Articles

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.

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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

15 Comments

  1. Wealthy Doc

    Nice write up, my friend.

    I had never thought of a 529 like a “Roth for education.” I like that analogy.

    I tell doctors to forget about Coverdell. Most make or should be making too much for that. And the contribution amounts are too small to be very helpful.

    A few more thoughts around 529s.
    The benefits vary a lot by state. My state gives a $1K tax CREDIT each year. That is much better than a deduction.
    I believe the 10% penalty only applies to EARNINGS, not CONTRIBUTIONS, correct? You can take out what you put in. Similar to a Roth as long as the money has been in there 5 years or more.

    Also, the true benefit of 529 is tax-free growth over time. You get the most benefit by front-loading rather than annual contributions. e.g. if you have the money you could put in $150K per kid when they are little. One and done.

    Reply
    • ThePhysicianPhilosopher

      That’s right, wealthy doc. The 10% penalty (plus tax) is only on the earnings. It’s not on the total withdrawal. I’ve changed the post a touch to reflect that better. Sorry for being ambiguous!

      I’d love to front load a 529, and may do that if we run into any windfall money or bonuses once my student loan debt is gone at the end of March.

      Reply
  2. Xrayvsn

    529 Plans are indeed a great benefit and unlike other plans there is no income limit so anyone can participate.

    You can put some serious money into a plan per child as contributions can come from both parents individually without reducing your gift amount allowable by the IRS. Plus if you do have a windfall you can front load the contribution for 5 years in a single year.

    If you do not use it on the original beneficiary you can change it like you mentioned, and so you can also designate grandkids when they start arriving.

    Another hack you should consider if you know you have kids but don’t have any yet is to start a 529 under your name and then when kid is born re-designate the account (can give you even a few more years head start)

    Reply
    • ThePhysicianPhilosopher

      I like the name change hack from yourself to your kids. That would REALLY be thinking ahead!

      Reply
    • PrudentPlasticSurgeon

      Slick move! I have 2 kids under 3 both w 529 but wish I had done this and started contributing earlier.

      The Prudent Plastic Surgeon

      Reply
  3. Grokking Money

    In my state I don’t have any tax exemptions for a 529 Plan. So for me the tax waiver on the gains is the only reason to stick with a 529 plan.
    Good alternatives. Thanks for sharing!

    Reply
  4. Andrew Wilner, MD

    Thanks for the update on 529s. I live in Tennessee, which doesn’t have income tax, so there is no state tax advantage for the 529. However, being able to invest without taxation upon withdrawal (Roth analogy) is great. Also agree that it’s important to fund my own retirement first. I just opened up a 529 for my new son (born 11/21/2018) at Vanguard, which uses a Nevada plan. The lowest management fee I could find for the investment options was 0.15%, which seems a lot higher than nothing, but looks like I’m stuck with that. I chose the Vanguard Total Stock Market Portfolio, which basically tracks the market. Anyone have any better suggestions? Hoping the next 18 years or so will prove profitable and pay for his college!

    Reply
    • ThePhysicianPhilosopher

      I created my own portfolio that shifts more toward bonds when they are entering the latter years of college.

      That said, some of these have target date funds. I just didn’t want the high international provided by them.

      Reply
  5. Dr. McFrugal

    Thanks for shedding some light on this 529 hack. I didn’t know about it before, and I like it!

    I was always hesitant to start a 529 because
    1) What if my kid earns a scholarship (problem solved thanks to this post)
    2) What if higher education is free in 18 years? (doubt it, but you never know)
    3) A taxable account allows greater flexibility for spending on whatever you want whether it is early retirement, funding your kid’s college tuition, or basically anything.

    The one reason why I started with funding my taxable account first is because California offers no tax benefit for 529 accounts (correct me if I’m wrong and I should verify this with my accountant). Plus as a high income earner, it seems to make more sense for me to put new money in a taxable account where I can tax loss harvest in order to decrease my current tax burden. I don’t believe you can do that with a 529.

    I know we are not supposed to predict or time the market, but at some point a major bear market is coming. I rather have the money in a taxable account and harvest those losses when the bear market comes. Then when the market recovers, I will consider deploying my extra cash in a 529 in addition to continuing to fund a taxable.

    The above might be faulty thinking, but that’s what is inside my head right now.

    Thanks again for another excellent post 🙂

    Reply
    • ThePhysicianPhilosopher

      Spot on about the tax loss harvesting. This cannot be done inside tax advantaged space. So, similar to a Roth IRA, I don’t think you can TLH from a 529.

      I am not a fan of timing the market or guessing what it’ll do, but understand your reasoning 🙂

      I think there are many worse things that can be done than putting money into a taxable account.

      Reply
  6. Dr. McFrugal

    Quick question… If my child earns a scholarship, I can make a non-qualified withdrawal from a 529 and not get hit by the 10% penalty, but I still have to pay the long term capital gains tax though, right?

    Reply
    • ThePhysicianPhilosopher

      Yes, still have to pay taxes on gains… Just don’t get hit with 10% penalty.

      Reply
  7. Rikki Racela

    hey guys currently I do Virginia 529 and I think it has the lowest fees for index funds as follows- not sure if you Utah, nevada, Cali or NY are lower:

    Index Portfolios
    Portfolios Asset Management Fee Administrative Fee Expense Ratio
    Total Stock Market Index 0.02% 0.09% 0.11%
    Total Bond Market Index 0.03% 0.09% 0.12%
    Total International Stock Index 0.07% 0.09% 0.16%
    Inflation Protection Securities 0.07% 0.09% 0.16%
    REIT Index 0.10% 0.09% 0.19%

    I know it’s tiny basis points here but is VA the clear 529 winner for lowest fees for index funds?

    Reply
  8. Vagabond MD

    I just took my first withdrawal this week for my second child’s (daughter’s) Freshman year, first semester tuition payment. My first child (son) will not use all of his, and I will likely transfer the remaining balance to #2 when #1 finishes in 2022.

    I also started UTMA accounts for both children, so that they would have a “starting in life” fund. Money to use for a home downpayment, seed a business, pay for graduate school, a wedding, or a (reasonable) car or even make up for an underfunded 529. In fact, my daughter is attending an extremely expensive private university with a very modest scholarship, and I have not saved enough in her 529 to pay for the whole tuition, so I plan to tap into this a bit. Nonetheless, each child will have over $100,000 in this account upon graduating from college, barring a major stock market collapse.

    When my son turned 21 earlier this year, I relinquished control of his UTMA (now an individual taxable account in his name) with some trepidation, but I did everything possible to discourage him from using the account without my input. I still have access to view the account and to make transactions.

    Reply

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