Let’s talk 529s...A 529 Plan is a is a tax-advantaged plan for education savings. Understanding and leveraging tax advantages is one of the biggest value propositions afforded to the clients that work with me, so why the heck would I not utilize these tax advantages for my own children?
How a 529 Plan Works
Ultimately a 529 Plan has tax treatment that is very similar to a Roth IRA…that is, you put money into the account and receive no tax break, however the money then is allowed to grow tax-free. Where it veers off from how a Roth IRA works is that to receive this tax-free money, it must be spent on qualified educational expenses. This brings me to the first and largest issue that I have with 529 Plan’s, lack of flexibility.
Over the past decade as a financial planner, two things have become increasingly clear: having a plan is exceptionally important, but things rarely go according to your plan. Planning for your child’s educational future is no different. Maybe your child gets a full scholarship; change your plans. Your child chooses to not go to college; change your plans. Good ol’ Uncle Sam decides to foot the bill for anyone who wants to go to college; change your plans. While there are two notable safety hatches for avoiding the 10% penalty of a 529 Plan, beneficiary changes and Roth transfers, these are still relatively inflexible and can leave you feeling stymied. Let’s take a closer look:
Beneficiary Changes– 529s allow for unlimited beneficiary changes. Because of this rule, my recommendation for families with multiple children is to fund only one 529 for the oldest child and to simply change the beneficiary once that child no longer has qualified educational expenses. Of course the downfall of this is that, if you are trying to guarantee an equal amount for each child, it can be difficult with this method. However, it does give you some level of confidence that even if one child does not pursue higher education the funds won’t be stuck in limbo.
Roth Transfers– This is a relatively new rule change that was passed with Secure 2.0 at the end of 2022. Beginning in 2024, an established 529 that has not had a beneficiary change in 15 years can be transferred to a Roth IRA. While this is a welcome change for those with funds stuck in 529s, most people are not interested in funding their child’s retirement. While it does have a $35,000 cap (per beneficiary), this is much more likely to be used as a tax-free intergenerational transfer for wealthy families and not something to be relied upon for middle class families.
Is it Really Worth It?
While the tax-free growth promised by 529s gives a whole lot of sizzle (tax-free, after all), the substance of it, when taken with a more discerning look, leaves quite a bit to be desired. Let’s take a deeper look at its tax-free growth. For the sake of illustration, let’s observe the McFly’s and their son Marty. Like many people, the McFly’s had some lean years when Marty was first born and are excited to start saving $100 per month shortly after Marty’s 9th birthday, giving them nine years of savings leading up to an expected departure for college at age 18. We will assume that the McFly’s are relatively aggressive with their investments for the first five years and receive an 8% average annual return on their funds, however because the funds are earmarked for college, they decrease the risk level during his high school years and only receive 5% return for the final four years of investment. Doing this would yield a total of $14,283 including $10,800 of contributions. In other words, they would save taxes on $3,483 of income.
If, instead, the McFlys had invested that same amount with the same returns in a taxable brokerage account, and they fell into the (most common) 15% capital gains rate, then they would owe $522 in capital gains taxes. While I never want to forego a tax break, it is worth seriously questioning if the lack of flexibility in investment justifies the tax benefit gained. In other words, the McFlys only saved a little over $500 by putting money in the 529 Plan, the entirety of which now must be used only for qualified educational expenses.
While the above representation is likely overly simple, it does closely imitate what I see in several middle-class families who are doing their best to help their children with the ever-increasing cost of college tuition. This begs the question, if not 529 Plans, then how should I help save for my child’s education? In all honesty, the answer for many people is that you probably shouldn’t help save for your child’s education. There is an adage in financial planning that you can get loans to go to school, but you cannot get loans for retirement. So, if you are in any way behind in saving for your retirement, you need to focus on getting caught up with that before you start setting money aside for your child’s education. If you are, in fact, on track for your retirement, then my recommendation for most people is a nice plain and simple taxable brokerage account. While you certainly do lose some tax advantages by not utilizing a 529 Plan, to me the flexibility gained from a taxable brokerage account which has virtually no restrictions and no penalties regardless of how the money is used, is well worth it.
A brokerage account solves for all of the scenarios above where money is no longer needed for qualified educational expenses. After all, aren’t we all just trying to give our kids an opportunity to start out with the best possible circumstances in life? Your child got a scholarship; use those funds for a down payment on their first house. Your child chooses not to go to college; use those funds to help them start a business. Uncle Sam now foots the bill; use those funds to help pay for a wedding. Quite frankly, to me and to most middle-class people, the extra benefit gained from the relatively meager tax savings is just simply not worth the inflexibility of a 529 Plan. After all, “the best financial plans contain a healthy amount of flexibility.”
If starting a taxable brokerage account to help fund you child’s education and anything else in their future sounds intriguing to you, but you’re not quite sure how to get started, schedule a complimentary financial consultation today.
This post is for educational and entertainment purposes only. Nothing should be construed as investment, tax, or legal advice.