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How Should I Save For My Kid’s College? Plus a 529 Plan Hack

By Jimmy Turner, MD
The Physician Philosopher

If you are reading this blog, the odds are high that you have heard about using a 529 plan while saving for college.  Today, we will discuss 529 plans, my thoughts on when it’s an appropriate vehicle, and cover alternative choices for funding college education.

I should note that this post is not focused on how to choose the right 529 plan.  For that, I’d suggest the following simple formula:

  1. Check your home state to see if there is a tax break for investing in their 529 plan.
  2. If no tax benefit in your home state can be found, then find a plan that has low fees, index fund options, and flexibility.

Some plans that are commonly mentioned as qualifying for number 2 include the plans offered by Nevada, Utah, California, and New York.

Should I Save for College At All?

Any reasonable conversation on saving for your kid’s college education should start by discussing whether saving for college education should even be a goal.  You may be thinking that we are about to dive into the downstream effect of paying for your kid’s college education… but as much as I love talking about how to prevent young adult entitlement, that’s not where this post is going.

The question I am trying to answer is this: should you invest in your retirement or your kid’s college education.  When this becomes an either/or question (i.e. you cannot afford to save enough for retirement and meet your goals by a certain age AND save for college), I find it helpful to ask a second question.

Do you think your child would rather take out loans to pay for college or have a high chance of having to pay for your medical care and living expenses in your elder years?  For most, the answer is clear.  They’d rather pay for college.

If you haven’t done the math to determine that you are investing enough to get to retirement by a comfortable age, then this should be your first priority. Don’t start saving for your child’s college education when you haven’t made a plan to take care of yourself first.

Trust me. Your children would rather take out college loans than pay for your expenses later in life and have a free college education.

Okay, now that we have that out of the way – let’s move on to the good stuff.

Unique Advantages of a 529 Plan When Saving for College

The most common question about 529 plans is whether people should use one.  Why not just put money in a taxable account when saving for college?

The basic advantage of a 529 plan is that you can contribute post-tax money and – as long as it is used for educational expenses – the money and the interest that has grown from it will not be taxed again.  It essentially functions like a Roth IRA, but for educational expenses instead of retirement.

One advantage of a 529 plan is that by using one you have specifically “ear-marked” an account for the sole purpose of paying for college.  Having a separate account like this is a great way to have a disciplined savings plan. Particularly if the money is being automatically sent to the account following each paycheck.

As alluded to in the number 1 recommendation for picking a 529 mentioned above, participating in a 529 in your home state can also provide a tax benefit.

There is one other thing to mention.  When you open a 529 plan, you have to name a beneficiary.  Fortunately, you can change the name anytime.  So, if your oldest gets a full ride to college, you can pass it along to their lucky younger sibling.

Alternatively, you could also leave the money in the 529 account and use it for graduate school expeses if they go that route.

Or you can use the 529 hack mentioned next.

The 529 Plan Hack – Scholarships

When you take money out of a 529 for a non-qualified withdrawal (i.e. money not used for educational expenses), you will incur a 10% penalty plus tax on the earnings.  This causes some people to avoid participating in a 529 plan, because they are worried that junior will get a full ride and they won’t be able to use it.

However, there is a hack to avoid this 10% rule. I mentioned that you could name a different beneficiary if your oldest earns a full-ride.  Let’s say that it isn’t your eldest child anymore.  It is your only child instead.  Or let’s say that they decide to attend a military school.  In this situation, they will be given a full-ride for accepting a military commitment after college.

Instead of naming a different beneficiary for the 529 plan, you could simply take the same amount of money as the earned scholarship out of the 529 plan.  The neat thing about doing this is that there is a rule that, in this specific situation, you are not hit with the 10% penalty plus tax for a non-qualified withdrawals.

For example, let’s say your kid earns a $20,000 scholarship.  Well, then you could take out $20,000 and spend it on a trip to Hawaii or just put it into your taxable account.

However, it should be noted that you will still be taxed on the gains you made inside of the account.  Essentially, this turns your “Roth” 529 account into a “deferred compensation” 529 account that gets hit income tax on any earnings. For this reason, some prefer to change beneficiaries to future generations with any leftover 529 money.

Using Other Accounts to Fund College

You may decide to use a 529 plan over the other available options.  However, you should at least know what the other options are!

One option that is often overlooked is using Individual Retirement Account (IRA) money.  Yep, IRA money.  You can take out money from these accounts for educational expenses.  When using IRA money for educational expenses you will not get hit with the 10% withdrawal penalty.  Even if you are less than 59 & 1/2 years old.

So, if you have money sitting in a traditional IRA or Roth IRA and feel it is appropriate to use this money on college expenses for your kids, be my guest.  It’ll function the same exact way as a 529 plan – except that earnings in a traditional IRA account may be taxed unlike in a 529 plan.

Coverdell Education Savings Acounts (ESA’s) are another choice for college education savings.  The trouble with these is that there is an income limit to contribute (you cannot contribute if you are married and earn >$220,000 or single and earn $110,000).  Also, you can only contribute $2,000 per year.

Another option, of course, is to use money from a taxable account to fund college.  You might even consider converting more of this money to bonds as your kid nears college age.   The hope would be to cover the cost of attendance as your child nears college age.

Take Home

Investing for college can be an important financial goal for those with children.  The take home here is to take care of yourself and your retirement first.  Then, consider saving for college and be smart about it.

If you decide to partake, and your kid earns a scholarship, know that you can avoid that 10% penalty by hacking the 529 account, if you so choose. However, you will have to pay income tax on any earnings that you take out.

Do you intend to pay for your child’s college education? How are you going about this?  Were you aware of the various options offered by 529 plans? Leave a comment below.

TPP

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