529 plans allow you to save for college for your children in a tax-advantaged account.
Most people I talk to only use a 529 if they have a state tax deduction or credit.
They think that's the biggest advantage.
But I completely disagree with this.
Before I can explain why, let me walk you through how 529s work.
529s offer:
They come with a lot of really great benefits. However, it is important to note that if your child does not go to college, then you can do the Roth conversion like talked about above. Then any remaining amount you want to take out would be subject to income taxes and then have a 10% penalty on the income earnings portion.
This is the downside.
If you did not want that, you could change to another child, save for grandkids, etc.
It does come with a lot of flexibility.
You can use a 529 for a lot more than just tuition costs. Here are some options:
This list includes a lot more than most people would think.
Like I said above, oftentimes people will only want to use 529s if they get the state deduction or credit, but this is misguided.
In most states, you get a deduction of $2,000-$10,000. With most states have a tax rate around 5%, this means you are saving $100 to $500 on taxes this year.
That is really not a huge benefit. It is one to take advantage of, but it is not what makes 529s so good.
The reason why 529s are so impactful for my clients is due to tax free growth component. Many of the people I work with superfund a 529. This means they do many years of contributions at one time so they can get dollars working for the longest time possible.
Let’s say someone puts $100,000 in when their child is 2 years old. This means over the next 16 years, a growth rate of 8%, this $100,000 would grow to $342,500. That is over $242,500 of capital gains avoided.
My clients are anywhere from 23.8% (20% LTCG + 3.8% NIIT) to 37.1% (20% LTCG + 3.8% NIIT + 13.3% state) so this would save them $57,715 to $89,900 on capital gains taxes. For my high income folks paying for multiple children's college, this can be a massive tax savings tool.
The real benefit of 529 plans is avoiding capital gains taxes at the end of the day. For lower income folks, the benefit is less of course. This is why we try and help our clients focus on more contributions early on, so they can take advantage of this. If you only have a few years to college, it is probably not worth utilizing as there isn’t enough time to grow the dollars in the account.
This is where people say, “well, what if they don’t go to college? We will lose so much money.”
I do not find this to be the case. Most of my clients will then give the 529 to their kids. They can do the $35,000 Roth conversion.
Then with whatever is left, they can pay the 10% penalty and income taxes. 10% penalty + income taxes at 12% (they are young and in a low bracket and can spread it out over a few years to not push themselves up brackets) is still lower than the capital gains bracket my clients pay. And on top of that, they could move to another child who is going to college.
Before I go into this, know that in most states with a benefit, you have to use that state's 529 plan to get the tax benefit. The only states that allow you to use any states plan are:
All the other states require you to use their own state’s plan.
Now, most states do have some benefit, but here are the ones that don't:
Then every state that has no state income tax also does not offer a tax deduction, but that is pretty self explanatory.
Here are some of the best states and why:
Make sure you understand your state's plan to best utilize it.
I think this is a really important topic to talk about. 529 plans are not for everyone. If your goal is for your kids to go to college, you have multiple kids, and you want to pay for most or all, a 529 plan is great.
On the flip side, if you don’t believe in college, think it will look vastly different in 10-20 years, want them to pay, think they will get scholarships, etc. then it may not make sense to use a 529.
It all comes down to your views, goals, and financial situation to see if it makes sense for you and your family.
Financial Advisor