Who Should Contribute to a 529 Plan?

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
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Continuing from my last article about saving for your kids’ college education, I’ve spent quite a bit of time reading, learning, and MATHING SHIT UP on this topic, and what I’ve discovered is that, as usual, while the Canadian college savings plan known as the RESP is relatively straightforward to understand and use, the American college savings plan known as the 529 is not.

So today I thought I’d share my thoughts on how best to use a 529 plan to save for your kids’ college expenses.

Should I Even Have One?

The big question we have to ask for the 529 plan is: Is it even worth having one?

It’s a bit surprising that this is even a question, since the general rule for the other tax-advantaged accounts like the 401(k) or the Roth IRA is “if you can afford to, max everything out.” Tax deductions are always better than paying taxes, and tax-free is always better than non-tax-free. The only downside of these accounts is the early withdrawal penalty if you retire before the age of 59 1/2, but once you learn how to build a 5-year Roth IRA conversion ladder, even this downside goes away. So contributing to 401(k)’s and Roth IRA’s are always a good idea if you have the money.

A 529? Not so much.

I first began to realize the complexity of these plans when I was talking to Jeremy from GoCurryCracker and he told me he’s not bothering with a 529 for his kid. He wrote a really good article about his decision making process here.

So what this tells us is that there are certain situations where it makes no sense to have a 529 plan. Let’s examine why that is.

Basically, a 529 plan works by taking after-tax money, investing it, and when the kid needs to go to college withdrawals are done in their name. Investment gains are tax-free, and if the withdrawals are done for a qualifying education expense (tuition, books, etc.), withdrawals are also tax-free.

Overall, sounds kind of like a Roth IRA, right? Not quite. The big caveat is the last part. In order for withdrawals to be tax-free, they have to be taken for a “qualifying eduation expense.” If the kid decides not to go to college, then melting down this account becomes a pain in the ass.

If you were take a withdrawal from this account that’s not a qualifying education expense, here’s what happens. You withdrawal gets divided into two parts: Principal (the amount you initially put in) and Earnings. To do this, the IRS uses this formula:

Principal = Withdrawal x (Contributions / Account Value)

Earnings = Withdrawal x (1 – Contributions / Account Value)

So let’s say you had a 529 balance of $50,000. You put in $30,000 over the years, and your investments added another $20,000. If you were take a non-education-related withdrawal of $10,000, your Principal portion that withdrawal would be $10,000 x ($30,000 / $50,000) = $6,000. Your Earnings portion would be $10,000 x (1 – $30,000 / $50,000) = $4,000.

Your Prinicipal amount you can take tax-free since it’s your own money being returned to you. The Earnings portion, however, will be subject to income tax as ordinary income. On top of that, you would be hit with a 10% penalty as well!

So as it turns out there is a down-side to the 529 plan. If you put money into it and your kid never goes to college, you’d be hit with all these taxes and penalties when you try to wind it down.

So what are the upsides to this plan then? You don’t get a federal tax deduction, but some states do offer you a state tax deduction. Also, your investments would compound tax-free over the 18 years, but you get that effect with other plans like a Roth IRA.

All these different rules can create situations where it doesn’t make any sense to create a 529 plan. An early retiree with a kid is one of these people.

If you’re retired (like Jeremy), you can structure your portfolio to effectively pay zero taxes. That makes the tax-free compounding advantage of a 529 plan worthless since your portfolio is already tax-free. And if your kid doesn’t go to college, you won’t get hit with all the taxes and penalties when you try to take your money out.

Using a Roth IRA To Pay For College Instead

Here’s something most people don’t know about Roth IRA’s. You can actually use it to pay for college expenses!

That’s right: If you make a withdrawal from a Roth IRA to pay for qualified education expenses, it can be done tax-free!

So now, a Roth IRA behaves exactly like a 529 for all intents and purposes. You can put after-tax money into it, your investments compound tax-free, and you can withdraw for educational purposes tax-free. BUT the Roth IRA doesn’t have the disadvantage where the funds HAVE to be used for tuition. If your kid doesn’t go to college, just leave the money in there and use it for your own retirement!

Of course, if you make a really high income, a Roth IRA may be locked out for you, but you can get around that restriction pretty easily simply by making a Backdoor Roth IRA contribution instead.

But Don’t Forget About State Income Taxes!

So is there any time it makes sense to use a 529? Turns out, yes. The only advantage the 529 has over other tax-advantaged accounts is that certain states allow you to deduct state income tax for contributions. Of course, this means the usefulness of the 529 heavily depends on what state you live in. Some states have no state income tax, like Wyoming and Alaska. Others have a state income tax but don’t allow deductions, like California and Kentucky. And others have both a state income tax and allow deductions, like Virginia and Oregon.

So check with your state’s 529 providers and see which category you belong in.

Should You Use a 529?

Don’t use a 529 if you:

  • Are an early retiree, or
  • Have low income, or
  • Reside in a state with no state income tax, or
  • Reside in a state that allows state income tax deductions for 529 contributions

You get none of the upside but all of the downsides. Leave your money in a taxable account.

Use a Roth IRA instead of a 529 if you:

  • Have a high income, and
  • Reside in a state with no state income tax, or
  • Reside in a state with a state income tax but doesn’t allow deductions for 529 contributions

Contribute to a Roth IRA (possibly using Backdoor Roth IRA Contributions) instead. Then make withdrawals under the “Qualified Educational Expenses” exemption for the early withdrawal penalty.

Use a 529 if you:

  • Have a high income, and
  • Reside in a state with a state income tax, and
  • Reside in a state that allows state income tax deductions for 529 contributions

 

Note that in all of this, I’m talking about the 529 SAVINGS here, not the separate college education plan also called the 529 plan in which you pre-pay your college tuition. Those are stupid and even more restrictive. Nobody should use those.

So what do you think? Do you use a 529? Do you think it’s worth it? Let’s hear about it in the comments below!



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23 thoughts on “Who Should Contribute to a 529 Plan?”

  1. Never thought about using a Roth IRA in place of a 529. Great idea! We originally planned to put money in to 529 accounts for our kids, but didn’t like all of the rules that came along with them. I think instead, we are going to move to Europe in ER and introduce them to the extremely low cost (yet quality) universities that are there and are basically free.

  2. I figured a 529 wasn’t as special as advertised… but when my relatives asked if they could contribute to one for our twins’ birthday/Christmas/etc., we went ahead and opened one up. A little cost-benefit analysis suggests that if we didn’t, future gifts might take the form of “stuff” instead of money. We’ll take investments with a 10% haircut over a bunch of Power Rangers or whatever any day!

  3. Very interesting! My husband has a 529 that I believe still has a balance after graduating but we’re not sure what to do with it. I wonder if it could be used toward those online skill building schools like Pluralsight or if it can only be withdrawn for traditional education without the penalties.

    1. Yeah that’s the big problem with 529’s. If you over-contribute and still have a balance left over, I don’t think there’s a way to get it out without incurring a penalty.

      The only suggestion I’ve read for people in this situation is to add another beneficiary (like a niece or something) and use it to pay for their education, but that’s not a really great solution in my head.

  4. Another reason to avoid 529’s. They count as available assets when figuring out need-based financial aid. Whereas 401k’s and Roth’s do not. I’ve debated opening one up a few times, and I keep coming back to the same conclusion that it’s not worth it.

  5. The only trouble with the Roth IRA is getting money into it. For most of the early years (<16) kids cannot be legally employed (with a few exceptions like modeling, acting, newspaper delivery jobs, etc). In other words, kids have no earned income until they're 16. That's 16 years of no compounding.

    A backdoor roth ira contribution has the same issue… no earned income means no contribution.

    One of the biggest advantages of the 529 is that anyone can contribute money — parents, grandparents, other relatives. It doesn't have to be earned income.

    1. Mr. Tako- It could be YOUR Roth that you contribute to, that in 18 years that money could be used to pay for your child’s education. If the total amount you earmarked for them is not used, the remainder is in your Roth to compound further or be withdrawn.

  6. Many states celebrate “529 Day” and offer financial incentives for opening a new 529 account, such as adding free money to the account. When does this occur? Why, on May 29th, of course! If you think you’re going to open a 529 account anyway, despite what Wanderer has to say about it, that would be the day to do it!

  7. One area that wasn’t touched on is how you can change the beneficiary to further maximize the state income tax savings. For example, in Wisconsin, our 529 plan has great tax benefits due to the loopholes built in the plan. In Wisconsin, I can contribute up to $3200 per beneficiary this year a deduct this from my state income taxes. Where this can be exploited is the definition of beneficiary and how I can transfer beneficiaries after I make the contribution. In my case, I can contribute $35,000 to my children’s college fund and take the state tax deduction on that whole amount. By dividing the contributions between my wife and I and then dividing it between our children we can be under the federal yearly contribution limit for gifts to our children. I plan to front load my contributions for my children ages 1 and 4 and let it grow tax free until they reach college age in order to maximize the tax benefits while reducing my state income taxes this year by $2000.

  8. I don’t think this was clear: in a 529 you can withdraw the earnings and pay no tax and no penalty if you use it for education, whereas in a Roth if you withdraw earnings for education you don’t pay the penalty but you still pay income taxes. I am pretty sure…
    Also, that CNBC article linked is a bit misleading: in one paragraph it says contributions can be taken out tax and penalty free and the following paragraph says you can only do that for education expenses (“provided that…”). I think the first paragraph of the two is the correct one. Please someone correct me if I am wrong.
    Great post!

    1. Regarding Roth withdrawl, there’s no tax or penalty if its a qualified withdrawl…whatever be the purpose of the withdrawl. See the IRS website excerpt below.
      ————

      It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
      The payment or distribution is:
      Made on or after the date you reach age 59½,
      Made because you are disabled (defined earlier),
      Made to a beneficiary or to your estate after your death, or
      One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).
      —————

  9. We have one without a state tax deduction, but we’re also maxing out all of our retirement accounts already. If I could go back in time I would not have started a 529 before maxing out all our retirement accounts (for a while there we could have both done 457 plans on top of 403b plans and backdoor Roths), but I didn’t know better.

  10. I appreciate a good challenge of conventional wisdom. This case looks more like confirmation bias though (when you only select evidence that fits your conclusion).

    529s are a useful in transferring wealth between generations. Early retirees are in a fortunate position to have more assets than they could ever spend in their lifetime and need to think about estate planning.

  11. You can also end up overfunded in the 529 account if your child gets a scholarship for part or all of the tuition costs. If the reason you are overfunded is because the child got a scholarship, the federal 10% tax penalty is waived on the amount of the scholarship, but you would still owe normal income taxes on any gains in the account.

    Some states offer state tax credit incentives for 529 contributions. Indiana offers a 20% credit for contributions up to $5000 per year, so, up to $1000 back as a credit on your state taxes.

  12. So surprised that a US tax savings program is much more complicated than a Canadian program designed to do the same thing. Go figure.

    (**sarcasm mode off now**)

    The only thing I’d add is that taking state tax deductions for 529 plan contributions (if your state offers that) can potentially lead to some tax headaches if you need to take non-qualified withdrawals (ie withdrawals not for education expenses. This is because in those cases, many states will want you to pay back the value of those tax deductions! Not sure how that would work in practice, but it seems complicated.

    So, if you put money into a 529, it seems important to only put in an amount that you are reasonably certain you will have to pay for college. An easy example would be if you have college expenses now and do not yet have a 529…you could put money into the 529 up to the state deduction limit, then immediately withdraw it to pay for school expenses. This would allow you to take the 529 deduction for spending you would have had to make anyway, saving you some tax money.

    Oh, another thing – it’s important to withdraw 529 money in the same calendar year that you send it to the school. This is because the IRS will attempt to match your qualified withdrawals (reported by the 529 provider) to the amount the university says they received (also reported to the IRS). So if you withdraw from the 529 in, say, December but the school doesn’t receive it till January, as far as the IRS is concerned it’s a non-qualified withdrawal for which you pay taxes and fees.

    My personal view is that they are more trouble than they are worth, but as always YMMV.

  13. I love that you are tackling this topic because I haven’t seen 529 and college funding enough in the context of early retirement.

    We chose to fund a portion of kids college through a 529 because I have seen in some places that that Roth withdrawals are counted as untaxed income on the FASFA for purposes of determining need based financial aid at US university. I have not been able to research fully. Yes 529 plans count as parent asset and IRAs do not count as parent asset but the expected family contribution is more dependent on prior year income of the child and parent than on parent assets. The Forbes article linked by GoCurryCracker said up to 47% of parent income but less than 6% of non retirement parent assets may be required as expected family contribution. So it appears the expected family contribution per FASFA would be much higher using a Roth withdrawal each year that increases parent or child income than the same amount in a 529 for otherwise low income retirees. Especially when a good portion of assets are in excluded 401k or IRAs. The GoCurryCracker article didn’t mention Roth withdrawals counting as income at all, but he is comparing 529 to taxable investments which are largely treated the same on FASFA. Please reply with link if you have seen this elsewhere.

    We are not planning to fully prefund college through the 529 so we don’t overshoot the needed amount for the reasons you listed. We are targeting 50% of tuition only for 4 years per kid so we also have flexibility if they live at home. We plan to use 529 first for expected family contribution and our Roth at the end as needed. But I have also seen 529 distributions may be counted as child income, so will have to research more fully when time comes.

  14. I don’t understand why people think the downside is so bad. Even if my kid doesn’t go to college, it’s not a big deal. We can pass it on to his children or our nieces and nephews. A college education will be very important in the future. Someone is bound to use it. It’s not a big deal at all to me.

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