By Dr. James M. Dahle, WCI Founder
A 529 plan is a college savings account called a Qualified Tuition Program (QTP) by the IRS. Federal law allows for each state to create one or more 529 programs. Any withdrawals used for approved educational uses are federal and state income tax-free. In addition, some states give a tax deduction or credit for contributions to a 529 account (see Best 529 Accounts to determine your options). Today, we'll go a step further and explain how you can superfund a 529.
What Can a 529 Plan Be Used For?
Approved educational uses include:
- Books, supplies, and equipment
- Special needs services for a special needs beneficiary
- Room and board (must be at least half-time), up to the allowance for room and board
- Computer equipment, software, and internet access
- Apprenticeship program fees and expenses
- Principal and interest on qualified student loans of the beneficiary or sibling (up to $10,000)
- K-12 tuition (up to $10,000 per year)
How Does a 529 Plan Work?
If you take money out of your 529 plan for any other reason, you will owe taxes on any gains at ordinary income tax rates AND a 10% penalty. You can also take out amounts equal to any scholarships received (including military academies), work assistance, and VA assistance. All of those would be penalty-free but not tax-free. You can also withdraw the money penalty-free (but not tax-free) if the beneficiary is disabled, although in many cases, you may wish to move the money into an ABLE account (the rollover does count toward the ABLE annual contribution limit, unfortunately).
529s Are for Rich People
For the most part, 529 accounts are a tax break for high earners, like most of those who read this blog. Lower earners could have trouble coming up with any money to save for college, and they benefit much less from the tax benefits of a 529. In fact, low earners that do save for college are probably better off using a simple taxable account most of the time since, for 2022, the tax rate on qualified dividends and long-term capital gains is 0% up to a taxable income of $41,675 ($83,350 married filing jointly). You have a lot more flexibility with a taxable account than a 529, so there's no sense in using it unless it provides you substantial tax benefits.
Even most regular readers of this blog have no need to “superfund” a 529. It's hard enough to just max out a single annual 529 account contribution, especially if you have multiple children. Imagine a household with four children earning the average physician income of $275,000. If this was 2022, that'd be $16,000 x 4 = $64,000, or 23% of the gross household income! Very few of us have set up our financial lives in such a way that we can do that. Frankly, there is rarely a need to do so. Imagine you don't even start saving until the kid is 8 years old and then you put in $16,000 a year for 10 years. Earning 8% a year, you still end up with:
=FV(8%,10,-16000) = $231,785
That pays for an awful lot of college. Used judiciously and combined with some work, scholarships, and contributions from current parental cash flow, it could quite possibly pay for both undergraduate and professional school.
However, there are a few of us who either have a lot of savings or a lot of disposable income and have become interested in “superfunding” a 529.
529 Max Contribution
The annual contribution limit to a 529 plan is the same as the gift tax exemption, $17,000 for 2023 (it was $16,000 in 2022). Superfunding is simply taking advantage of a provision of the tax code that allows you to put up to five years of contributions into the account all at once. So, you can put $85,000 into a 529 at the same time. If you are married, you can put in $170,000 all at once (might need to use two separate 529s). You can do it again five years later—and then again five years later. If you did this in 2022, when the limit was $16,000, you could theoretically have as much as (again at 8%).
=FV(8%,5,0,-160000) = $235,092 after 5 years
=FV(8%,5,0,-235092-160000) = $580,520 after 10 years
=FV(8%,5,0,-580520-150000) = $1,073,374 after 15 years and
=FV(8%,3,-16000,-1073374) = $1,404,085 at the time of enrollment at age 18
I say theoretically because every state has a limit of how much can be in a 529 plan (it ranges from $235,000-$550,000 in 2022) before you are prohibited from contributing more. But honestly, you could work around this simply by opening up a 529 plan in another state once you hit the limit in your state. You could get even more in there by starting a 529 for yourself long before the kid is born and then just changing the beneficiary to your kid after they are born. Or you could open accounts for a dozen of their cousins and then change the beneficiary to your kid. It's entirely possible to have millions and millions in a 529 account for one child.
Should I Go for the Maximum 529 Contribution?
The problem with going for the maximum possible 529 contribution (assuming you can afford to do so) is that you will likely have a hard time spending it all on that child's education. The problem becomes compounded if you have done the same thing for multiple children. Then, you are stuck with a bunch of money in a 529 account. If you find that you have far more money than needed in a 529 account, here are your options, listed in order of desirability:
- Change the beneficiary to your grandchild (or another qualifying family member)
- Pull out as much as you can, paying taxes at your ordinary income tax rate on any gain but WITHOUT paying a penalty, for scholarships and other approved reasons
- Pull the money out, paying taxes at your ordinary income tax rate on any gains AND a 10% penalty
Some people have looked at using 529s for retirement, figuring that all that tax-deferral must be worth more than that 10% penalty. However, if you run the numbers of a 529 account vs. a taxable account for retirement in any honest way, the taxable account will win out for three reasons:
- The slightly higher costs of the 529
- The 10% penalty
- The fact that gains are now taxed at ordinary income tax rates instead of the lower long-term capital gains rates
Don't believe me? Fine. Let's run the numbers. We'll assume something very tax-efficient, such as a total stock market fund. We'll use a single $100,000 contribution. We'll assume a period of 30 years before withdrawal. We'll assume the top income tax bracket throughout since those are the folks that would consider doing this. We'll assume an additional cost of 0.1% in the 529 plan. We'll assume a pre-fee, pre-tax return of 8% a year.
Grows at 8% – (2% yield * (1-23.8% qualified dividend rate)) = 7.52%
=FV(7.52%,30,0,-100000) = $880,395
Then you pay capital gains taxes on the gains leaving you:
($880,395 – $100,000) *( 1-23.8%) + $100,000 = $694,661
Grows at 8% – 0.1% additional cost = 7.9%
=FV(7.9%,30,0,-100000) = $978,686
Now you have to pay the taxes at ordinary income rates PLUS 10%
= ($978,686 – $100,000) * (1-47%) + $100,000 = $565,704
Note that, for sake of simplicity, my comparison DID NOT adjust for the fact that the dividends reinvested in the taxable account would not be taxed twice. This, of course, skews the results in favor of the 529 account, further strengthening my case that it is dumb to save for retirement in a 529.
What About a Multi-Generational 529?
Clearly, you want to use a 529 for education. If your kid doesn't use it up, you use it for your grandkid. If they don't use it up, then it can go to their kid. And so on for dozens of generations, right? Well, there is one issue with doing this. But first, let's explain how estate planning laws and 529s interact.
First, a 529 is a pretty cool account from an estate planning perspective. It is the only account in which the contribution is removed from your estate but over which you still retain full control, including the ability to liquidate the account and spend it on yourself at any time (after paying any applicable income taxes and penalties, of course).
Imagine superfunding the 529s for five grandchildren all at once. You just removed OVER $1.5 million from your estate. Cool trick. However, if you die during the five years after “superfunding” a 529, the extra contributions for the years after your death are pulled back into your estate.
When you die, the beneficiary of the account does not change but, depending on the state, the new owner either becomes your designated contingency owner OR the beneficiary themself. No big deal, you can probably work around that if you're trying to do the multi-generational thing.
If the beneficiary dies, you can pull out the money penalty-free (but not tax-free), or preferably, just name a new beneficiary. No big deal here either.
So what's the big deal? The big deal is the Generation Skipping Tax (GST). The GST is put in place to ensure that estate taxes are charged for every generation. Let's say you have a $500,000 529, and you want to change the beneficiary from your child to your grandchild. You can only give that grandchild $17,000 per year  ($34,000 if married) without using up your gift/estate tax exemption ($12.92 million for an individual, $25.84 million jointly for 2023). So, if you gave $500,000, you would use up $483,000 in exemption. When you run out of exemption, gift taxes start kicking in (called estate taxes if your estate runs out of exemption after death).
It is entirely possible that this 529 account could be passed down generation to generation without any of the generations actually being wealthy enough to trigger the GST/Gift/Estate tax. But it will certainly add an element of complexity to your estate planning. Plus some person down the line is probably just going to liquidate it and use it for their house down payment. Or to just blow it all on a Tesla demolition derby. Probably best to set up some kind of trust instead if this is really what you want to do.
How 529 Superfunding Works
We've established you probably shouldn't go for the maximum or try to use a 529 as a multi-generational education trust, but you may still want to frontload your 529 savings by superfunding once or twice. Should you actually do it?
There are three reasons you might not want to do it.
- You might have a better use for your money. Paying off your own credit cards, student loans, or even mortgage may be a better use of your money. Maxing out your retirement accounts certainly is. We tend to buy homes at about the same time in life as kids are born too, so you may need some down payment or closing cost money.
- You might lose out on state tax benefits. In most states, if you fund the 529 all at once, you only get a tax deduction or credit for that first year. Check with your state tax laws or 529 provider, but that's probably the way yours works.
- There is some paperwork. Normally, 529 contributions are really straightforward. That's not the case when you superfund.
You should also be aware that you can actually put more than $80,000 ($160,000 married) into a 529 in a given year. It just uses up your estate tax exemption. If you don't care about that, I guess you could put $529,000 into your California 529 plan all at once and let it ride!
Technically, “superfunding” means making the five-year election on your contributions. If you contribute $80,000, it's really straightforward. You make the five-year election and you don't contribute anything for the next five years. But what if you only contribute $50,000? What happens then? Well, that $50,000 is still spread over all five years, $10,000 per year. You can still contribute another $6,000 each year. Or you can make another “superfunding” contribution the next year of, say, $30,000. Then, $6,000 of that would be applied each year for the next five years.
So how do you actually make the five-year election? You do it on IRS Form 709. Including its four schedules, it's five pages long (the same length as the corporate tax return form, incidentally). Still want to superfund? Maybe not. The Form 709 Instructions discuss 529 superfunding on page 7.
Here's what the IRS writes on Line B (Qualified Tuition Programs (529 Plans or Programs)) (and remember, in 2021, the 529 annual limit was $15,000):
“If in 2020, you contributed more than $15,000 to a qualified tuition plan (QTP) on behalf of any one person, you may elect to treat up to $75,000 of the contribution for that person as if you had made it ratably over a 5-year period. The election allows you to apply the annual exclusion to a portion of the contribution in each of the 5 years, beginning in 2020. You can make this election for as many separate people as you made QTP contributions. You can only apply the election to a maximum of $75,000. You must report all of your 2020 QTP contributions for any single person that exceed $75,000 (in addition to any other gifts you made to that person). For each of the 5 years, you report in Part 1 of Schedule A one-fifth (20%) of the amount for which you made the election. In column E of Part 1 (Schedule A), list the date of the gift as the calendar year for which you are deemed to have made the gift (that is, the year of the current Form 709 you are filing). Do not list the actual year of contribution for subsequent years. However, if in any of the last 4 years of the election, you did not make any other gifts that would require you to file a Form 709, you do not need to file Form 709 to report that year's portion of the election amount.”
And here's what that section of the form would look like:
That $15,000 gets totaled up at the end of Schedule A and transferred onto line 1 of Part 2 on the main form (page 1) like this:
Not too bad, really. And if you don't give any other gifts, you don't actually have to file this form for the next four years.
Here are some other rules.
- You cannot make the five-year election with less than $17,000.
- The five-year election is all or nothing. No making a $50,000 contribution and calling $17,000 of it this year's contribution and making the five-year election for the rest of the $33,000.
- There are no joint elections. If you want to do it for both you and your spouse, you have to do two Form 709s. You might potentially want to just do it for one spouse.
- Don't forget other gifts. All gifts you give that person count toward the $17,000 per year limit. It isn't a separate 529 gift limit.
529 superfunding is a way to get a bunch of money into a 529 account all at once. Even though it probably won't be used by the vast majority of white coat investors, it's still an option because it can certainly be a useful estate planning technique.
What do you think? Did you superfund your 529 accounts? Why or why not? Are you glad you did? Comment below!