Mid-career professionals with young children severely underutilize Section 529 College Savings Plans. That is not to say that these parents are unaware of 529 Plans or not using them for college savings. In fact, most mid-career professional parents who I meet already know about 529 Plans and are often funding these accounts for future college expenses. They may not be able to recite the specific tax advantages of 529 Plans but they understand there are some tax benefits to merit using them. However, experience demonstrates that high-income mid-career families with excess cash flow (after maximizing retirement plan contributions and paying the bills) fail to exploit the power of 529 College Savings Plans as much as they should.
Although situations obviously vary, there are five primary reasons why most high income families with children fail to really exploit 529 Plans – some legitimate and some deserving to be debunked:
1) Parents feel limited by the investment choices.
If you want to invest your child’s college fund in pork belly futures, a hedge fund, or the stock of a Lithuanian mining company, then a 529 Plan may not have enough investment choices for you. Otherwise, I find this to be a poor reason to avoid or underutilize 529 Plans. There are more than 100 different 529 Plans offered by 49 states and the District of Columbia. Each plan has a plethora of investment options, any of which are available to you – regardless of the state where you reside.
2) Parents do not desire to pay the costs of college for their children.
This one does come up and it is provides a valid reason for high income earners to avoid using 529 Plans. There’s nothing wrong with parents who want to teach their children the lessons of real life. Often times, these are parents who had to pay their own way through school and who expect their children to do the same – from employment income, savings, and the assumption of debt. Parents with this objective really have no reason to aggressively fund 529 Plans.
3) Parents don’t have sufficient free cash flow to save aggressively in 529 Plans.
Importantly, families who are not saving enough for retirement in spite of their high income or who have a significant amount of debt to repay are often not well served to aggressively utilize 529 Plans. There is no perfect answer for all situations on how to prioritize debt paydown, retirement savings, and education savings but in most situations, it makes little sense for parents to aggressively fund 529 Plans if they’re falling short on retirement funding. Slow paced, rather than aggressive, 529 Plan funding is often more appropriate in these situations.
4) Parents worry too much about overfunding 529 Plans.
I find that many parents who have the ability to save aggressively in 529 Plans fail to do so because they’re worried about overfunding. What if my children get scholarships? What if my children go to in-state schools and college costs are not as high as we expect? In response to these common concerns, we published this article last year to highlight the underpublicized and underappreciated flexibility of 529 College Savings Plans. “Fortunately”, we wrote, “529 plans provide flexibility to address the “problem” of overfunded accounts. This flexibility encourages parents, grandparents, and other high income individuals planning to cover post-secondary education expenses to exploit the benefits of 529s as early as possible and to be aggressive in their funding.” Any parents with the desire to pay for their children’s post-secondary education and the ability to save more dollars in a 529 Plan who worry about overfunding would be well served to review this article as it may allay those concerns.
5) Parents don’t fully appreciate the tax benefits of 529 Plans.
Here’s the common situation we encounter: High income parents of young children are maxing out 401(k) or 403(b) contributions, making backdoor Roth contributions, contributing the maximum to an HSA Plan, making modest 529 Plan contributions, paid off all high rate debt, and are now looking for where to save additional dollars. Their question: “Where should I be saving additional dollars?”
In nearly all of these situations, there is a strong argument to be made for more aggressively funding 529 Plans when the children are young with the excess cash flow. Granted, these parents may be able to pay excess college expenses from income when the children are in college. That’s missing the point. If the parents have maxed out their tax-deferred retirement accounts and still have the ability to save additional dollars in a 529 Plan while the children are young but they’re not aggressively funding the 529, then they’re often ignoring a huge tax advantaged opportunity.
529 Plans are, simply put, a tax haven for high income earners. Like it or not, 529 Plans are perfectly designed for high income, not low or middle income, families with young children. Consider the three reasons why:
a) The tax free growth feature of 529 Plans is most beneficial for taxpayers who face high tax rates. Taxpayers who face low tax rates really get limited or no benefit from a 529 Plan. Taxpayers who face high tax rates get a huge tax advantage.
b) The longer the time horizon, the more powerful the compounding impact of tax free growth becomes. That is, the earlier you fund a 529 Plan, the more benefit you should get from the tax free compounding of these plans. High income families who can afford to save when their children are younger reap the most benefit.
c) There is effectively no contribution limit for 529 Plans. Whereas other tax favored accounts like 401k’s, IRA’s, HSA’s, and 403b’s all face annual contribution limits as low as $5,500 for an IRA or $3,400 for an individual HSA, the 529 effectively permits unlimited annual contributions. Granted, every state restricts additional contributions to their 529 Plan once the account hits a certain size but those limits range from $235,000 to more than $500,000 per beneficiary. Want to contribute $1,000,000 per child into 529 Plans this year? Open and fund two accounts for each child – one in Virginia ($500k limit) and one in Pennsylvania ($511k limit)[i]
The pushback on this advice tends to revert back to “Well, we don’t want to so aggressively save in 529 College Savings Plans that we overfund these accounts. Part II of this article is going to mathematically demonstrate using real life examples, that for high income earners facing high tax rates, there is such a tax advantage to the tax free growth of 529 Plans that parents could contribute money to 529 Plan accounts, never use the funds for college expenses, and still come out ahead. Said differently, the tax advantage that these accounts provide over an extended period of time for high income earners is so great that it may economically outweigh any penalty faced for non-qualified distributions.
There are good and bad reasons for high income earners to avoid aggressively funding 529 Plans. Our advice is simply not to let a lack of understanding or misperceptions about 529 Plans keep you from exploiting the opportunity. If you are a parent in the fortunate position of being capped out on tax-favored retirement accounts and trying to figure out where to optimally save the next dollar, we would make the case that the tax advantages and flexibility of 529 Plans make them dramatically underutilized by high income earners.
[i] There may be the perception of contribution limitations imposed by the annual gift tax exemption but this will be of little consequence for all but the wealthiest of wealthy. Only contributions of more than $70,000 to one beneficiary in a 5-year period have to be reported on the IRS Form 709 and contributions in excess of that amount do not face any tax or penalty until they exceed $10,980,000 in aggregate for a married couple.