529 Accounts for Grandparents

lightning_mcqueenIf tax-advantaged investment accounts were characters from Pixar’s Cars movie, I’d award star-status to the 401K as the Lightning McQueen character voiced by Owen Wilson. Meanwhile, 529 education savings accounts would have to be represented by a grandfather-type character – like the Doc Hudson car from the 1950s – voiced by Paul Newman.

I partly assign these roles based on their relative effectiveness in winning the wealth-creation race. If you have to choose where to put your investment dollars, the 401K will get you a lot farther, a lot faster, than the more limited 529 account. Mostly, however, I think 529 accounts not only resemble a slower investment vehicle, they also seem to me mostly useful for grandparents to benefit their grandchildren, rather than for a still-working generation facing limited resources.

I’ll explain my logic, and some of the severe limitations of 529 accounts, as well as why prosperous grandparents looking to help out grandchildren may find them most useful. And then finally, a nod to the social justice issue of 529 accounts.

Grandma vehicle

Unlike a 401K, or an IRA, or even a health savings account, you do not get any federal income tax benefit from your 529 account contributions. Further, if you earn income in a place like Texas (like me!) that doesn’t have a state income tax, you also do not receive state income tax benefit from your contributions to a 529.

Doc_hudsonSo right off the bat, when choosing a vehicle for investing your surplus, you get better mileage out of almost any tax-advantaged account except a 529 account.

It is true that when you finally take money out of a 529 account to pay for a child’s education, you will not pay taxes on income from investments made within the account. So there is that tax benefit of a 529 account, when compared to a fully taxable investment account.

However, here another disadvantage arises, and suggests 529 accounts work better for grandparents than parents – because of college financial aid formulas.

Colleges using the standardized Free Application for Federal Student Aid – known as Fafsa – count the student’s and parents’ income and savings when considering scholarship aid, but do not consider 529 accounts held by people other than a child’s parents. Meaning: Grandparents, take careful note!

Grandma’s 529 account created and held for the benefit of her grandchild will not hurt junior’s chances at a generous financial aid as calculated on the Fafsa. That therefore arguably makes a 529 account more valuable in the hands of a grandparent, rather than a parent.

A further nuance to the Fafsa system soon arises. The Wall Street Journal noted recently that, beginning in the 2017/2018 academic year, a student who receives benefits from a 529 account must report that benefit as the student’s income the following year, which may then affect Fafsa formulas for scholarships in the academic year after that.

For this reason, grandparents who make tuition payments for grandchildren from a 529 could be advised to wait until the student’s final year(s) of college, in order to minimize affects on financial aid packages.

A few other factors convince me that 529 accounts make the most sense for families with well-off grandparents. Unlike IRAs or Coverdell education plans, 529s have no income or age limits on who can contribute, making them suited for older folks with a grandchild they would like to subsidize.

Finally, bolstering my thesis that 529s are grandparent-vehicles more than anything else is the following estate tax strategy:

fafsaIf you are a grandparent with substantial means, then the 529 accounts are a great way to support the next generation, while reducing future estate taxes. Grandad can contribute up to a maximum annual gift tax exemption amount of $14,000 to junior’s future education. If Grandad really wants to get clever, he could combine up to 5 years’ worth of gift-tax exemptions and contribute $70,000 all at once. And then if Grandad and Grandma combine efforts, they could gift up to $140,000 in one year to one lucky grandchild’s education. With multiple grandchildren, and generous grandparents with means, that’s $140,000 per kid all at once, a whole lot of reasons to fund 529 accounts. I mention all this because my sense is that this is a standard estate-tax reduction technique for well-off grandparents.

Limited resources

In all this focus on grandparents, I mean to make the point really for parents trying to decide – with limited resources and a confusing menu of tax-advantaged accounts – where to invest their surplus. And the simplest thing to say is this: always choose a retirement account like a 401K and IRA before choosing the much less powerful 529.

In addition to the difference in tax treatment, another simple way for parents with scare resources to understand the save-for-college versus save-for-retirement is this: You can’t generally borrow money to retire, but you (or your child) can borrow money for education. If money is tight – and I’m only talking to about 99 percent of you now – then always favor contributions to your retirement accounts over educations savings accounts. If you are part of the 1 percent that has plenty of surplus, well then, by all means fill up that 529.

And…social justice

So 529 accounts mostly make a whole lot of sense for a wealthy older generation ensuring their third generation stays ahead in the education game. Which is awesome, don’t get me wrong.

social_justiceBut from a social justice standpoint – if you care about that kind of thing – you might sort of see how the peculiar design of 529 accounts looks terrible. This is basically why in January 2015 the Obama administration briefly floated the idea of eliminating the tax benefits of 529 accounts, which at the time I thought was mean and unfair of them. Unfair, to me, because I have 529 accounts for my kids. But they had a point. According to the Wall Street Journal at the time, the administration argued that 70 percent of benefits went to households with incomes above $200,000, or the top 4 percent of households.

In a non-surprising development, people don’t like their tax breaks taken away, and the proposal lasted roughly three seconds before the administration retracted it.

My social-justice point here on 529s is two-fold – and thematically resembles my approach to advice on many aspects of personal investing. First, the game of investing for college – or anything! – is kind of rigged in favor of the already-wealthy. Second, if that already-wealthy status applies to you, here you go: have some nice instructions on taking advantage of the game.

 

A version of this ran in the San Antonio Express News

 

Please see related posts:

You Want To See Something Really Scary – Saving For College

College Savings v. Retirement Savings

Ask An Ex-Banker: Estimating Monthly Savings To Plan For College

Ask An Ex-Banker: Using Savings Or Debt To Pay For School

 

 

 

 

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