United States: Overfunded 529 Plans: Avoiding Too Much Of A Good Thing

Last Updated: May 5 2015

The expense of college for children and grandchildren is a troubling issue for almost all of my clients.

I think this is because at an instinctual level, long before crunching any numbers, clients know what the charts below show: college costs have gone truly exponential in the last one and a half generations, far outstripping increases in the earning power and asset base of the upper middle and lower upper class.

Because the issue is concerning, clients often have a strong instinct to do something, anything, to address the problem. As a result, their attention often turns to Section 529 plans.

To evaluate how useful these might be, it's useful to review their key features.

A 529 plan (sometimes known as a qualified tuition program) has a designated beneficiary and is set up to allow you to either prepay, or contribute to an account established for paying, a student's qualified education expenses at an eligible educational institution. Total contribution limits to 529 plans vary by state, but generally are at least $300,000 (Kentucky's is $350,000).

Contributions to 529 plans are not tax deductible for Federal purposes, and (unlike certain other states), Kentucky does not offer state income tax deductions for contributions. Nonetheless, 529 plans do offer a limited income tax benefit, in that account earnings are not taxed until withdrawals occur. In addition, distributions made from 529 plans for qualified educational expenses are not income taxable.

On the down side, distributions from 529 plans that aren't for qualified educational expenses are income taxable, and incur an additional 10% penalty (which the IRS euphemistically describes as an "additional tax").

In simple terms, then, you can think of a 529 Plan as somewhat like a Roth IRA for education, with no income limitation on contributions. Our recent post explored whether Roth IRAs really are all they are cracked up to be in many situations.

This post similarly estimates a plausible upper bound on the tax advantages a 529 plan might offer (compared to saving for college in a taxable account), and compares the potential benefits to negative aspects of these plans – notably, their many restrictions, limits, and fees.

Let's suppose that when a child (Harriet) is born to taxpayers in the highest marginal state + Kentucky income tax bracket of 49.4%, her grandparents are trying to decide whether to contribute $350,000 to Harriet's 529 plan, or instead put it in a trust or other taxable savings "wrapper", earmarked for college costs.

I built a model, available here, showing the account's alternative performance inside and outside the 529 plan. If you like, you can download the worksheet and use your own parameters for tax rates, investment costs, projected inflation rates, and 529 plan costs, to produce a forecast better tailored to your situation.

(If you do that, bear in mind that the model is "back of the envelope" only because it assumes linear investment returns and doesn't reflect actual period-to-period volatility in those returns.)

In my model run, I used actual costs for Kentucky's current 529 plan, and low-cost ETF alternatives for bond and broad-based equity exposure. I assumed a 60% stocks, 40% bonds investment mix. For stocks held outside the 529 plan, I assumed long-term holdings until Harriet was 18, and that bond income was taxable each year, used in part to pay taxes, with the remaining bond income reinvested in more bonds. Beyond that, I didn't model any periodic rebalancing, a simplifying feature that somewhat underestimates actual tax effects of the non-529 plan option.

Note, however, that the model does include the drag caused by 529 plan's comparatively high fees, relative to low cost index-based passive investments outside 529 plans.

The model suggests that a 529 plan funded with $350,000 for newborn Harriet might reach almost $950,000 by the time she was 18, while a taxable account would reach only $803,000, net of taxes. The net-of-tax advantage for the 529 plan is about 15% of the potential account balance by Harriet's freshman year. The chart below shows how this advantage accrues in a "pop" at Harriet's freshman year when withdrawals are taken income tax free, but until then, excess investment costs of the 529 plan cause it to lag taxable alternatives.

So, we've learned that a "fully loaded" 529 plan could save as much as $150,000 in taxes. I think if you're looking for an upper bound on how good these plans can get, that's a reasonable one.

But, what do you have to give up to get this income tax advantage (again, at its very best, about $150,000, or about 15% of your college funding "kitty")?

To understand whether the seeming benefits of a 529 Plan will help you — in short, whether the tax advantages these plans offer are worth it — it's important to understand certain defined terms.

Designated beneficiary. The designated beneficiary is generally the student (or future student) for whom the QTP is intended to provide benefits. The designated beneficiary can be changed after participation in the QTP begins.

Qualified education expenses. These are related to enrollment or attendance at an eligible educational institution.

To be qualified, some of the expenses must be required by the institution, and others must be incurred by students who are enrolled at least half-time.

Expenses that can be qualified if they are required by the institution include tuition and fees and books, supplies, and equipment.

Expenses that can be qualified if incurred by students enrolled at least half-time include room and board (but only room and board not exceeding the cost of attendance used for federal financial aid purposes, or the actual amount charged to the student for housing owned or operating by the institution).

Eligible educational institution. For purposes of a QTP, this is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions.

Consider what's not included in these defined terms, which are the boundary posts on whether funds in the 529 can serve all the purposes a family might want them to.

Qualified education expenses don't include boarding school tuition, summer camps, travel team expenses, or trips to Europe. They don't include stipends to cover living expenses during an unpaid internship. They don't include brokers' fees and a deposit on an apartment in the big city for a first job after graduation. They don't include the cost of a car to get a student to and from college and graduate school. They don't include wedding expenses, or a down payment on a home.

In short, qualified education expenses don't include a great many of the ways families actually spend money to launch their children and grandchildren in life.

Another pitfall of 529 plans is that they generally offer limited investment choices, which can only be changed selections once per year. If a family has a great investment idea, or a particular risk aversion, or a single-stock or single-industry concentration to manage, they have a really difficult time doing that with 529 plan assets.

Those are the main reason I usually encourage families to be very thoughtful when evaluating 529s – to consider the flexibility they are surrendering in order to obtain a relatively limited-scale income tax benefit.

If a 529 plan is funded at a level targeted to cover actual qualified education expenses a student will have in the future, while avoiding overfunding, it's possible to capture the income tax advantages, while avoiding the pitfalls outlined above.

To explore this issue, I modeled current qualified education expenses for undergraduates at Vanderbilt, as a proxy for private college costs. (These seem to be about $239,000.)

If these expenses continue to grow at twice the general projected inflation rate ( see here for more on how to determine projected inflation rates), 18 years from now they will be approximately $420,000. In the example discussed above, Harriet's "maxed out" 529 plan would be overfunded to the tune of over $525,000!

You can "goal seek" the model to explore target funding amounts (in our example, the model suggests a 529 funded with about $155,000 would fully fund qualified education expenses, while avoiding overfunding).

I think the case for 529 plans is much like the case for Roth IRAs: conceptually, they're attractive, but it's critical not to deal in generalities. Instead, evaluate your specific facts very carefully, particularly your likely time horizons, your current and future asset base, and your income growth trajectory.

Only then will you be able to make decisions about 529 plans for your family that appropriately balance flexibility and tax savings opportunities, and avoids the frustration of a substantially overfunded 529. (In a future post, we'll discuss options for what to do if you do end up with an overfunded 529 plan.)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

 
In association with
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.