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#17 Should I Contribute To My Child's 529 If I'm Behind In My Own Planning?

#17 Should I Contribute To My Child's 529 If I'm Behind In My Own Planning?

May 12, 2023

529 accounts can be wonderful tools ... if you're financially prepared to contribute to them. In this episode, we discuss various features of 529s, and how to determine whether they're the right tool for your children's education savings.


Business Insider article


Brenton: [00:00:00] 529s are excellent tools for parents looking to set aside money for their children's education. But it's always good to know what other options are on the table. In case you want to add them to the mix when it comes to saving for your children's future, or whether you consider it as a viable alternative, if 529s aren't right for you.
And this episode, we talk about some of those alternatives and how to know whether it is, or is not a good fit for your children's financial future. Let's get started.
Hi, my name is Brenton Harrison of new money, new problems, and your host for the new money, new problems podcast. If you joined us in our previous episodes, one of the things that we covered was new legislation that allowed you in some instances to roll unused 529 dollars into a Roth IRA. But we also share that rather than using it for your own finances, it could be a tool to roll those dollars and kickstart your children's retirement savings.
In the process of doing so we introduced 529s for the first time, and I gave you some [00:01:00] definitions, that showed you how it straddles the line between the features that you see in a retirement plan, and some of the benefits and flexibility you see with a non-qualified brokerage account, which we've also covered on the podcast.
As an example, one of the key benefits of retirement plans is their tax deferral. You put money into an account. And as that account grows, you don't owe taxes on that growth.
Instead, you either pay income taxes on those funds when you put it in, or when you take it out.
And 529s are probably most similar in terms of retirement accounts to these Roth vehicles, because the money that grows in 529s are tax deferred. You don't owe taxes on the growth from year to year. And you're putting in funds in terms of your contributions that have already been taxed similar to a Roth IRA or Roth 401k.
And as long as you withdraw it for an eligible education expense, there are no taxes at that time, either. Now what's considered an eligible expense is often a lot more forgiving than most people [00:02:00] think. You can use them for a community college. You can use them for vocational schools. In some instances, you can even use it for an apprenticeship, and it's also easily transferrable.
If you have 529 funds that one of your children doesn't use, you can transfer those dollars to another child. You can transfer them to other family members. You can use them for yourself. So you're not stuck if you have a single child for which you've saved education savings, who decides that it's not the path for them.
Another similarity to a retirement account is that there are contribution limits to 529s, but those contributions are very flexible. And the amount that you put into a 529 is probably something more similar to what you'd see in a brokerage account.
As an example in 2023, if you wanted to contribute money to an individual retirement account or a Roth IRA, you'd be limited if you're under 50 to $6,500 for the year.
But 529 accounts have a significantly higher contribution limit at $17,000 for the [00:03:00] year of 2023. And in addition to that, you're not limited to just putting that $17,000 aside if you so choose. 529s have a wrinkle that allow you to front load up to five years of contributions. So even though $17,000 is the technical annual limit, a person who would like to do so is able to put up to $85,000 in a 529 account in a single year.
So when it comes to the structure of 529s and the potential benefits and uses, you can see that it's a really powerful tool in theory. And there are some people who have the ability to take advantage of all of its benefits. You have people out there who are extremely wealthy or who come from wealthy families who have a person who wants to put 17,000 or 85,000 aside, wealthy grandparent who wants to kickstart their grandchildren's education savings and front loads, or contributes significant amounts of money that child can use when it comes time to spend for their [00:04:00] education needs.
And even if you're not in that situation and you wanted to put 50, a hundred, $150 aside into your child's 529, then I say, go for it, provided that you have addressed other areas of your financial need. To me, the limitations of a 529 come, not in the foundation or the structure of the plans, but the financial preparedness of the people who are saving the dollars.
Because in my situation, I am often dealing with people who are trying to take one arrow and shoot it at multiple targets. They're currently paying, trying to give their children a better experience than they had growing up financially. They're trying to cover their own retirement needs. They're trying to progress in their own career. And there are limited funds that are set aside to attack all of these objectives.
As a matter of fact, after 14 years of doing this, I can count on one hand the number of clients with whom I've worked, who've been able to pay for even a single year with the funds they [00:05:00] set aside in their children's 529. And if you took away a few of my fingers, I'd still be able to count the number of people I know who've been able to pay for their children's full education with the dollars they set aside in a 529.
Instead, what happens is in trying to establish and pursue all of those objectives. They don't really get to make progress on any of them. They pay for their children's private schooling all the way through. They build up that muscle of cashflowing education, thinking that there'll be able to stop doing so at the age of 18.
As a result, they're putting limited dollars into their retirement fund. They're not establishing a significant non-qualified savings. They're dealing with credit card debt and other consumer debt.
And by the time their child gets to college, that parent is not on track for their own retirement savings. They have not paid off their consumer debt. They may still be trying to get the home of their dreams, which means they're trying to navigate a down payment and hoping that their current home has increased in equity. And they look at this 529 and they realized that after all that [00:06:00] sacrificing of their other financial goals, they still have to cashflow their kids' college savings because there's not enough in the 529 to cover it.
So here's my rule of thumb when it comes to 529s and the people with whom I work. If you are going to put more than the 50, 100, hundred and $50 a month that I talked about in the beginning of this episode, you need to have a financial plan in place. You need to be able to articulate its objectives and show that you are on track to meeting those objectives before you put significant funds away, that can only be used for education.
This is my rule, because through experience, I can tell you the better prepared you are financially, the better prepared you will be able to help your child when it comes time to pay for school. But if you're not in the place where you need to be, and you don't have money set aside, you just going to end up in a situation where they still have to borrow, or you have to sacrifice whatever progress you had made, which puts you further behind the eight [00:07:00] ball.
So what we're going to do after the breakers, we're going to tell you the story of a couple who evaluated an alternative to a 529. Thought through the benefits of the 529 and this secondary tool for their family. And at the end, were able to articulate why neither option was the right tool for their children's education savings.
When I was getting ready for this episode, it reminded me of an article from business insider that I read in August of 2022. And we'll put the link to this article in the show notes, but the title of the article was, and I quote, 'experts often steer parents towards a 529 plan or UTMA to save for their kids' future, but we went another direction instead'.
And in this article, it tells the story of a woman named Katie and her husband who were trying to figure out the right place to save for their children's education funds. And at the beginning it says, and I quote, 'when my husband and I started saving for our two daughters, we knew we wanted the money to be invested in the stock market.
We also knew [00:08:00] we wanted to be able to provide them with funds, regardless if they chose to go to college such as to help buy a home or start a business'. So at the beginning, they are articulating that the way that they want to support their daughters is not limited to funding their education, which may be something that you identify with.
As this couple started looking at their options. It came down to a 529 plan. And also the UTMA that we mentioned in the title, which stands for uniform transfers to minors act.
Now the best way to describe an UTMA is it is a tool that carries a lot of features, similar to what you'd find in a non-qualified brokerage account. The UTMA itself is just a shell. You put money into that shell or property into that shell. And once it's in the shell, you decide how you want to invest it. You can invest it in stock. You can invest in mutual funds or index funds, if you so choose. But you're doing so for the benefit of a minor child.
Many people like UTMAs because [00:09:00] they allow you to do things like put funds aside that have no restrictions on their use.
But there are some things of what you need to be aware when you use an UTMA. The first is, even though it is a child who has these funds in their name, they would still pay taxes on investment income. Now, fortunately, in many cases, a child's tax rate is significantly lower than that of their parents. But if that account produces too much income, which in this instance would be considered unearned income, the tax rate can be elevated to that of the parent. So if not managed properly, you can see a scenario where the income that's kicked off by an UTMA account can be substantially taxed if not cared for appropriately.
And another major downside to this account, depending on how you view your child's level of maturity, is that with an UTMA account and also with a similar alternative called an UGMA account, the ownership and responsibility of these funds transfers to your child in full when they reached the age of [00:10:00] majority in your state.
As a matter of fact, reading from the section in the article where they discuss these accounts, the mother says, and I quote, 'however, the funds in an UTMA account automatically transferred to the minor when they reach legal age, which is 21 where we live.
While 21 sounds like an old enough age to turn over the funds. We also know there's a chance our child won't be responsible enough to handle a financial windfall. Of course we hope for the best, but we also know life happens and don't want the added pressure or poor decision-making that could come along with a substantial monetary gift'. And maturity aside, we talked about some of the negative things and guilt and lack of responsibility that can come when you receive an inheritance in our episode about money disorders. So this is a real thing that led this family to turn away from UTMAs as a possibility. Which leads us to the 529. This couple decided that a 529, although an extremely popular choice was not appropriate because of its limitations.
They talk about tax deferral. They [00:11:00] talk about the ability to use it for education expenses, but going back to their feelings , 'if the child chooses not to go to college and the funds are not transferred to another family member, however, the account can be closed and the funds withdrawn, but taxes and an extra 10% fee will be charged while we expect that there's a good chance.
Our girls will be college bound. It's hard to say for sure, the education landscape is changing rapidly and we know that. The next 15 years will bring even more change while I don't doubt that further education and training will be paramount. I'm not certain if our children will take the same four year college path that we did. Thus, why we decided not to start a 529 at this time.'
This means that this couple decided that neither tool was right for them. And in the end, they actually opted to open a non-qualified brokerage account in their name, not their children's name, with the intention of transferring the funds to either a 529 or an UTMA at a later date. So [00:12:00] they're feeling that if they can put these funds aside for their own benefit and in their own control, that would be the preferable alternative because they now have complete autonomy on its use and no restrictions on its use either. , Conversely, if they put these funds in a 529 or an UTMA at the start, you can not unscramble that egg. So when your children are young, when you are young and trying to make sure that you're saving for them and also saving for your own future, the flexibility can be preferred in spite of the benefits that are offered by either of these tools.
And if you're in a similar situation where you don't know what the future holds, but you do know that you are not quite in a place where you're on track for your financial objectives, then I'm not telling you to not save for your children's future. I'm telling you to think about the utility of the funds and if you feel a 529 is something that you would like to utilize in a limited capacity, then also keep in mind whether that is the tool or whether it's just a [00:13:00] small part of a comprehensive pool of options that you can use to make sure they're in the best place and you're in the best place when the time comes to turn that money over to them.