If you’re here, reading this page, you probably understand what a Sec. 529 plan is. This plan, a tool for accumulating money for college costs, lets you put money into an account where the money grows without being taxed.
And then, as long as you withdraw the money to pay for qualified higher education expenses, the money (including any investment earnings) isn’t subject to any income taxes.
The superficial appeal of these accounts seems pretty sound, right? You save money for a child’s or grandchild’s college costs, but thankfully don’t have to pay income taxes on the interest or investment income those savings produce.
Some Minor Details
Let me, just to put us all on the same page, go over handful of details here, too.
You can put up to $14,000 a year into one of these plans without triggering any gift tax reporting requirement. For example, in 2014, you could put $14,000 in a Sec. 529 and not worry about gift tax reporting.
Further, you can elect (through what amounts to a special loophole) to accelerate your funding and do five years of contributions all at once, thereby putting not $14,000 into one of these accounts but $70,000 all at once.
In other words, the tax law will allow you in 2014 to put not only $14,000 for the 2014 calendar year… but also the $14,000 for the 2015 calendar year, $14,000 for the 2016 calendar year, $14,000 for the 2017 calendar year and $14,000 for the 2018 calendar year.
Qualified higher education expenses, by the way, include all the stuff you’d expect: tuition, books, lab fees, necessary supplies and equipment. Further, for students attending school at least half time, qualified higher education expenses also include reasonable room and board costs.
Finally, if it turns out the money in the account isn’t used for qualified higher education expenses, any withdrawals are taxable and also subject to a ten percent penalty.
On the face of it, though, a Sec. 529 plan looks pretty good.
But as a tax accountant, the father of two daughters who went to college and an uncle to, gosh, maybe a dozen nieces and nephews, I see three really fundamental problems that greatly diminish the attractiveness of the Sec. 529 tactic.
Problem #1: Your College Money Probably Won’t be Taxed Over Saving Years
The first problem with a Sec. 529 plan is that its fundamental benefit, that “tax-free” compounding of interest, isn’t really a unique benefit.
And here’s why: That college savings money you’re saving for your kids? The investment income earned on that money probably won’t be taxable anyway because of the child’s roughly $1,000 standard deduction.
In other words, and using dividend yields and interest rates from yesterday’s Wall Street Journal, you could have roughly $80,000 saved for a kid invested in a stock market index fund and that money still would not generate enough income to be taxed once you get this income against the child’s standard deduction.
If you wanted to use certificates of deposit or treasury bonds, the interest rate is higher than 1.2% obviously. But not that much higher. Maybe if you go all CDs or bonds, then, you can have $40,000 saved in these sorts of investments which if in the kid’s name isn’t going to be taxed. Because the interest income on this amount of money gets wiped out once you net the income against the child’s standard deduction.
Depending on the asset allocation you use, then, the first $40,000 to $80,000 of college savings you accumulate for a child or grandchild won’t be taxed at all.
And then the next $40,000 to $80,000 will be taxed very lightly. Qualified dividends for example will be taxed at a zero percent tax rate. And interest income will be taxed at 10%.
Note: If you had even more money saved for a child, he or she pays taxes using the parent’s marginal rate.
But let’s stop here and ask a question: How much money do you have saved? Do you even need to worry about income taxes on your kid’s college savings? For most people, the answer is “no.” Which means that for most people, the Sec. 529 plan arrangement fails to deliver its principal benefit: tax-free compounding over the years before a child enters college.
Problem #2: Your College Money Possibly Won’t be Taxed Over College Years
Well, so okay you’re thinking, maybe the investment earnings on any college savings won’t be taxed during the accumulation phase… but surely when the student begins spending down the money in college, the capital gains will create tax.
Okay, so let’s look at this scenario. Say that you put $40,000 in a kid’s college fund the day he or she is born. Furthermore, assume by the time the child starts college this money has appreciated to (say) $100,000. That’s great. Spending down this sum at the rate of $25,000 a year will pay for most or even all of a public university. Or a nice chunk of a private school.
And won’t there be taxes on the capital gains implicit in this scenario?
I think the answer is “no.” And here’s the reason: If your son or daughter pays their way through college with money from their savings (or from money from a Sec. 529 by the way), they very likely aren’t going to be your dependent any longer. They’ll be paying more than half of their living expenses using the money you saved for them. And so they’ll be independent.
And because of this, you need to think about a bit of tax law weirdness. Someone with a taxable income of less than about $35,000 a year (like a college kid) pays a zero-percent long-term capital gains rate and qualified dividends. So it probably turns out that the liquidation proceeds aren’t subject to tax either.
Note: By the way, under current tax law, if your kid is independent of you and has a job, he or she will probably end up the recipient of some generous tuition-related tax benefits.
Let me stop and summarize the likely situation with regard to those supposed tax benefits of a Sec. 529 plan. A Sec. 529 plan probably doesn’t save most people any taxes over the savings years. And a Sec. 529 plan probably also doesn’t save someone taxes during the spending years.
Which is weird, right? Because the tax savings angle is the very reason people think about using one of these plans.
Problem #3: The High Probability Your Child Won’t Spend Four Years in College
But there’s one more practical problem with a Sec. 529 plan, too, as compared to just saving the money in a kid’s name.
Don’t freak out, but you should know that there’s a pretty good chance that either your kids won’t go to college or that if they do, they won’t actually spend four years in college and complete a degree.
I know. Unbelievable, right? This statement on the face of it seems to be just the sort of absurd assertion that proves people can’t believe what they read on a blog. So let me provide some backup data.
Here’s a link from the Bureau of Labor statistics (click here) that says roughly 66% of 2013 high school graduates enrolled in college …which means of course that about 34% didn’t enroll.
But let’s dig deeper. While that 66% figure seems to indicate two-thirds of parents should stretch to save money for college, “starting college” isn’t the same thing as “needing money for four years of college.”
So an important question is, how many kids in that 66% cohort actually finish.
The answer is shocking—to me at least. In a study available at their website (click here) the Chronicle of Higher Education suggests that after four years of study, perhaps less than half actually finish a degree. So maybe on average only 33% actually need full funding for a degree?
And just to beat this thing to death, this value isn’t out of line with a couple of other data points.
The U.S Census Bureau, for example, reports that overall, college graduates make up about 27.5% of the population aged 25 or older (click here for that report). And the Brookings Institute provides data that meshes pretty neatly with this figure too.
In fact, let me point out something which is awkward to bring up but let’s go there anyway. You might agree with all this talk about college being an investment that seems to work a lot less well than most people think. But then you might also quickly assume that because you’re socio-economically privileged that the statistics shared don’t apply to you—and maybe you’d be right. But that Brooking Institute data (click here for example) suggests that even kids from the highest quartile have graduation rates that are barely over 50%.
So this represents the third problem with a Sec. 529 plan and a final big flaw: if your child or grandchild ends up not going to college (a pretty good chance of that) or ends up going to college for a little while but then changes course (also a pretty good chance of that), you maybe don’t want the money you’ve earmarked for their future locked up inside a Sec. 529 plan.
Why? Well, again, remember that these Sec. 529 plans are all about tax planning. And in this very plausible scenario where a kid doesn’t spend the money on college or all of the money on college, someone will be paying ordinary income tax rates and a ten percent penalty on the money withdrawn. Ouch.
Summing Up the Sec. 529 Situation
So, bottom line, do Sec. 529 plans make tax-sense? The best case for you depends on your specific situation, but it’s pretty tough to justify a Sec. 529 based on the tax savings for most people.
Furthermore, locking up your money inside one of these accounts isn’t going to work very well if your kid decides he or she wants to do something other than go to college. If this happens, you might have wished the kid could use the money to get some other form of job training, to buy a small business, or to purchase a home.
Finally, please note that I’m not suggesting you not save money for your kid’s future if you’ve got the ability to do so. I think saving for things like college makes great sense. But you can probably get to the same place and end up with a lot more flexibility if you don’t use a Sec. 529 lpan but rather a regular investment account for the kid or grandkid.
Note: You can ask the bank or mutual fund company about this, but probably you’ll put the money into something like a “Uniform Gift to Minors Act” trust (sometimes called an UGMA account).
Steve says
One of the advantages of a 529 over an UTMA (formerly UGMA) account that you don’t seem to consider is that the 529 account remains an asset of the parent, whereas an UTMA account is an asset of the child. This has (at least) two key effects. First, money in a 529 remains in control of the parent. Money in a UTMA has to be turned over when the child becomes an adult; if the parent doesn’t like what their heir does with the money, tough patootie.
Secondly, most financial aid packages consider the student’s income (those capital gains you pooh pooh) and assets as being almost solely intended to pay for education. Money in a 529, being an asset of the parent, only has about 6% of its value per year included in the expected family contribution calculation.
Furthermore, if the child doesn’t go to college, the money can be shifted to another sibling, neice, or nephew. With an UTMA account, the money belongs to the child and must be spent on or by them regardless of whether they go to college.
All of these issues could be avoided if the parents keep the money in their own name in a regular account, but then they don’t get any tax benefits.
Steve says
I think your points are all really good and very valid… E.g., the UTMA or UGMA account is the child’s… for good or bad. If a parent wants control, yup, that’s not going to work.
Regarding the financial aid element, also true… though (and here we probably need to talk about specific income levels of parents, etc.) I wonder how much need-based financial aid a child from an affluent family able to save a bunch into a Sec. 529 plan really gets. In the situations where I have first hand knowledge, (my kids, nieces and nephews, clients’ kids, etc.) people able to save big amounts into a UTMA or Sec. 529 or who have saved big money into an UGMA or Sec. 529 are getting basically no financial aid.
You make a good point about an ability to shift the dollars to another person… but if you’ve also provided for your other children (so shifting to a sibling isn’t needed), the idea of shifting funds to (say) a niece or nephew … or jumping ahead to the next generation seems a bit of a stretch to me. I care about my nieces and nephews… but I’d personally rather help my kids buy a business or make investments.
But, to summarize, your points are good and definitely something that parents, grandparents should include in their analysis. Thank you for sharing them. 🙂
Frank Wilson says
I think you are forgetting about the kiddie tax. A child who uses savings to pay for college may not be a dependent if they provide more than half of their own support, but the kiddie tax will still apply unless the child pays more than half of his or her support through earned income, and savings don’t count as earned income. Most college students will not be able to earn enough income to pay more than half of their support while going to college full time. So they will be subject to the kiddie tax, and after the first thousand in income, the earnings and capital gains on the savings used to pay for college would be taxed at the parents’ presumably higher tax rates. That will not be the case if the savings are taken from a 529 account.
I also think the statistics you post on finishing college in four years may be misleading. Many of those who start college but don’t finish in four years don’t drop out completely, but take more than four years to finish, making a 529 account even more valuable, not less so.
I think you need to rethink your advice I this column.
Steve says
I have seen a number of college students avoid the kiddie tax (often because they’ve got good jobs working for the family business), but you make a very good point. I should have discussed this reality… but didn’t…fortunately you nicely cover. Thank you.
Regarding the go-to-college statistics and stay-in-college statistics… I wish they were misleading. But I’m afraid I don’t think they are.
8/12/2014 Edit/Addendum: After originally replying to Frank Wilson’s constructive criticism regarding the kiddie tax stuff, I found myself thinking, “Gosh, why haven’t I seen more returns with significant kiddie taxes even though the parents have saved money in the kid’s name?” And after noodling around with Lacerte a bit, I think the answer is complicated. First, obviously, the last year in college, a kid who goes out and gets a job probably won’t be subject to kiddie tax because via earned income he or she will contribute more than half of their support. Second, if the parent’s income is middle-class, the capital gains tax rate used in the kiddie tax calculations equals 0% which will on its own drop the kiddie tax to zero or a very modest value. And third, if the kid doesn’t qualify as a dependent on the parents’ tax return, on the kid’s 1040 return, he or she gets a full personal exemption which may shelter investment income. So, bottomline, the kiddie tax issue that Frank Wilson raises is excellent. But I think parents probably want to work the numbers out to see how much actual damage the kiddie tax creates…
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