Blog

By: Jonathan Edwards

Recently I have heard from some people, including advisor colleagues, that 529 accounts just aren’t worth it.  They say that due to all of the limitations it is a subpar vehicle.  However, I strongly believe these college savings plans do make sense for the vast majority of families saving for college.

529s certainly have their downsides.  Investment options are limited.  Similar to most 401(K) plans, 529s must be in mutual funds, or index funds, and are NOT allowed to invest in individual stocks.  I have always wondered why they would want to be so restrictive but I think it comes down to simplicity and liability.  It has been my experience that when someone has a 401(k) with limited investment options they are less likely to want to mess with it, more likely to view it as long-term, and view their contribution rate as the only lever they can pull to improve it. 

The best outcomes coincide with psychology and good habits.  Day trading does not work for most people.  Even swing trading, or getting in and out of the market over multi-week periods, typically results in worse results than a buy and hold strategy.  Having your 529 separate from your other savings will allow to match the appropriate investment strategy to the goal and you will be less tempted to trade it. 

What if my kid doesn’t go to college? Or what if they join the military, get a scholarship, become disabled, start a business, or pass away before they reach their college years?  Good questions.  If you do need to take funds out of a 529 for a non-qualified purpose it is not the end of the world.  Yes, you will need to pay a 10% penalty (only on earnings) on top your income tax rate on the withdrawal, however, that money has grown and compounded tax-free up until this point.  You pay the 10% penalty only on the earnings portion, and the young person receiving the money could be in a 0% or 10% tax bracket, which could make them better off using the 529 even if they don’t go to college.  The saver using the brokerage account would be more tempted to make buys and sells over time and thus the tax drag could be much more than a one time capital gain hit of 15 or 20%.

There are some withdrawal exceptions that can exempt you from the 10% penalty on non-qualified withdrawals, but the earnings are still taxable as income.  Exceptions are: join a U.S. military academy, get a tax-free scholarship, die early, become disabled, received education assistance from employer, or if the qualified education expenses were used to generate the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC).

Section 529 plans can be used as an estate planning tool.  529 balances are not included in the estate of the contributor.  You can use the annual gift tax exclusion (currently $17,000) or even give 5 years worth of gifting at once ($85,000), though part of that stays in your estate until the 5 years have passed.  Unlike IRAs, 529s have no requirement minimum distribution.

NEW FEATURES – Starting in 2024 you will be allowed to rollover up to $35,000 from a 529 into a ROTH IRA for beneficiary!  You can now withdrawal up to $10,000 per year to pay for K-12^th grade education! This truly strengthens the argument for 529s.  Once funds are in a roth, they can be distributed tax-free after the account has been setup for five years.

529 plans are arguably the best way to pay for college and that higher education goal is often top of mind since it usually comes chronologically before you reach the retirement goal.  The only question is why don’t more people take advantage of these tax advantaged savings vehicles? 

Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.