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?
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.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
Below I’ll discuss the ins and outs of the new SECURE 2.0 529-to-Roth IRA rollover provision. While an understanding of the details is great, the more important issue is this: does this new rule fundamentally change financial decision making and planning?
UPDATE 1 March 1, 2024: There are now significant doubts as to the validity of SECURE 2.0, including the 529-to-Roth IRA rollover provision. See my YouTube video on a very important court decision that puts SECURE 2.0 on very shaky ground (though it is still the law of the land as of March 1, 2024).
UPDATE 2 March 1, 2024: As of now, the IRS and Treasury have not issued significant guidance on the 529-to-Roth IRA Rollover. Thus, many questions remain on how it works.
529-to-Roth IRA Rollover Introduction
SECURE 2.0 has a special rule (see Section 126 on page 2161), first effective in 2024, allowing a tax-free transfer of money inside a 529 to a Roth IRA. This provision has been met with some unbridled enthusiasm that, to my mind, should be scaled back.
Before we get started, it’s important to note that (i) this is a very new rule and (ii) at any time the IRS and Treasury could issue guidance concerning this new rule. For both those reasons, everything discussed in this post is subject to change.
The above said, let’s discuss the parameters of this new rule, adding in the context of the already existing Section 529 rules.
First, consider the statutory definition of a 529. From Section 529(b)(1)(A)(ii): an account which is established for the purpose of meeting the qualified higher education expenses of the designated beneficiary of the account.
A program shall not be treated as a qualified tuition program unless it provides adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the qualified higher education expenses of the beneficiary.
To my mind, the combination of these two rules* and how the IRS views them in a new environment where money can go tax-free from a 529 to a Roth IRA tamps down on any affirmative planning to stuff 529s with a primary purpose of getting money into Roth IRAs. I would not be surprised to see the IRS and Treasury come out with regulations more explicitly prohibiting stuffing 529s in this way.
What I believe is very much allowed is parents rounding up when funding a child’s 529. The above-cited Section 529 language should not be read to require parents to be conservative when funding 529s. Future higher education expenses are quite speculative. What will future college tuition be? Will the child go to grad school? Will the child graduate undergrad 3 years, 4 years, or 5 years? Will the child get scholarships?
529-to-Roth IRA Rollover Details
First, the rule provides that, in any year, the beneficiary of the 529 can be given up to the annual maximum allowed Roth IRA contribution as a Roth IRA contribution from the 529. If done, the contribution from the 529 becomes the beneficiary’s annual Roth IRA contribution for the year. Thus, this new rule does not create additional Roth IRA limits for the beneficiary.
One advantage is that the contribution is not subject to the Roth IRA MAGI limits. This advantage is not all that great, considering most young adult beneficiaries will not earn income exceeding the Roth IRA MAGI limits. Even if the beneficiary is very high income, he or she may be able to use the Backdoor Roth IRA to get around the MAGI limits.
Second, in order to execute this maneuver, the 529 must be at least 15 years old, and the amount contributed is limited to the amount of contributions (and earnings attributable to those contributions) occurring at least 5 years prior to the transfer to the Roth IRA. The 5 year rule defeats the idea of “oh, my daughter’s a senior in college, let me contribute $30K to her near-empty-529 and now have runway to make 5 annual Roth IRA contributions for her for her first 5 years after college graduation.”
Third, the total that can be transferred to the beneficiary’s Roth IRA is $35,000. The $35,000 is not adjusted for inflation, significantly limiting the benefit of this new rule.
As a planning tool, this technique is quite limited because the technique does not create any new Roth IRA contribution limitation. The new rule does not, generally speaking, increase Roth IRA contribution limits. Further, parents thinking of supporting young adult children can simply gift their adult children their annual Roth IRA contribution out of Mom and Dad’s bank account.
529 Rollovers as Roth Contributions and Roth Earnings
The new 529-to-Roth IRA maneuver preserves earnings in the 529 as “earnings” inside the Roth IRA. I refer to this as the “earnings-to-earnings rule.” This impacts how any future nonqualified withdrawals are made from the Roth IRA. From the now adult child’s perspective, a regular annual Roth IRA contribution is better than a 529-to-Roth rollover, because the 529-to-Roth rollover limits how much of the contribution is easily withdrawn as a return of prior contributions.
Here are two examples to illustrate the concept:
Example 1: Mark graduated college and started his first full time job in 2024. He contributes $6,500 to a Roth IRA for 2024. If Mark ever has an emergency, he can withdraw the $6,500 from the Roth IRA at any time for any reason tax and penalty free.
Example 2: Julile graduated from college and started her first full time job in 2024. Her father named her the beneficiary of a 529. Assuming the 15 year rule and the 5 year rule are satisfied, her father can direct $6,500* from the 529 to Julie’s Roth IRA for 2024. At the time of the transfer, the 529 consisted of $30,000, $15,000 of previous contributions and $15,000 of earnings. The $6,500 goes into the Roth IRA as $3,250 of contributions and $3,250 of earnings. Assuming Julie has made no other Roth IRA contributions, the most she can withdraw from the Roth IRA tax and penalty free for any reason prior to age 59 1/2 is $3,250.
*Note the 2024 Roth IRA contribution limits have not been published as of this writing. This uses the 2023 contribution limit as the 2024 contribution limit for illustrative purposes only.
The earnings-to-earnings rule makes sense to (somewhat) protect the 529 earnings rule. If 529 rollovers went into Roth IRAs entirely as contributions, the 529-to-Roth maneuver could be used to bail out 529 earnings by rolling to a Roth IRA and then immediately withdrawing, taking advantage of the Roth IRA nonqualified withdrawal rules to get the 529 earnings out tax free.
The above said, the hope for most receiving the benefit of the 529-to-Roth IRA rollover is that they do not make withdrawals from their Roth IRA for many years, making the new earnings-to-earnings rule mostly academic.
Sean’s Take
So how do I view the 529-to-Roth IRA rollover? I view this as a helpful, though quite limited, bailout technique for overfunded 529s. As a bailout technique, it’s a nice tool to have in the toolbox. The people who should be happy about it are those parents/grandparents with either a student in college today and/or a recent graduate and an overfunded 529.
The above said, the 529-to-Roth IRA is not a technique that provides much, if any, value from a planning perspective. I do not believe that this new maneuver significantly impacts financial planning for most parents, as I don’t believe it makes the 529 all that much more attractive.
Compare (i) 529s and this provision with (ii) simply investing money in taxable mutual funds and then using that money to fund a child’s college education and giving them $35K to be invested in Roth IRAs as a young adult. Yes, the 529 plus the 529-to-Roth is better than using taxable accounts, but not by enough for me to get very excited. Remember, in the FI community, the primary goal is not to optimize your child’s tax situation. Rather, for most parents, the primary goals are to secure Mom & Dad’s financial independence and be sure that Junior never has to worry about Mom & Dad’s financial security during Junior’s adulthood.
Second, those parents with extra money in 529s after a child graduates college should still consider changing beneficiaries to younger children or grandchildren primarily, and use the new 529-to-Roth IRA bailout technique as an alternative if no other beneficiary needing tuition assistance is readily available. To my mind, if there’s a successor beneficiary readily available, changing the beneficiary will usually be the preferable option, as it can be done instantaneously without worrying about limits and holding periods, and there’s no need to coordinate with the Roth IRA’s financial institution.
529 Seasoning
Some are discussing new parents opening a 529 at birth just to season the account so the account qualifies for the 529-to-Roth IRA maneuver sooner rather than later (before the child’s 16th birthday). As I believe young parents should be focused (financially) on securing their own financial future, I do not believe it should be a priority to do this. My (financial) hope for most young parents is that they first secure their own financial future during their child’s childhood.
If the parents’ financial future is secured by the time the child is in high school, the parents can start 529 funding to grab some state tax deductions or credits (if applicable). In such cases, when the funding occurs closer in time to college, it should be much easier for the parents to “right size” the 529 such that it is not overfunded for college. In those cases, any small remaining 529 balance can be bailed out by changing the beneficiary or using the 529-to-Roth IRA maneuver, even if it does take a few more years to satisfy the 15 year rule.
In addition, what’s the rush? So what if you have to wait 10 years until after Junior graduates college to execute the 529-to-Roth IRA rollover? In those 10 years you get tax free growth, and even if Junior has become the CEO you can still execute the maneuver, since the annual contribution MAGI limit has been eliminated for those doing the 529-to-Roth IRA rollover.
The downside of foregoing several years of pre-graduation seasoning is that additional time could cause growth such that the total in the 529 exceeds $35K by the time the 15 year clock is satisfied. I’d argue a 529 established much closer to the beginning of college is less likely to be significantly overfunded, mitigating this downside concern.
Multiple Beneficiaries
I think multiple beneficiary planning for the 529-to-Roth IRA maneuver is going to be very challenging. Consider the following situation:
Example 3: Dad owns a 529 and Son, age 21 is the beneficiary. Dad has paid for Son’s first three years of college through the 529. Daughter, age 25, is already a college graduate and in the workforce. If Dad’s 529 is now worth $100,000, in theory Dad could do a partial rollout of $30,000 to a 529 naming the Daughter as beneficiary with an eye towards the 529-to-Roth IRA rollover for Daughter’s benefit. However, remember the 15 year rule. The new 529 could not seed Daughter’s Roth IRA until Daughter is age 40. Further, if Daughter never uses any of the money for qualified educational expenses, the account is likely to run into issues being a valid 529.
529 plans cannot have multiple beneficiaries. This alone makes split-up planning for the 529-to-Roth IRA maneuver quite difficult. That said, if Daughter attended a year of graduate school at age 27 largely funded by this new 529, then Dad’s maneuver works, though remember that Daughter can only get the money into her own Roth IRA starting at age 40.
Starting with Owner as Beneficiary
Some might consider a parent opening a 529 before the child is born naming the parent as both owner and beneficiary. After 15 years, the parent can make annual 529 to Roth IRA rollovers to their own Roth IRA. Once the $35K maximum has been hit, the parent could then change the beneficiary to a child. Considering the 529 statutory language discussed above, I don’t believe that is a wise course of action. Such a course risks 529 account disqualification unless the IRS and Treasury come out with rules affirmatively blessing it. Further, all that’s been saved is tax on interest, dividends, and capital gains of $35,000 of Roth IRA contributions. Under today’s investment friendly tax rules, that will not be very much tax.
Don’t Plan on Using the 529-to-Roth IRA Maneuver if You Aren’t Going to College
The online world is full of scuttlebutt, and already I have seen social media posts inquiring as to whether adults should fund 529s for themselves with the idea of funding them today and starting 529-to-Roth IRAs rollovers 15 years later. I do not believe this is a wise course of action.
Based on the language in Section 529 quoted above, I am highly skeptical of planning to put money into the 529 looking to get it into a Roth IRA. Sorry to all those 40-somethings out there thinking about throwing $20,000 into a 529 to fund their Roth IRA annual contributions in their 50s and 60s.
Even if Congress were to change Section 529 tomorrow and explicitly allow 529 stuffing to get money into a Roth IRA, I don’t believe it makes much sense to affirmatively look to use a provision like this. It doesn’t increase the limit for Roth IRA contributions. If one is working 15 years from now, they will probably have the cash flow to fund their Roth IRA. Why do they need to invest through a 529 and get a very small tax break on the money for the 15+ years beforehand? Further, what if they aren’t working and don’t have compensation income in 15 years?
Considering the language in Section 529 discussed above, I doubt the IRS will allow middle-age 529 owners whose schooling is far behind them to change the 529 beneficiary to themselves and then do the 529-to-Roth IRA maneuver. Yes, the IRS and Treasury may allow the successor beneficiary to step into the 15 year clock of the original beneficiary. But if the middle-age owner becomes the beneficiary, the 529 is no longer for the beneficiary to use for qualified educational expenses. At that point, it appears that there is a high risk the account may cease to be a good 529. If the owner then executes the rollover maneuver and their MAGI exceeds the annual Roth IRA contribution MAGI limit, they create an excess contribution to the Roth IRA.
It’s possible that the IRS will view this differently, but I would not count on it. Until the IRS and Treasury come out with more definitive guidance, I would expect that the benefit of this new rollover maneuver will largely be limited to those who completed their college education after the funding of a 529 for their benefit.
Changing the Beneficiary and the 15 Year Clock
Does changing the beneficiary on a 529 reset the 15 year clock?
My hope is that the IRS and Treasury allow a successor beneficiary to inherit the holding period the original beneficiary had. My view is that the IRS and Treasury are protected by the statutory language requiring 529s to be for the educational expenses of the beneficiary. If the successor beneficiary plans on using the 529 money only for their Roth IRA, the 529 can be disqualified. But if the successor beneficiary uses some of the money for education and then has leftover amounts, he or she should not need to wait until the passing of a new 15 year clock to get the money into a Roth IRA.
If the IRS and Treasury are worried about abuses here, one possible compromise would be to allow the successor beneficiary to inherit the original beneficiary’s clock only if (i) the successor beneficiary is no more than ten years older than the original beneficiary and (ii) the successor beneficiary is a member of the original beneficiary’s family.
A Critical Look at the 529
Watch me discuss on the 529 on YouTube
Conclusion
For those with an overfunded 529, the new 529-to-Roth IRA maneuver is very good news. That said, to my mind, it is just another tool in the tool box. In many cases, overfunded 529s are better used for another beneficiary, such as another child or a grandchild. But still, overfunded 529s are an issue, and it is good to have another bailout tool available, particularly if there is no successor beneficiary in the picture.
I generally do not view the 529-to-Roth IRA maneuver to be a great planning tool. Generally speaking, it does not increase the amount that can go into a Roth IRA. That alone significantly diminishes its value from a planning perspective. Of course, everyone needs to do their own analysis and planning considering the particulars of their own situation.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
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.
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.
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.
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.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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.
