I’m a CFP and a Mom. Here’s Why I’m Not Investing in a 529 Plan for My Kid

A photo to accompany a story about 529 plans Courtesy of Naomieh Jovin
Pamela Capalad and her husband say they will not invest money in a 529 plan for their son. By not locking their money in a 529, they have more flexibility in case their son decides not to go to college when he’s older.
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I was helping a client decide whether or not she should contribute to a 529 plan for her new baby. 

“So if I put $10,000 into the plan in New York state, I get a state tax deduction? What’s the math on that?”

Pamela Capalad
Pamela CapaladCourtesy of Naomieh Jovin

I’m a certified financial planner at my company, Brunch & Budget, and we help people of color build generational wealth. I quickly looked up state tax rates for her income bracket — she’d pay about 6% state tax.

“You’d save about $600,” I shared.

She scrunched up her face. “That’s it?”

“Yeah, not a huge amount,” I agreed. “Also, if you don’t end up using the account for educational purposes, you actually get hit with a 10% penalty and will owe taxes on the gains.”

Needless to say, she didn’t open a 529 plan.

529 plans were designed for the wealthy and marketed to the rest of us. 529 plans are investment accounts that have special tax breaks if you use the funds for qualified education costs—and penalties if you don’t use the funds for education.

I learned about 529 plans early in my career when I worked in wealth management. We helped our high net worth clients open them and fund them. We told them all the benefits:

  • There’s a state tax deduction in 34 states (as long as you open the plan in the state you live in)
  • You put the dollars in after tax, but all the investment growth on the account is tax-free (much like a Roth IRA)
  • All the distributions are tax-free, as long as you use it for educational purposes (now up to $10,000 per year can be used for K-12 private education)
  • You can change the beneficiary anytime to anyone
  • You “only” pay a 10% penalty, plus capital gains tax, if the distributions are not used for education

But this was the kicker: you can gift large amounts of money at once without eating into your lifetime gift/estate tax exclusion.

If you just read that sentence and you’re thinking, ‘Wtf are those words?’ let’s break it down:

Let’s say you have an estate worth about $12.5 million (so, about 0.2% of you). If your estate is worth more than $12.06 million (in 2022), you will owe up to 40% in estate taxes when you die for every dollar over $12.06 million, so in this example you’d owe estate tax on $440,000.

Of course, you’re thinking, ‘Well I don’t want to pay estate taxes on $440,000 of my $12.5 million estate! That would put me out almost $150,000 in estate tax (or 1.1% of my total estate)!’

Here’s where the 529 plan comes in. Every person is allowed to gift up to $15,000 per person, per year ($30,000 per couple) in what’s called an “annual gift tax exclusion.” This allows a wealthy person to get money out of their estate now and avoid paying estate taxes later down the line.

A 529 plan has a rule that you’re allowed to frontload your annual gift tax exclusion up to five years, which means that a couple can put up to $150,000 at once into a 529 plan. Let’s say you have 3 kids and you open three 529 plans. You moved $450,000 out of your estate and saved $150,000 in federal estate tax (the Obamas did this for their two girls in 2007).

My client above, who was not quite worth $12.5 million, and who would in fact struggle with putting $10,000 into a 529 plan, was looking at a maximum $600 income tax break. She wasn’t sure if her child would need the money for college, or to buy a house or start a business. She couldn’t afford to take the risk of a 10% penalty, plus taxes if the money didn’t go towards education. And depending on her family’s income, the tax savings of a 529 plan might actually be $0. Here’s why.

How the Rich Benefit From 529 Plans

One of the biggest benefits of a 529 plan is you don’t have to pay capital gains tax on any distributions used for education. The capital gains tax rate is based on income, and if your household makes less than $83,350, your capital gains tax rate is 0%. The median household income in 2022 is $61,937, so most American families would be paying a 0% capital gains tax rate anyway. 529 plan contributions also count against financial aid calculations. 

It’s no wonder that “only 0.3% of households in the bottom half of the income distribution have 529 accounts, while 16 percent of the top 5 percent do,” according to the Conversation, citing Federal Reserve data.

The main benefits of 529 plans are additional tax shelters for high net worth families, and it’s costing taxpayers billions of dollars. In a 2017 piece, Richard Reeves at Brookings College states that “As 529s grow, so do the cost of associated tax advantages, which will cost the federal government almost $30 billion over the next decade.” This estimate only takes into account capital gains tax breaks and not the estate tax shelter for the wealthy, which could add up to billions more in lost tax revenue. 

The cost of college has grown faster than inflation over the last several decades, on average about 8% per year according to Finaid.org, meaning the cost will double every 9 years. 

By the time my client’s child is 18 years old, one year of undergrad could cost $100,000. I’m a mom of a 2.5-year-old and I love him to pieces, but we can’t afford to send him to college if it costs that much! Since the benefits of a 529 plan are restricted to education expenses, we chose not to set one up for our son.

Reeves also posits in his piece that the rising tuition costs and the growing use of 529 plans could be related: “The cost of college has increased fastest at the types of institutions preferred by, and attended by, students from the households most likely to benefit from the 529 public subsidy. These institutions also typically have relatively low numbers of students on Pell grants.”

The average American family does not benefit from opening a 529 plan and in fact, may face hefty penalties if the funds don’t end up getting used for education. We need a better solution to help lower and middle income families cover the rising cost of college. 

Other Options Instead

If you want to save for your child, a simple savings account or a basic investment brokerage account will do the trick. We have our son’s savings in a regular savings account for now and will soon move it to an investment account. We want our family to have the flexibility to help fund whatever future plans our son creates for himself.

If you want to get really fancy, consider setting up a UTMA (Unified Trust for Minors Account). It’s an investment account for your child where you are the account holder while your child is a minor. The ownership transfers to your child at the age of 21 and they can use this money for anything. Give you and your child complete control over where the money is spent, whether or not they decide to use it for higher education.

Pro Tip

If you want to invest for your child, consider a savings account or a UTMA, which is a Unified Trust for Minors Account. It’s an investment account that gives your child the complete flexibility to spend the money on anything, rather than higher education.

My client needed to prioritize maxing out her 401(k) at work, paying down credit card debt, and building up an emergency savings fund. She wanted to start setting aside money for her new baby, but I ended up telling her that the best gift she could give her child was to not have to take care of her mom in retirement. 

She’s currently setting aside $100 a month into a savings account earmarked for her child and when that grows to a certain amount, I’ll help her move it to an investment account. By prioritizing her own financial journey, she will end up prioritizing her child’s in the long run.