What is a 529 plan? Should you invest in this plan and what should you do if your kids don’t want to attend college? What do you do with the money then?
What is a 529 Plan?
A 529 plan is an investment vehicle for the purpose of saving for your children/ grandchildren’s higher education expenses. You name a beneficiary and invest the money after it is taxed. The tax advantage is that the money grows tax-free. You can withdraw the money tax-free as long as you use it for qualified expenses. But, what happens if your kids don’t want to go to college?
Qualified Expenses
They include costs required for the enrollment or attend a college or university such as:
- Tuition, fees
- Books, supplies
- Room and board
- Up to $10,000 per year can be withdrawn tax-free to pay for K-12 tuition
Non-qualified Expenses
Qualified expenses include:
- Application fee
- Testing fees such as ACT/ SAT
- A car so that your child can drive to and from the college
- Transportation costs, including traveling home for the holidays
- Extracurricular activities (spring break anyone?)
- Some room and board costs (must be enrolled at least half-time basis and the amount is limited)
Tax Advantage
The 529 plan has a tax-advantage. After tax dollars are invested and the money grows tax-free. After investing it and having it grow, you can withdraw the money for qualified education expenses. You do not pay a tax on the growth. This can be an advantage, especially if you are a high income earner.
There is a down side to this tax-savings plan. If you don’t use it to pay for college for the intended beneficiary, you will have to pay income tax on the earning plus a 10% penalty. In this case, you are worse off than having this money invested in a regular after tax account. In an after tax account, you would pay a long term capital gain since it’s likely you had the money in the account more than a year. Paying a long-term capital gains tax is less than paying the ordinary income tax plus a 10% penalty.
Pros on 529 College Plan
- Money grows tax-free
- Withdrawal is tax-free as long as it is used to pay for expenses related to higher education for the beneficiary
Cons on 529 College Plan
- You pay income tax and 10% penalty on the earning if it is not used for the purpose it was intended
- Not flexible
- Difficult to gauge exactly how much to save
Case Study
While I understand that the governing body that make these savings plans had good intension. However, I do not like plans that are so prescriptive. What happens if your kids don’t attend college?
My dear friend Betty saved diligently for her child over the last 18 years and accumulated $150,000. But her child does not want to attend college. What are her options?
Case Study
Options Without Paying Taxes and Penalty
Betty has following options if she doesn’t want to pay additional taxes and the penalty:
Use the money to enroll her child in a 529 apprenticeship program. This may include a partnership program with a company or an apprenticeship program, which may include a program with health care industry (SECURE Act). The caveat is that it has a lifetime limit of $10,000 per beneficiary.
Change the beneficiary to herself and use the money for her own education. She can make herself the beneficiary and use the funds to attend colleges to improve her career.
Betty can change the beneficiary to another child, another family member (nieces, nephews, in-laws or parents), herself or save it for your grandchildren.
Make her niece the beneficiary since she’ll be attending college soon.
Leave the money in hopes that she may have grandchildren one day.
Options With Paying Taxes and Penalty
Have the current beneficiary, her daughters, claim it on their income tax and pay the 10% penalty.
Since her daughter doesn’t have a job, it’s recommended that she have her daughters claim it on their tax return accordingly:
Her daughter would pay $30,079 on taxes and $15,000 penalty. For a $150,000, her daughter would receive a net of $104,921. It’s a steep amount considering the fact that Betty has already paid income tax on the contribution.
I believe the 529 college plans were meant with good intension of getting parents to save for higher education. They are acceptable for high-income earners who need a tax break.
Recommendations
If you are a young parent and thinking about starting a 529 college plan, I recommend the following:
- Think about your overall financial goal. Is your goal is to save a down payment on a house? If you are already on a positive trajectory of meeting that goal and have money left over, then contribute to a 529 plan.
- Do not sacrifice more immediate goals in lieu of a college plan. Having an emergency fund of 1-3 months may give you more financial security than a 529 plan.
- Don’t contribute too much into the 529 plan. Contributing $200 per month will net about $80,000 in 18 years. By the time your kids are college age, you will make more money and be able to contribute the rest for their college needs.
After Tax Investment Account
Consider opening an after tax investment fund, that will give you the flexibility to cash out the money for a first home, college tuition for your kids, emergency fund or whatever you want. I call this the Financial Freedom Fund (What You Should Save For).