Shortly after our children were born, we started 529 plans to get a head start on college savings. Before they could walk or talk, these lucky kids had thousands of dollars invested in a tax-advantaged account with many years for that money to compound before they might need it.
I say “lucky” because the vast majority of kids don’t have a 529 plan. Greater than 97% of families in the United States don’t use them, which is a shame, because these accounts are an excellent way to pre-fund at least a portion of a child’s future education.
There are the tax advantages that we’ll detail, the flexibility that can be useful, and the benefit of earmarking money solely for education in an account that you won’t be tempted to use in any other way.
With those advantages come some potential disadvantages, and we’ll cover those, too. I’ll also highlight some of the best plans available, discuss why you may or may not want to use your own state’s plan, and share the reasons that you probably don’t want to fund all your child’s education via a 529 plan.
529 Plans: What You Need to Know About College Savings
Established in 1996, this “qualified tuition program” is based on section 529 of the Internal Revenue code, hence the term “529 plan.”
They come in two varieties, but the most common is a savings plan, which is essentially an investment account with a current or future student named as the beneficiary.
The other flavor is a prepaid tuition plan, which is currently an option in FL, IL, MD, MA, MI, NV, PA, TX, VA, and WA. With these plans, you typically pay for tuition at the current rate and the beneficiary will have their tuition covered later on regardless of the cost at the time.
Personally, I prefer the flexibility of the savings plans, as the money can be applied to any of many thousands of schools nationwide (and some internationally, as well). The prepaid plans may allow you to use the money at a different institution, but the rules vary by plan and you may not get the best value if you choose a different school.
However, there may be a case for prepaid tuition. If you live in Ann Arbor, bleed maize and blue, and the previous five generations of your family are proud Wolverines, you might want to consider the MET, Michigan’s version of a prepaid tuition plan (and the first 529 plan) for your child. When our kids were born in Michigan, we chose the MESP, the Michigan Education Savings Program, which is a good thing because my kids bleed maroon and gold.
Tax Savings from 529 Plans
The tax treatment at the federal level is the same no matter which plan you select. You invest with post-tax money and your invested money will grow tax-free. If used for qualifying educational expenses, there will be no taxes levied on the withdrawals.
Qualifying expenses include tuition, fees, books, computers used for education (not gaming), and room and board up to the amount determined by the institution as part of the cost of attendance.
Ineligible are things like health insurance, transportation, or student loan payments.
In addition to the tax-free growth, most states offer a tax break of some sort on your state income taxes. States that don’t levy a state income tax (AK, FL, NV, NH, SD, TN, TX, WA, and WY) obviously cannot give you a state tax deduction or credit.
Most states offer a deduction, but some offer a partial tax credit if you have low income. CO, IL, MN, UT, and VT offer credits of 5% to 50% and most (but not all) other states offer a tax deduction, and many of those require you to invest in the plan of the state you reside in.
If your state is like most and offers a tax deduction rather than a credit, there is a wide variety of benefits with some being generous and others minuscule.
Some states place a limit on the deduction per beneficiary, and some have a deduction limit per household, and it’s common for couples to get double the limit as an individual. Oregon’s limit for a deduction is under $5,000. Minnesota’s in only $3,000 (but is a 50% credit if you have an AGI under $75,000). A few states like IL, MS, and OK will give you a deduction on up to $20,000 per year per couple.
You can look up the specific rules in your state here.
The Tax Penalty on 529 Plans When Not Used for Education
As I mentioned, there are some downsides. One is the tax penalty you will be on the hook for if you withdraw money to buy a new hot tub instead of a liberal arts degree.
The penalty is only applied to the earnings. For example, if you invested $100,000 and the plan grew to $200,000, which you withdrew completely to fund your travel habit because Johnny’s more interested in his grunge tribute band than Logic 1001, you’d pay the penalty on $100,000 of the withdrawal.
You’ll owe a 10% penalty plus income tax on the money when used for non-eligible purchases. Depending on your income bracket and how much of the money in the account is earnings versus basis, that could add up to a tidy sum.
Fortunately, there are options to use the money for other people, including yourself, in creative ways, so you shouldn’t have to pay this potentially severe penalty.
This would be a good time to point out that you should only invest in a 529 plan if you’re also taking care of your own retirement. Loans can be taken out for school, but they don’t work well at all for funding your own retirement.
Using a 529 Plan for K-12 Private and Parochial Education
Starting in 2018, money in 529 Plans became eligible to be used for Kindergarten, Elementary School, and High School costs. Up to $10,000 per year can be taken from a 529 plan to pay for private schooling.
Note that not as many states will give you a state income tax break when using 529 plans on K-12 education, and currently only these 21 states do.
If you’re considering doing so, you may want to run the numbers. Note that if you contribute and withdraw $10,000 from a 529 plan, the money that went round-trip may not be eligible for a deduction at all.
California has gone so far as to impose a 2.5% tax on earnings when money is withdrawn for K-12 education, so you’ll want to take a good look at your own state’s rules before employing a 529 strategy as part of a plan to fund a private school K-12 education.
529 Plans and Financial Aid
If you’ve been a diligent 529 saver and your child qualifies for a merit-based scholarship, what then? There are likely some eligible expenses that won’t be covered by the scholarship, and you can withdraw 529 funds tax-free for those.
Regarding need-based financial aid, 529 plans are considered when applying for aid and will be reported on the FAFSA. The presence of money in a 529 account predictably, and one could argue rightfully, reduces the financial need of a student.
That last point is another drawback of a 529 plan, although most people who choose to fund these plans are in a financial position that will likely exclude their children from any serious need-based financial aid. A notable exception is a child whose 529 plan is being funded by a wealthy relative or friend of the family in a case where the parents have little means.
Who Can Open a 529 Plan?
You don’t have to be a parent to open a 529 Plan on another’s behalf. In fact, you can be a non-parent and open one on anyone’s behalf, including your own, as long as you’re a U.S. taxpayer.
Why would you want to name yourself as a beneficiary?
The most common reason would be that you plan to have children, and want to get a head start on their college savings. You can name yourself as the beneficiary, and change it later on when you’ve made some babies. Miss Bonnie MD did this, opening an account for her son before he was born.
How many of these eligible taxpayers are taking advantage of 529 plans? As I mentioned in the intro, very few.
According to the most recent data published by the Federal Reserve, only 2.5% of U.S. households had a 529 account in 2013, down from 3.1% in 2007. For those with income below the 50th percentile, it was only 0.3%.
Nearly 8% of households with income at the 90th to 95th percentile had one, and 16% of the 5%ers in the 95th to 100th percentile of income were using one.
The average balance reported across all income levels was about $56,000, but, like income data, the mean was skewed by those at the very top. The average balance for the bottom 95% was in the $25,000 to $33,0000 range, while the highest income households had an average balance of about $120,000.
The numbers are even more skewed when households are broken down by wealth. The average balance of a 529 plan in households with wealth under the 50th percentile was just $3,800, whereas the wealthiest 5% have an average balance of $152,300.
Superfunding a 529 Plan
Some of those wealthiest households may have contributed the bulk of that balance in one fell swoop. In a move sometimes called “superfunding,” a couple can contribute up to $160,000 to a child’s 529 plan without affecting their gift tax.
The way the gift tax works is that, normally, the amount of any gift of over $16,000 per person to another individual in 2022 ($32,000 as a couple) results in a lowering of one’s estate tax exclusion.
For example, if my wife and I give someone $152,000 to buy a tricked out used Lamborghini (we don’t like anyone that much), and if our estate was someday worth more than the current 2022 estate tax exclusion of $24.12 Million, our exclusion would be “only” $24 Million. We can give $16,000 each with no consequence, but we went over that by $120,000, and so our lifetime estate tax exclusion would be reduced by $120,000.
In this example, any money inherited by our heirs in excess of $24 Million would be subject to federal estate tax. It’s a very first-world problem and unlikely to be an issue for the vast majority of us, but it’s the reason this superfunding loophole of sorts exists.
A contribution to a 529 Plan is considered a gift, and therefore, one would normally be limited to annual per-recipient gifts of $16,000 as an individual or $32,000 as a couple. However, with 529 plans, you’re allowed to give five years’ worth of gifts at once.
As such, an individual can put $80,000 into each kid’s 529 plan and a couple can put up to $160,000 in at once. If you do this, any contributions in the following 5 years would affect your gift tax exclusion, so if you think you can afford this option, you might as well go all in and give to the max.
Reasons not to superfund a 529 include not having a swimming pool full of cash or living in a state that gives you a tax deduction up to a certain amount each year. It’s probably best to space out your giving in those instances.
However, if you are figuratively or literally swimming in cash and live in a state with either no state income tax or no state tax deduction offered for 529 contributions, superfunding could be a legitimate consideration.
How Much Can You Contribute to a 529 Plan?
Like the answer to most of these questions, it depends on where you live. Every state has a cap at which the account will no longer accept contributions. It can be as low as $235,000 as it is in GA, MS, and TN, or as high as $500,000 or more, as it is in D.C., LA, MI, NH, NM, NY, PA, SC, VA, and WA.
These limits will vary as laws change, and some are tied to inflation, so be sure to check the latest cap for your state. I’ve found Saving for College to be an excellent resource for up-to-date data on 529 Plans.
Note that the 529 plans can grow to be larger than these limits, but you cannot continue to contribute once the cap has been reached.
How Much Should You Contribute to a 529 Plan?
It’s a common question, and I don’t have a great answer. Stop me if you’ve heard this one before, but personal finance is personal. The correct answer will depend on many factors specific to the needs and wants of both you and your children (or other beneficiaries).
We’ve chosen to fund our kids’ plans rather aggressively, knowing for the last few years that my high-income years could be coming to an end. They don’t know it yet, but our boys each have just over $100,000 in their 529 plans, we’re not done contributing, and they won’t be of typical college age for another 8 to 10 years.
What should you do?
Factors that Suggest Contributing Generously to a 529 plan:
- Private K-12 schooling
- A desire for private college or university (or out-of-state public without reciprocity)
- Beneficiary unlikely to receive an academic or athletic scholarship
- A high likelihood of graduate or professional school
- Parents earn too much or have too many assets to qualify for need-based aid
- You can easily afford it after prioritizing funding your own retirement
- A desire for multi-generational college funding
- An interest in your own life-long education
Factors that Suggest Contributing Meagerly to a 529 plan:
- Child (or recipient) is not “college material.”
- Public schooling for K-12
- A desire for an in-state public college or university (or out-of-state with reciprocity)
- Recipient is likely to qualify for academic or athletic scholarships
- Recipient will likely complete high school with substantial college credits
- Need-based financial aid is likely
- You are unable to max out your own tax-advantaged retirement accounts
- You prefer an alternative method for college funding
What To Do With Leftover 529 Money
If you find yourself among the tiny percentage of Americans who not only contribute to a 529 plan (remember only 2.5% of households do this at all), but end up overcontributing, you’ve got some viable options for those stray dollars.
There is the option to withdraw the money and pay the 10% penalty and income taxes on the earnings. This is not a great option, but if you need the cash, it’s the one that will put the most money in your pocket.
However, you probably don’t need the money if you were in a position to overfund a 529 account in the first place. In this case, you will look for someone else who might be able to use the money. That could be a sibling of the beneficiary, a first cousin, or even a future child of the beneficiary. Some people like to call them Grandchildren (assuming your child was the initial beneficiary).
Just imagine what two to three decades of tax-free compounding could do for that 529 balance if your college-aged offspring don’t need the money.
You might also find the most appropriate beneficiary in the mirror. How would you feel about paying for room, board, tuition in fees in one of five eligible schools in Paris, France? You’ll find hundred of eligible international schools in this document. There are also two dozen U.S. culinary schools that might be fun to try.
What’s the Best 529 Plan?
If your state offers a tax break for contributing to your own state’s plan, the best plan is almost certainly your own state’s plan.
On the other hand, if there is no state tax incentive to contribute to your own state’s plan (or any plan), you might as well choose a plan that has the best investment options. Generally, that means having a reasonably broad range of low-cost investment options. The cap at which contributions must cease may also be a consideration; the higher, the better.
I’m not going to make a judgment call here, but plans that fit the bill and are frequently mentioned in the “Best of” lists include CA, NV, NY, UT, AZ, DE, MA, NH, MI, and probably a couple others. Any of these plans will offer a range of index funds with expense ratios under 0.20%.
Personally, I think there’s no good reason to consider an advisor-sold plan. You can choose your investment(s) directly and save some money. Many states have a “target date” option that becomes more conservative as the beneficiary approaches college age.
Whether or not such a plan makes sense for you depends on your risk tolerance, how dependent you are on those particular dollars fully funding education, and your interest in multi-generational funding. We’ve chosen to invest aggressively in stock-based funds and plan to remain invested that way until the money’s gone or we’re blessed with leftovers for another generation.
529 Plans as an Estate Planning Tool
Like I said, most of us will not need to worry about bumping into an estate tax issue, at least not if the exemption remains near its current level, but there’s a chance some of us will. The estate tax exemption could return to previous levels in the range of $5 Million like we had in the early 2010s.
Consider an example where the estate tax exemption for an individual is $5 Million. The matriarch of the fortune was never married, and she’s stricken with a terminal illness with a net worth in the range of $6.5 Million.
Money in 529 plans will not be subject to the estate tax. Suppose the cannabis-infused energy drink baroness has 20 grandchildren under the age of 18. She could superfund a 529 plan for each of the 20 future heirs and heiresses with $750,000 and reduce her taxable estate to $5 Million, eliminating the possibility of paying hefty taxes on that $1.5 Million of her estate.
Why You Should Not Plan to Pay for College Completely with a 529 Plan
If you’ve got kids in college and income (specifically, modified adjusted gross income (MAGI)) under $160,000 as a couple, you would be a fool to cover all of your child’s education costs via a 529 plan.
Why? The American Opportunity Tax Credit (AOTC) is why.
If your income qualifies — it phases out over $80,000 to $90,000 as an individual or $160,000 to $180,000 as a couple — you would be forgoing free government cheese.
The AOTC gives you a full tax credit on the first $2,000 paid toward college expenses for your dependent each of the first four years. For every dollar you put in in the first $2,000, your tax liability is lowered by a dollar. That’s free money.
The AOTC also gives a 25% credit for the next $2,000. That’s a total of a $2,500 tax credit if you chip in $4,000 from your checkbook rather than a 529 plan.
If your income is in the range that qualifies, you should absolutely pay for the first $4,000 out of pocket before tapping a 529 plan. If your salary puts your MAGI over $180,000 (or $90,000 for single filers), then it doesn’t much matter. But it does make early retirement a little more enticing, doesn’t it?
529 Plan Alternatives
No discussion of 529 plans would be complete without a discussion of the alternatives to college funding in this manner.
I’ve heard people talk about investing in Roth IRA accounts to pay for college. After all, you can pull Roth contributions out tax-free and penalty-free as long as you’ve had a Roth IRA for 5 years or more.
I would not recommend this option. There’s only so much money you can get into Roth, and it’s very valuable there. Leave it be for as long as possible.
You can also invest in a plain old taxable brokerage account. There are no restrictions on how the money is used and tax drag can be minimized. If you don’t benefit from a state income tax deduction on 529 contributions, the upside of the flexibility here may outweigh the potential drawbacks of the limitations imposed on 529 money. Money is fungible, so money in a taxable account can be used to pay for college or anything else.
Another plan outlined is to buy one rental property and use the proceeds to pay for college. Bonus points if the property is next to a college campus that your child ends up attending and actually lives there.
I think this is a decent option if you’re going to be investing in rental real estate, anyway, but I don’t see it as a substitute for investing in a 529 plan. Again, money is fungible, so only choose this option if you like real estate as a primary investment vehicle.
Finally, there are Coverdell ESA accounts which can be used as a supplement to a 529 plan. They’re not a replacement, because the annual tax-advantaged investment amount is only $2,000 a year.
Furthermore, there’s a phase out that starts at $220,000. They also must be used up or rolled over by the time the beneficiary turns 30, whereas 529 plans have no such age limit. There is no state tax deduction for contributions to them. I’m not a fan and don’t use them, but I mention them because they still exist and The White Coat Investor published a Pro / Con piece on them (he landed squarely on Con).
The 529 Plan: What You Need to Know
By now, I hope you’ve learned much of what you need to know. In summary, the 529 plan is an investment account that offers everyone the advantage of tax-free growth and many the benefit of a state income tax reduction as long as the money is used for education when withdrawn.
A small minority of households use them, and I feel they’re woefully underutilized. Student loan debt is crippling and our graduates are leaving school with ever-increasing levels of debt. If we can afford to do so, we should do what we can to ease that burden from our loved ones in the next generation.
Be sure to take care of your own retirement before you fund someone else’s schooling, even if it is your own children we’re talking about. No bank that hopes to remain solvent is going to underwrite a retirement loan.
Finally, be sure to understand the advantages and potential disadvantages of funding a 529 plan in the state in which you live. Every time you cross a border, the rules and numbers can change.
The average indebted medical student graduated with about $200,000 in debt in 2018, and that debt level tends to grow throughout residency and fellowship. It’s not uncommon for undergrads to matriculate with a six-figure student loan debt that can stick with them for decades.
Think about that when you debate whether or not to open a 529 plan for someone you care about.
Have you opened a 529 plan yet? Are you funding one for your own children, someone else’s children, or even yourself? I’d love to hear your perspective on 529 plans.