Related Posts:
Part II: High Income Earners and the Math of 529 Contributions
Is Overfunding 529s Really so Terrible?
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On to the good stuff. Though they have risen in popularity as tax benefits have expanded in recent years, many mid-career professionals with young children still underutilize Section 529 College Savings Plans. These parents are not unaware of 529 Plans and they may be using them for to fund future college expenses already – and most understand there are some tax benefits. Experience informs us, though, that high-income mid-career families with excess cash-flow (after maximizing retirement plan contributions and paying the bills) are not capturing the full power of 529 College Savings Plans.
We identify five primary reasons why most high-income families with children fail to exploit 529 Plans. Some of these reasons are legitimate others are in need of debunking:
1) Parents feel limited by the investment choices.
If pork belly futures, a hedge funds, or the stock of Lithuanian mining companies are on your college plan investment wish list… well, a 529 Plan may not have enough investment choices for you! If, though, you aim to build a well-diversified, prudently invested portfolio you can do so across the risk spectrum in virtually every 529 plan available. 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 your home state.
2) Parents do not desire to pay the costs of college for their children.
Often-times parents who paid their way through school find great value in that experience and want their children to benefit from that same real-life financial experience. Through these experiences young adults learn about employment income, savings, and the responsible assumption of debt. Parents with this objective 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.
We find that many parents who have the ability to fund 529 Plans aggressively fail to do so from a fear of overfunding. What if my children get scholarships? What if my children attend in-state schools and college costs are not as high as we expect? In response to these common concerns, we published this article to highlight the underpublicized and underappreciated flexibility of 529 College Savings Plans:
Fortunately, 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.
Desire to pay for their children’s education and have the ability to save more dollars in a 529 Plan but you worry about overfunding? Review our article as it may allay some 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 the next best place to save. 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, perfectly designed for high income – not low- or middle-income – families with young children. Consider three reasons why:
- 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.
- 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.
- 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? “Well, we don’t want to so aggressively save in 529 College Savings Plans that we overfund these accounts.” In Part II of this article we demonstrate that for high-income earners, 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.
Closing Comments
There are good and bad reasons for high income earners to avoid aggressively funding 529 Plans. Our advice is simply to be thoughtful and avoid these common misperceptions as you consider taking maximum advantage of the 529 savings opportunity. If you are a high-income earner in the fortunate position of being capped out on tax-favored retirement accounts, the tax advantages and flexibility of 529 Plans make them a nice option for that next dollar of savings.
[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 $75,000 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.
