Is Saving In a 529 Plan a Mistake?
529 plans have long been the go-to for college savings. And for good reason - all the growth is tax-free if used for qualified educational expenses. But in recent years they have come under question as parents and grandparents wonder if all that college savings is for waste. After all, many expect the education system to have some type of reform as the cost of college has ballooned over the past 40 years.
With the idea of some type of reform looming, many are wondering if they should save in a 529 account at all. It’s a valid concern that is worth exploring.
To start, let’s define what a 529 can be used for -
(1) Tuition (including K-12 up to $10,000/year)
(2) Books, supplies, internet, computer, etc.
(3) Room and board
Despite the broad allowances for what a 529 can be used for, there are some common concerns.
Will my 529 will be wasted if my child gets a scholarship? A 529 can be used to reimburse a child for a scholarship without incurring a penalty (taxes on growth still due).
What if my child goes into the trades? A 529 can be used for any post-secondary education, including trade schools.
What if one of my children doesn’t go to college? A 529 can be transferred tax-free to any eligible family members including other children or even grandchildren in the future.
However, if a child does not use a 529 for eligible expenses, taxes and a 10% penalty are due on the earnings (not contributions) when withdrawn.
Let’s take a look at an example to see how that might play out in a worst-case scenario where none of the money is used.
Jim saves $6,000/year for his newborn, Jim Jr in a 529 plan.
Bob saves $6,000/year for his newborn, Bob Jr in an investment account.
Both accounts grow at 7% per year (not guaranteed) and neither of the children uses any of the money for college. Bob pays 15% capital gains tax on the growth each year but then has access to his investment account tax and penalty-free. Jim’s 529 grows tax-deferred but then he is taxed at 20% ordinary income tax plus a 10% penalty after 18 years.
Jim takes an early lead by having all the growth tax deferred. At the end of 18 years, Jim has $224,000 vs. $201,000 for Bob. However, Jim has to pay 20% tax and a 10% penalty on all the growth of $110,000 – resulting in a bill of $33,000! After taxes, Jim has $10,000 less than Bob so saving outside the 529 won, but just barely and not nearly by as much as some might expect.
Personally, I too think that reform is likely at some point. For a child going to college in the next 5-10 years, I wouldn’t bank on it. But for someone with a newborn or young child, it’s worth considering how college might be different in a few decades. I still think it is prudent to save for the expected cost of college, whether inside or outside a 529. I think the benefits of a 529 are considerable enough to save at least partly in a 529 – perhaps to fund half the expected cost, while investing outside for the remaining half in case it is not needed.
Thank you for reading,
Alex
This blog post is not advice. Please read disclaimers.