one reader funding a 529 is the cause of the problems of American higher education.
But, if I’m a university used to collecting soaring tuition and fees, I’m all for 529s. 529s subsidize what has become bad behavior by university administrators. Less focus on 529s helps move the needle towards universities needing to act responsibly in order to attract students.
Camilla Jeffs raises an interesting point on her LinkedIn page: Part of the reason college is so expensive is because in many cases the customer (the student) does not bear the cost. 529s feed into that problem. Camilla’s recent podcast episode on 529s is also full of good food for thought.
529 Use Cases
The above limitations of the 529 noted, I do believe there are good use cases for the 529. These cases assume that the parents have decided to pay for their child’s college education.
Financially Independent Parents
Joe and Sally are married and 45 years old. They have saved 30 times their annual expenses in retirement accounts and taxable brokerage accounts. They have a 10 year old daughter they are reasonably sure will go to college, and they would like to pay for her college education.
This is a great use case for the 529. Mom and Dad’s financial future largely secured (generally speaking), it’s time to focus on (i) college savings, since they want to pay for college, and (ii) tax planning. Joe and Sally, already holding substantial taxable brokerage accounts, benefit from saving through the 529 so they avoid adding more dividend, interest, and capital gains income to their annual tax return.
Capturing State Tax Benefits
Aaron and Amanda are married and are 50 years old. They have saved 20 times their annual expenses in retirement accounts and taxable brokerage accounts. They have stable jobs. They have a 16 year old son who is very likely to go to college. Aaron and Amanda want to pay for their son’s college education. Since they live in New York State, if they contribute $10,000 annually to the New York 529 for his benefit ($5K each), they get an annual $10,000 state tax deduction on their New York state income tax return.
Aaron and Amanda are not financially independent by many metrics, but they are doing pretty well, and are likely (though not guaranteed) to be financially successful. In their case, paying for college is not financially ruinous. If Aaron and Amanda are going to pay for college, they might as well utilize the 529 annually to scoop up state tax deductions, particularly in a higher income tax state like New York. Further, beginning the 529 much closer to the start of college decreases the odds that the 529 will become over funded.
Contrast Aaron and Amanda to parents of newborns. Newborns’ parents are closer to the beginning of their financial journey. In most such cases, state tax benefits would not, in my opinion, be valuable enough to justify the use restrictions on 529 contributions.
Conclusion
My view is that the detriments of the use restrictions on 529s are not adequately compensated by the federal and state tax advantages offered by 529s in most cases. That’s certainly not to say there are not good use cases for the 529, but my view is that most parents should prioritize saving in their own names (even in taxable accounts) before making contributions to 529 accounts.
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I follow your reasoning through all of this, but it seems to ignore the value of tax-free growth and withdrawals for qualified expenses. This would be a point in favor of contributing more, and earlier. If a couple has a mostly secure financial future, and has reasonable confidence in their kids incurring qualified expenses down the road, then it would seem that there is great value in putting money into a 529 as early as possible. It would have maximum time to grow (tax free) and then get, in essence, a 15% or more discount on the eventual education expenses due to the tax-free withdrawals. Have I overlooked something in this reasoning? To me the immediate tax benefits (i.e. a small deduction on my state returns) are much less interesting than the potential long term benefit.
Thank you for reading and commenting. I appreciate it.
How many parents of newborns are financially independent when the child is born? It’s a rare fact pattern. Securing the parents’ financial future is worth much more than tax benefits on 20 years of investment income. I allude to the fact that early on the benefit is likely to be very small, as early on most parents using a 529 will only be able to get a very modest amount into the 529.
Sure, if the parents are already financially independent at birth, they should strongly consider a 529. But that is an exceedingly rare fact pattern, even in the FI community.
The other issue is the long term benefit is capped at 22 or 23 years in most cases, and can be shorter, since college will be done for most by age 23. The long term benefit of getting 5 figures (in many cases) out of investment tax for 22 years is something, but not enough for me personally to get excited about, and not enough for me to like signing up for use restrictions on the use of one’s own money.
Thanks for writing this!
I’m personally a bit tired of 529s being pushed so hard. Sacrificing ones financial wellbeing in favor of a nebulous benefit for children’s education seems absurd.
I was surprised though you didn’t cover that the principle can be distributed at any time without penalty, that does seem like something to figure in the calculation.
Matthew, thank you for reading and commenting, I appreciate it.
I would, generally speaking, say that Roth IRA contributions can be distributed at any time without tax and penalty. I wouldn’t go so far as to say something similar about 529s.
Look at Hal’s example above. Sure, for the $1,000 nonqualified distribution, he accessed $600 tax and penalty free. But in order to withdraw that $600 at any time tax and penalty free, he had to subject himself to tax and a penalty on the $400 of earnings.
Said differently, the Roth IRA nonqualified distribution rules are taxpayer favorable: they require accessing old contributions tax free prior to accessing Roth earnings. The 529 rules are generally not as favorable as there’s no way to only access old contributions separate from taxable earnings (unless there’s been a loss in the account), and the only way to avoid the tax on the earnings is to use the money for qualified education expenses (or close-in-time reimbursements thereof).
Right you are! I did miss that, thanks for pointing it out.
What about those who live in NY and are planning to pursue further education for themselves, is there any reason not to contribute $5k annually to a 529 in the years leading up to that education? I see your points and tend to agree with you, however if you’re using it for yourself, you know you’re going to need that masters for your career, why wouldn’t you do this?
Rachel, thank you for reading and commenting, I appreciate it.
You bring up a potential good use case for the 529. Scooping up state tax deductions absolutely can make sense. The benefits are real but small, so I think people in that boat should review the investment options and fees inside the 529 and make sure they are satisfied. It’s good to make sure that scooping up state tax benefits is not accompanied by less than desirable investment options and/or fees.
Of course, this is not a comment on investments options and fees inside any particular state’s 529 program.
Thanks for posting. Maybe I missed it in your post, but aren’t 529s one of the best wealth transfer vehicles around. For example, my 529 plans have my children as beneficiaries, but, if they do not use all the funds, I could name their children as beneficiaries. Then, when I pass, it is not included in my estate and my children , I believe, can take over the 529, and then potentially name their grandchildren, etc. over 50 plus years, even with modest returns, a $100,000 at 7% would be close to $3 million, and all tax free if used for educational purposes (including private high school and many other uses besides just college).
Jacob, thank you for reading and commenting. I appreciate it.
You raise several interesting issues. Here are my initial thoughts on them (not advice for you or any other individual).
Estate tax planning: Most Americans are not likely to be subject to the estate tax (the combination of high exemption rates and portability by themselves will kick most Americans out of the estate tax). Second, for those worried about the estate tax, the simplest tactics tend to be filing the Form 706 at the first spouse’s death for portability, annual exclusion gifting, and Roth conversion planning. I generally favor those three (which do not have use restrictions) to 529 planning in terms of low hanging fruit to reduce/avoid estate taxes.
Generational income tax reduction: I’d prefer to avoid use restrictions on $3 million. Some might argue $3 million in a tax free growth account is great. My view is that we now have a significant use restriction on $3 million, which is quite a price to pay. Further, why not just leave heirs taxable assets? Death eliminates capital gains (built in at the time of death) — there’s no need to use a 529 to eliminate capital gains taxes when death does it.
What can/will heirs spend on in the future?: There’s no immutable law of physics that says 40 or 50 years from now colleges will be able to charge $40K, $50K, etc. for annual tuition. There’s no immutable law of physics that even says college will exist as we know it 40 years from now. Viewing 529s as being for 50, 60 plus years bakes in very deep societal assumptions on what the future holds for training, education, etc., and what one’s heirs might want to pursue in terms of education. I’m leery of relying on that many assumptions.
I’m very concerned about handcuffs on wealth, especially over long periods of time.