By Dr. James M. Dahle, WCI Founder
529 plans are a critical part of the four pillars of paying for college. They're named after a section of the tax code, just like 401(k)s. Stupid, I know, but that's the way these things work. What they should have been called was “The Tax Break for the Rich”, because that's what they are. Or at least, the tax break for the high-earners, which isn't necessarily the same thing as the tax break for the high-net-worthers. Why is it the tax break for the rich? We'll get to that, but first, 529 plan basics.
What Is a 529 Plan?
A 529 account is a state-sponsored way to help you save for your kid's college. Basically, you put after-tax money into it, then it grows tax-free, and if spent on legitimate college (or med school) expenses, it comes out of the account tax-free. An individual can put up to $17,000 in there in 2023, up from $16,000 in 2022 ($34,000 for married couples) and still stay below the annual gift tax exclusion.
In 2017, the Tax Cuts and Jobs Act expanded 529s allowing their use to pay up to $10K for private elementary or high school tuition.
Each state has its own plan (or two), and some are better than others. Sometimes you also get a break on your state income taxes if you use the one in your state. The expenses of the plans, like 401(k)s, vary quite a bit and change often.
You can move money from one 529 to another (including a 529 ABLE account) fairly easily, much like transferring an IRA from one custodian to another.
Which State Has the Best 529 Plan?
If your state doesn't have any income tax, or if it doesn't give a break for 529 contributions, or if its expenses are ridiculously high, you may want to look into the best 529s out there. Since the plans change often, so does this list, but I would consider looking into the plans from front-runners Michigan, Utah, Illinois, and New York (direct). Compare investment options, plan expenses, and expense ratios of the various funds.
Pre-Paid Tuition Plans
Some states offer a pre-paid tuition type plan. Basically, you pay tuition at today's price and the state takes the risk of tuition inflation. Given the past rate of inflation, that might be a pretty good investment, but be aware that the deal may be different for in-state schools versus out-of-state schools, unlike the more standard “defined contribution” 529s.
529 Plans and Financial Aid
529 plans do count against a kid if they are trying to get financial aid. Thanks to a 2009 law, a 529 in either your name or your child's name has an expected family contribution of 5.64%. (Consider having the grandparent own the account if this is an issue, but honestly, most readers aren't going to qualify for any sort of financial aid anyway.)
Who Maintains Control Over the 529 Plan and Whose Money Is It?
The 529, unlike a UGMA, isn't your kid's money. It's yours. So you can take it out and spend it on a boat if you like (but you'll have to pay a 10% penalty, plus your regular income taxes on the earnings). You can also roll it over from your daughter's 529 to your son's 529 to your grandson's 529 without any penalties, which gives you a lot of options when Junior decides to smoke dope and play disc golf professionally instead of going to Yale like you planned when he was three. Be aware that the “generation-skipping tax” only applies if the new beneficiary is two or more generations away from the old beneficiary and only applies if the transfer exceeds the gift tax exemption amount.
Why Is a 529 Plan a Tax Break for the Rich?
Several reasons:
#1 High Contribution Limit
An Educational Savings Account/Coverdell/Education IRA works just fine for those who don't make much. All these plans can offer lower expenses and more investment choices than a 529. You don't get a state tax break, but the working class doesn't pay all that much in income taxes anyway. The problem with an ESA is that you can only put $2,000 a year into it. That just isn't enough to pay cash at Harvard. This isn't an issue for the working class. It's hard enough to put $2,000 into that account for each of their kids. But for a high-earner, it's nice to have the higher contribution limit ($17,000 per year for an individual) of the 529.
#2 State Tax Breaks
My state allows both me and my wife to put $2,040 EACH (2021) into a 529 for EACH of our children and get a credit for it on our state taxes. Tax break going in, tax break while growing, tax break coming out. Can't beat that.
Future 529 plan recipients
#3 You Can Front-Load a 529 Plan
Would you like to shelter MORE than $17,000 per child, per parent, per year? You can. You're allowed to front-load up to five years worth of contributions at one time, up to $85,000 per child. Eventually, there's a limit on contributions. But imagine putting in $85,000 when your child is born, $85,000 when your child turns 5, $85,000 when your child turns 10, and another $51,000 when your child turns 15. By the time they turn 18, assuming 8% returns, you'll have well over $1 million for college. I don't care what tuition inflation is, that's going to cover it. Obviously the poor can't do this, but the rich can.
#4 College Savings
The working class pays for college by working their way through it and taking loans. They're doing well to put away $17,000 for retirement, much less for their kid's college. They simply don't have a need for a 529 plan. As a general rule, only high-earners have a little extra to put away for the next generation.
Should the High Earner Overcontribute to a 529?
Now, for the advanced reader, a discussion of whether you should purposely overcontribute to a 529. Let's say you've maxed out your IRAs, 401(k)s, etc. You've got more money to save, but are already saving plenty for college. Should you put even more into 529s planning to take it out later and spend it during retirement? Let's analyze how you'll end up.
First, some assumptions:
- Let's assume you get a 5% tax break on your contributions.
- Your investments earn 8%/year.
- You pull the money out 30 years after you put it in.
- Let's further assume that your state DOESN'T recapture the state tax breaks you got years earlier when you contributed it. (Some do recapture these.)
- We'll also assume you invest in a relatively tax-efficient investment such as a stock index fund, and that the 529 expenses are 0.3% higher than they would be in a taxable account, and that your total marginal tax rate when you withdraw the money is 30% and your total capital gains tax rate is 15%.
Investing in a 529 vs Taxable Account
Let's compare investing in a 529 plan with a taxable account.
$10,000 into a 529
Instant 5% return = $500
After 30 years, $10,500 invested at 7.7% (reduced for 529 expenses) grows to $97,199. 30% taxes plus 10% penalty reduces this to $58,319.
$10,000 into a Taxable Account
After 30 years, $10,500 invested at 7.7% (reduced for capital gains/dividends of 2%/year taxed at 15% rate) grows to $97,199. You now sell it at 15% capital gains rates with no penalty, leaving you with a total of $82,619.
Now, you might have to pay a little more in taxes in the taxable account if you churn your account, but you also might have opportunities for tax-loss harvesting, charitable donations, etc. to reduce your tax burden. (See my article on Taxable Accounts for more details.)
It's pretty clear that investing in a 529 for reasons other than education isn't very bright. If you do mistakenly over-contribute, you can always roll it over to another family member's 529, but you certainly shouldn't be trying to game the system by purposely over-contributing for your retirement. Over-contributing to start a college fund for a grandkid is another matter, of course, as is over-contributing in order to roll it into an ABLE account for your disabled child.
In summary, a 529 is a great way to save money on your taxes and help Junior avoid the loan burden you probably had to deal with. As tuition continues to skyrocket, even state school undergraduate degrees may soon be out of reach of those who can't pay at least part of the bill using savings.
Are you funding your children's education with 529? Why or why not? Comment below!
i believe the 13k limit per year mentioned isnt really a limit of 529 plans but a limit to avoid the yearly gift tax. Thus if you can get a bunch of different people to contribute (grandparents), you can go even higher. You could still go above 13k per year if desired, just need to realize how the gift tax works. My biggest problem with 529 plans (which isnt really a problem with the plan) is that since the investing time horizon isnt as long as when you invest for retirement, you might accidentally have bad “market timing” and not do so well since few actually start a plan and contribute heavily when the child is an infant (other costs take priority) but really start putting money in when the child is age 7 or so and thus you only have a decade for returns. Of course you could invest in lower risk products like annuities but at some point the return isnt worth doing. Im not saying dont do it since i do but what i am saying is dont have the same long term expectations that you have with your retirement accounts.
I believe you are correct. The only limit for Utah’s 529 plan is $387K in total contributions. I suppose you could put it all in in one year if you wanted to.
Excellent analysis. I have both plans for my daughter (Coverdell and 529). My ‘problem’ is, despite the relatively low 2k annual limit on the Coverdell, thanks to some lucky stockpicking, the value of that account now is nearly 90k. She is attending a state school (UMass-Amherst), and should have lots left over after graduating in 2015. Can those funds be used for grad school? If not, are they transferrable to other beneficiaries as in a 529? Last question, does it make sense to spend dollars from one account preferentially over the other? Her 529 investments total about 45k, and are in various Vanguard index funds, which are underperforming the holdings in the Coverdell dramatically. Thanks in advance.
Yes, they can be used for grad school, yes they can be transferred to other beneficiaries (there are limits of course on who those beneficiaries can be). Coverdell assets are slightly more valuable than 529 assets because they can be used for pre-college educational expenses, but in general they are the same. You can also withdraw the money, pay the taxes and 10% penalty, and buy yourself a Porsche.
I recently heard a rumor that the earnings from a 529 plan are subject to state (but not federal) income tax, except if specifically exempted by the state. Is this true?
to clarify the above, I mean that the earnings are taxed by the state when they are withdrawn.
I don’t know of a state where 529 withdrawals used for education purposes are subject to state income tax. It would be easier to look up if you could connect your rumor to a specific state, rather than looking up all 50.
There is one exception to the example that a taxable account is better than a 529 plan. Some states allow you to direct the non-qualified 529 withdrawal to the beneficiary. Assuming your child is not working during school the tax rate would most likely be 10% + 10% penalty. So depending on what happens with capital gains taxes in the future the 529 could actually be beneficial. Lets say capital gains rates rise to 20% + the health care tax added for high earners 3.8% the 529 would have an advantage 20% VRS 23.8%.
One last point if you only take out enough profit to reach the standard deduction for your child you would only have to pay the 10% penalty and your child would not owe any federal taxes. So if you are overfunded you can still take out a small amount each year at only 10% penalty which will be better than capital gains rates.
As a grandpa, in Wisconsin, I put $3000. for each grandchild annually on their birthday, which can be deducted from the state tax to that amount. I use the aggressive index which is .18% (but I could use the Large cap for .12% or a Balanced for .14%). Retired I have a marginal rate of15% and will have for the forseeable future. Assuming I leave it in for 17 years for each child and they use it for college I would think I would do better than investing in a taxable account but I am not sure how to do that calculation. I also don’t know if I have to pay tax when it is withdrawn for college expenses.
You don’t have to pay tax when it is withdrawn. So yes, it comes out ahead after taxes. How to do the calculation? Just apply the appropriate tax rates to it as it grows and kicks off distributions and when you liquidate it. Ballpark maybe assume you lose 23.6% of all gains to the tax man if you don’t use a 529. Plus you lose that state tax break.
Now in your case, if your marginal tax rate is 15% (12% federal 3% state?) then you don’t pay taxes on capital gains or dividends, so the savings won’t be as big as it would be for someone like me with a 45.8% marginal tax rate who pays 23.6% federal and 5% state on LTCGs/dividends.
LG-
I’m not sure what you mean by “directing the withdrawal to the beneficiary.” I believe the withdrawal goes to the owner of the account. Now I believe that once the child is 18 you can make the child the owner (and of course the beneficiary) of the account and work this scheme of yours. I don’t think there is anything state specific about it though. Federal taxes are just that.
But you can only overfund the thing a little. You would need to get it all withdrawn ($5K-15K a year) while the child is still without significant income (probably just 4 or 5 years) to still come out ahead.
Agreed, just noting that not all the non-qualified distributions need to be taxed at a high rate.
True. In fact, part of the distributions are return of principal and not taxed at all, and some would likely be taxed at a lower rate.
If I overfunded a 529 could I use the excess as an educational gift to my grandchildren? Seems like a decent way to avoid inheritance taxes all the while enjoying tax free growth.
Yes….depending on when the grandchildren are born and as long as you follow gift tax rules. And, of course, assuming you’re actually going to owe inheritance taxes.
I am confused on this point, of grandparents gifting to a 529 because it is in the parent’s name, not the grandchild’s.
Here is our situation. I set up a 529 for my 1 year old daughter. (I haven’t contributed yet, but fidelity visa rewards points have the account up to about 500. yay.) My MIL informed us last week that she wants to contribute 14k to our daughters education. (Her wealth is beyond 5.45 mil and she is trying to avoid estate tax in the future.) I think she actually wants to give 14K each to me, my wife and my daughter and for us to direct 42k into my daughter’s 529. Fantastic. Extremely generous. But will I pay tax on that since it its beyond 28K? Can a check for 14k be written to my daughter and then put into her 529? Is the 529 even hers or is it mine? You state above,
“The 529, unlike an UGMA, isn’t your kid’s money. It’s yours. So you can take it out and spend it on a boat if you like.”
I guess she could do 70k 5 year stretch, but again, can it be written out to my daughter, put into mine and my wife’s checking account, and then transferred into my daughter’s (my?) 529. And if so, could this be done again x2 with checks written to my wife and me and then put into 529? I doubt she wants to do 210k, but I think she wants to do 42k/yr for several years.
thanks
Gift tax doesn’t work that way. If she gives more than $14K a year to any one person, it comes out of her estate tax exemption amount. Nobody actually pays taxes until she dies and then the estate does. She should write each of you a separate check, then you can do what you want with it. Since you can put 5 years of contributions into a 529, you can then put it all in there, no tax issues.
If you are the owner of the 529, the money is yours, not hers. She can have her own 529, but that’s not the way most families do it. Yes. A check for $14K can be written to your daughter. Who can give you $14K tax-free. And you can put it in a 529 of which she is a beneficiary, but it uses up two years of your contribution (and one of your wife’s) to put it all in there.
Grandma can start her own 529 for your kid too and put 5 years of contributions in there.
I don’t anticipate getting any financial aid for my 8-year twins. My wife and I (both physicians) max out 401k, IRAs (including backdoor Roth IRA conversions) and HSA contributions plus enough for our taxable accounts. At present, my twins have $70,000 each in their 529 accounts plus another $25,000 each that their grandparents set up in their own accounts. Total contribution limit for Nevada Vanguard 529 is $370,000. How much is enough? Is there a benchmark we should be aiming for? I don’t even know if my kids will go public or private college education at this point. Worst case scenario: my alma mater, University of Pennsylvania’s Undergraduate Cost of Attendance
Budget Items Living On Campus
Tuition and Fees $45,890
Housing 8,330
Meals 4,592
Books 1,190
Personal 1,798
Total Budget $61,800
( Actually, I don’t mind if my kids go to Penn State or Rutgers)
It’s impossible to tell how much is enough. If you plan on paying every dime, that would be an important figure. But keep in mind you have lots of options.
1) They could pay part of it
2) They could take out loans
3) You could take out loans
4) You could cash flow it
5) They could get a scholarship
6) They could go to a less expensive school
From personal experience, my father (who is a retired physician) paid for my college and medical school tuition/room and board, and my father-in-law (also a retired physician) paid for my wife’s college and medical school costs. They are 1st generation Americans who highly value education. My wife and I greatly appeciate their generosity, as it has greatly helped with getting our family’s finances off the ground.
Right now, we on track with our retirement savings. We would like to help our children’s education as much as possible (after meeting our retirement goals, of course and provided that our children value their education and their futures). The rate of college inflation and college loan industry is ripping off Americans, saddling them with debt that they can barely afford to pay off.
Great site. I always recommended it to all the physicians here. Briefly, here is my situation. I will leave active duty in 2015. I will probably join the reserves (I have prior time) until I can retire. In the meantime, until 2015 I will like to maximize my retirement acount contributions. I ve maxed out TSP and back door roth. Can I get an HSA account without having private insurance, presently? Can I contribute to a 529 without having kids (hopefully one day)? thx
No, you can’t use an HSA while in the military. Yes, you can do a 529. You just set the beneficiary as another family member (perhaps even yourself) and then transfer it when a kid is born. But I don’t really recommend you start saving for a kid’s education until someone is at least pregnant with said kid.
Two questions:
1) In the example above, will the 529 non-qualified withdrawal really be taxed at 30%, if you withdraw after retirement and have no income?
2) Won’t a 529 also be a good shelter for your money in case of litigation, especially if #1 above is true?
Thanks!
It’s a 10% penalty plus any taxes due. If you have zero income (which seems unlikely after retirement since you’ll at least have SS), then that is all you’ll owe.
A 529 does provide some asset protection benefit in most states, but it hasn’t been tested much.
There is another way to save using 529s – for you and not your children.
My wife and I live in Virginia which has state income tax and a state income tax deduction for 529 contributions. We’re paying for her tuition using cash (actually a family loan) from her father. We pay the first $10k in tuition in cash, so we’re eligible for the full $2000 federal lifetime learning credit. The remainder of her tuition we pass through the 529. This saves her father 5.75% (the marginal state income tax rate). 5.75% on $150k plus of tuition payments adds up.
Is there a 529 version for those high earners with no kids, no spouse?
Sure, it’s called a 529 with you as the beneficiary. Think of it like a life insurance policy in the sense that there’s the person who pays the premiums/contributions and a (usually different) person who receives the benefits. In your case, you can set one up for yourself for an MBA, sommelier classes in Napa, or history class in Europe. Or you can fund it and change beneficiaries to a kid when/if you have one. Or name a niece/nephew as beneficiary.
I love theses Back-to-Basics posts! I am almost done with the “beginner” level. A couple of comments:
1. Edit this: “consider looking into the plans from Utah, Nevada, Illinois, Georgia, MIssissippi, Colorado, and Illinois.”
2. Edit this: “$130K in when your child is born, $130K when your child turns 5, $130K when your child turns 10, and another $78K when your child turns 15.” You started by saying the cap is about ~330k. Then threw that wonky number in. You explained yourself a little in the comments section by saying the limit for “Utah’s 529 plan is $387K”. But your math is still drastically off. (UT 2014 update: $397k)
3. Can you do a math calculation for me that I have been thinking about conceptually? Assuming there is NO state deduction (tax-free state), is it possible to have money grow faster by keeping it all in one account rather than spreading it across five, seven, or ten children? Doesn’t compounding work like that? Then the beneficiary could be switched as each child needs the money. Will you show me how to calculate theoretical numbers with this?
1. Fixed the inappropriate capitalizaiton
2. You’re right. Unless your investments perform terribly, if you put in $130K every 5 years you would max out the account long before college. But keep in mind those state limits only apply to that state’s plan. You could open another 529 in another state if you wanted to, so you really could have a million dollars in 529s.
3. Sorry, compound interest doesn’t care if the money is in one account or multiple accounts. You could do just one 529 to keep things simple, but I don’t know of anyone doing that. I have one for each of my kids. It’s not that big of a hassle. Keep in mind you may have more than one kid in college at a time.
Thanks for the math clarification. I thought it would multiply differently.
Regarding #1, you have Illinois listed twice.
And you are right, opening the accounts is easy…which is why I wanted to make sure that there wasn’t a huge benefit to keeping them all lumped together. 🙂
I ought to take it out and put New York in. New York’s plan is quite good- things keep improving with 529s every year.
Quick question. I read that many bogleheads skip the 529 and borrow from their 401k. I understand that borrowing from a retirement vehicle is often a bad idea. But if I can’t max out my 401k, my 457 b, wife’s independent 401k (employer and employee contribution), my Roth, wife’s Roth, why open a 529? I understand that 529s are great once you’ve maxed out all other vehicles. But in my state (TN) I don’t get any tax break for the 529.
Any thoughts on the boglehead philosophy?
Side note, was getting ready to open a 529 two weeks ago before POTUS threatened to tax the withdrawals. I know it isn’t going to get passed through congress now…but the tax man cometh…
While many Bogleheads may do that, I wouldn’t call it “the boglehead philosophy” by any means. I look at it like this. If you can’t afford both retirement and college, fund retirement first. If you don’t have to max out your 401(k) to reach your retirement goals, and you would also like to save for college, I see nothing wrong with saving for retirement in a 401(k) and for college in a 529.
I don’t think 401(k) loans are a good idea for college for several reasons. 1) If you lose your job you have to pay that loan back quickly or you pay a penalty. 2) If someone is going to have to borrow for college, I think it ought to be the student, not his parents. 3) If the kid dies, the parents are then still on the hook for that 401(k) loan, but student loans would have been forgiven.
WCI – continuing the Bogleheads idea…
What are you thoughts on using a Mega Back Door Roth instead of a 529? (or perhaps I should say maxing the Mega Backdoor before using a 529). I’ve recently discovered my company 401k allows the MBDR. Instead of continuing to put money into my kids 529’s (ages 6 and 4), shouldn’t we be seeking to max out the MBDR first? If there is anything left in our budget we could then put into 529. My thought is that we shovel as much as we can afford into the MBDR and then roll to Roth IRA. That Roth could then be used to fund the kids education to the extent the need it and/or we want to. Withdrawal of a portion of the conversion/basis could be done on a yearly basis, washed through the 529 to get the state tax deduction and then used to pay for tuition, etc. If the kids get scholarships, do military, etc, then we have extra retirement savings.
Thoughts?
If you’re saving money for retirement, then use the 401(k). If you’re saving for college, use the 529. I think playing games using 529s for retirement or retirement accounts for college isn’t usually a good idea.
529 plans for fixed income are considerably worse than CD’s for FDIC insured returns. I have a son beginning medical school in 3-4 years. I was considering if he started the 529 in his own name, then I used 5 year election, then it seems he could withdraw it without significant earnings/penalty and put it in a CD. Is this illegal or unethical in anyway that you know? I have plenty of lifetime gift tax exclusion so its not that big a deal, but it seemed like it might be ok to do this. FAFSA is not a concern, we get no aid and he is likely to get an academic scholarship anyway.
Not sure what benefit you get aside from a state tax deduction if you withdraw shortly after contribution.
Excellent blog. I have a question about after maxing the 529 plans. My question probably is more relevant in estate planning but we will have a taxable estate. I will shortly max out my two children’s 529 plans (in New York it is $375K per child). My wife and I have been contributing the maximum for each child up to gift tax exclusion ($28K/child for the both of us). Because we have a taxable estate (over 11M), I am actually going to fund the children’s education using our taxable accounts. Would I be correct that the 529 plans would fall outside of our taxable estate because they were funded using gifted monies? I also assume that there would be a 10% penalty if not used for education purposes but that sounds like a small penalty if it grows tax free.
Congratulations on your success!
You are correct, that 529s are generally included in the beneficiary’s estate: https://us.axa.com/plan/education/529-plans/estate-planning.html with some exceptions.
Using a 529 for something besides education isn’t usually a good idea tax-wise because not only are you paying the penalty, but gains are paid at your ordinary income tax rate instead of capital gains rate if not used for education. You would have to run the numbers for your situation. But when you add in the fact that it is outside your estate…maybe that would tip it over the edge.
I’m not convinced you’re doing the right thing by spending taxable money instead of 529 money, but it’s a good discussion to have with a NY estate planning attorney.
Thanks for your prompt response. Excellent site for doctors. There is very little I disagree with on all your posts. I think I will ask my estate lawyer. She has already set up our living trusts and ILIT.