By Dr. Jim 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!
Not sure if anyone has run into this… I just moved to South Carolina where you are allowed to take an state tax deduction for 529 contributions with no yearly limit. Any money you roll over from another state’s 529 is also eligible for state tax deduction (which didn’t sound right to me but I confirmed this with the plan administrator).
I have money in another state (NY) where I took a small state tax deduction of <$100 when I made the contribution years ago (during training). I’d like to transfer this to SC now. If I pull this out of NY, do I have to file a NY state tax return so that they can reclaim the state tax deduction I took years ago? I’ve read through all of this state’s plan documents and they all just say they reclaim any prior state tax deductions but they don’t say exactly how to do this. Thanks
My wife and I have income in two states (OH and WI) for 2022. Can we claim the state 529 tax deduction for each state (4k and 3.5k per beneficiary)?
Better read the laws of that state carefully. They may require you to file as a resident in order to get it, but I doubt it. I bet you can do both.
Hello
I have read most of your posts and I am getting through a few of your books. I love the insight and knowledge your books have provided.
I had a few questions about the secure act 2.0 that I was not able to find in your books.
Lets say I name myself the beneficiary of a 529 and I only put in a small amount and then I add money in slowly over time. If I have the IRA for a total of 15 years then can I convert it to a Roth IRA without a tax penalty provided it is less 35K and subject to the yearly limits of a Roth IRA. I am wondering if I can also change the beneficiary and convert some of the amount for myself in Roth and some in a Roth for a dependent. I understand that either party (dependent or myself) would need to have earned income the year that the money was put in (I assume earned income does not come from 401k distributions when I in my 60’s). Is this is a good strategy or would you go with the brokerage?
Thank you again
More on Secure Act 2.0 here: https://www.whitecoatinvestor.com/secure-act-2-0/
All my books were written before that passed.
I’m getting this question twice a week though. I’m advising patience for a few more months so we know how this 529 to Roth IRA rollover is really going to work before engaging in 15 year schemes like this one. I do think something like your strategy will probably eventually work, but it’s not worth THAT much. You’re just getting $35K into a Roth IRA instead of a brokerage account 15 years earlier. If tax-free compounding is worth an extra 1 or 2% a year maybe, you can quickly run the numbers and realize we’re only talking about a few thousand dollars. Once you subtract out the cost of the hassle factor and additional 529 fees maybe less. Bottom line, no harm in waiting a year before starting something like this.