Happy National 529 College Savings Day! Let’s celebrate with five reasons to avoid 529s.
Cart Before the Horse
I’ve said it before and I’ll say it again: far too often new parents have relatives extolling the virtues of a 529 at the reception after the Baptism.
Those relatives rarely step back and ask “how are Mom and Dad’s finances?”
Picture a typical late-20s / early 30s Mom and Dad of a newborn. What are their financial pain points? What’s needed in their financial lives?
I can tell you what is not their financial pain point: taxes on investment income. Yet this is what the 529 solves for. The 529 for a newborn’s parents is often the equivalent of a cast for someone with a paper cut!
What do Mom and Dad need in their financial lives? If they are anything like the typical American adult, they probably need more in the way of retirement savings. Shouldn’t Mom and Dad prioritize their own compelling retirement needs over saving for a speculative potential future expense of their newborn baby, college education?
Listen to me discuss the 529 on The Personal Finance Podcast.
The Tax Benefits Aren’t That Great
In 2024 we’re in a great time to own taxable investments. Long term capital gains and qualified dividend income are taxed at 0%, 15%, 18.8%, and 23.8% (when factoring in the potential net investment income tax). Having equities inside a 529 avoids that tax, which is quite modest by historical standards. That tax is particularly small considering the low dividend yield environment we currently have.
Further, the state tax benefits are usually modest. In our three largest states, California, Texas, and Florida, there’s no immediate state benefit for a 529 contribution.
Flexibility
As much as possible, a dollar ought to be able to serve multiple masters and multiple purposes.
Inside a taxable brokerage account, a dollar can efficiently support (i) Mom and Dad during their working years, (ii) Mom and Dad during their retirement, (iii) a new roof for the house, (iv) a family vacation to Yellowstone, and/or (v) Junior’s college education.
Inside a 529, a dollar can efficiently support (i) Junior’s college education.
Why should the parents of a newborn handcuff their money when the tax benefits are quite modest? Why shouldn’t Mom and Dad remain flexible for their own financial future and decide what to do with that dollar later on, when they have more knowledge and information?
Many things can happen in the future that could make having a large sum in a 529 a bad thing: maybe Junior went to trade school, Junior got a scholarship, and/or Mom and Dad had financial struggles and now need that dollar to support their own retirement.
The 529 Overfunding Problem
Scholarships happen. Some newborns don’t end up going to college. These are just two of the reasons that 529s get overfunded.
Taken for non-educational purposes, 529 distributions that represent earnings are subject to ordinary income tax rates and a 10 percent penalty. Ouch!
There are bailout techniques available to avoid negative tax consequences, but they are all limited to various degrees. The SECURE 2.0 529-to-Roth IRA rollover is very limited and, in my opinion, not something to be planned into.
Feeding the Beast
What grade would you give American higher education in 2024?
American higher education often produces graduates who are ill-equipped for the modern economy and/or have staggering student debt loads. Many colleges and universities have administrative bloat that has gotten wildly out of hand.
Why should newborns’ parents handcuff their money such that they can only avoid a penalty by paying it over to American higher education? How does that make sense? Very modest tax benefits are nowhere near sufficient to make that make sense.
Conclusion
I’m not here to say funding a 529 never makes sense. But I am here to say (1) I believe that 529s are wildly overhyped and (2) 529s rarely make sense for the financial profile and needs of the parents of newborns.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.
First off, love your blog and have learned a lot from it. And while I think this post is all technically accurate, I think it misses the mark a bit on the “personal” aspect of personal finance.
On your first point, you of course are not wrong. But is it really realistic to ask Aunt Judy or Grandma Mabel to give money to your retirement accounts when it is little Johnny’s birthday? My boys are 10 and 8 now, and we asked relatives (particularly when my kiddos were at those younger ages) to avoid buying stuff that’s just going accumulate in my house but instead give to their 529s. They truly enjoyed feeling like they were giving to the future of my children. Don’t think they’d feel that way about me asking them instead to give $30 I can dump into an index fund.
As to the tax benefits, again you are right speaking of right now, but we have no idea what those tax rates will be in 10 or 20 years. It could change drastically. I just never like to solely base future decisions on current facts. Also, in my state, up to $10K of 529 deductions are deductible each year. Helps a lot come tax time.
Your flexibility point is spot on. But, for some folks who maybe lack the financial discipline or need stricter parameters to help them make savings decision, committing to even $25/month into a 529 gives them the peace of mind that they are looking out for their kids. Yes, they could put that $25 into a Roth and have greater flexibility, no argument there.
Overfunding? Another great consideration. Of course no one needs $1M in a 529. But we are planning on a nice little nest egg of about $250K for my two kids (combined). Maybe it covers all expenses, maybe it doesn’t. Maybe they go to college. Or maybe they enter a trade school, take certification courses, need a laptop or other computer-related software. Those are all things 529s can be used for. The chances neither of my kids have any education-related costs seems VERY low to me. And if they don’t have any? I have education expenses ready for grandchildren. Nice little generational gift.
And on your final point, it’s hard to argue. I work tangentially in higher education and see many of the deficiencies and pitfalls. And I not a parent that is going to force my kids to go to college. But in our current society, there are many options that simply would be unavailable to them without a college degree. I’m a pragmatist, and I’m going to do whatever I can to give my kids a leg up for a better life than I had.
Are 529s overhyped? Possibly. But I personally wouldn’t be so dismissive of them.