Rethinking the 529 Savings Plans – Do I really need it?

When I was growing up, 529 education plans did not exist. My parents had to save up extra money if they wanted to fund my college education. That didn’t really happen, simply because the price of college was outside of our family budget. Ultimately it didn’t really matter since our fair country is built upon credit—I was able to borrow for college and medical school, albeit at interest rates much higher than what you’d get with a mortgage or a car.  Maybe the easy credit in this country contributed to the housing crisis a decade ago. Who knows?

My car dealer allowed me to walk off his car lot with zero down payment on a 5-year loan at 0% interest! If college tuition were only like that…

The back story

529 Plans are great in that it allows families to receive some state tax benefits while providing a tax-free vehicle to invest in education expenses.  You can essentially deduct a set amount of your 529 contributions from your state taxes–this varies according to state rules.  This amount can also grow tax-free as you invest within the account.  States like South Carolina allow you to deduct the full amount that you contribute from your state taxes, whereas California gives you no deduction.  If you are fortunate enough to live in a high-tax state with a great custodian and investment options, you can build up a pretty penny to fund your kids’ education.

Even if your state doesn’t have great investment options in its 529 program, you can even invest through other states’ plans. You won’t get the state tax deduction, but your investments can still grow tax-free if used for education.

Since your money can only grow if it is invested, one of the power moves with 529 investing is that you can fund up to 5-years of contributions ($70,000 as of 2018) at once while avoiding the federal gift tax penalty. If you include your husband in the mix, that’s $140,000 of contributions towards the 529 at once! You can rinse and repeat in 5 years to maximize the time that your investments stay in the market.  By the time Junior is applying for college, you’ll have hopefully stashed $210,000 in the bucket plus investment gains. That’s more suited to fund an expensive private school education.  And you can do that with every single child you open a 529 for—the child doesn’t even have to be yours!

The caveat

There are two considerations when trying to invest big bucks into an educational fund: (1) what if your educational needs exceed the amount in the account when you need it, or (2) what if Junior opts to forego higher education?

College and graduate school expenses have no upper limit. The longer you remain in school, the more money you’re going to spend. College alone cost me over $120,000 decades ago, and medical school racked up another $200,000. With rising education costs, there is a good chance that your 529 will not have enough to fund a private school education, even if the stock market is on a tear. I prefer to view education not only as a financial investment in one’s future, but also as a privilege—you apply and are accepted. I’d be willing to borrow some money to enroll in a great school, but not a fly-by-night online school.  If your 529 investments made any money, then you’ve come out ahead.

If Junior doesn’t go to college, all is not lost. You can easily transfer the savings bank to another family member, relative, or friend who still has potential for higher education. You can even cash out of the 529 if you’d like, but you’d be on the hook for any tax liabilities on the gains.  In this case, just hope that Junior has found her calling in life and won’t be asking mom and dad for handouts or a place to crash while in between jobs.

Should you even risk having to cash out of a 529 Plan?

This situation is more of a judgment call.  How much tax savings are you gaining through a 529 plan? The savings would be any state tax reduction plus tax drag compared to investing in a taxable account.  If your state had a 6% marginal income tax rate and you invested a lump sum of $70,000 to cover five years worth of contribution, you’d reduce your state tax burden by $4,200.  Is this pocket change?

You’d really have to think about it, and whether saving that amount over five years would make a difference to lock your investments into education.  It would be worth it to some people but I definitely have colleagues who would rather have more flexibility with their money.

This guy never got a 529 plan, but clearly is doing just fine!

When you are ready to use the money, investment gains within the 529 are protected from the marginal investment tax rates. For high-income earners, this is 20%. You might be able to save another $4k or so of long-term capital tax gains.

If you are a high-income earner and do not live in a state that offers any tax advantages, you should consider what advantages a 529 would have for you–do you want your kids to have a means to fund for college? Should they fend for themselves? Would you serve them better if you took that same amount and funded a real estate venture that can provide cash flow to fund college and have the flexibility in case your children aren’t destined to be college-bound?

Do you have a 529 Plan for your children?

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