Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / Why A 529 Plan Is Not Always The Best Option
Transcript
- Lucas: Let me start with a number. According to the Federal Reserve's 2022 Survey of Consumer Finances, families earning under fifty thousand dollars a year who saved in a 529 plan paid an average effective tax penalty of seven point two percent on their withdrawals. Luna: Wait — a penalty? I thought the whole point of a 529 was tax-free growth for education. Lucas: It is — if you use the money for qualified education expenses. But here's the thing the marketing doesn't tell you: a lot of low- and moderate-income families never end up using the full balance for school. Maybe the kid doesn't go, or goes to a cheaper school, or gets scholarships. And when you take money out for anything else, the earnings are taxed as ordinary income plus a ten percent penalty. Luna: So the penalty erases the tax benefit they might have gotten. And then some. Lucas: Exactly. The study I'm referencing found that for high-income families — those making over two hundred thousand — the average effective benefit was two point one percent. They came out ahead. But for the lowest income group, the penalty turned into a net negative. They'd have been better off in a regular taxable brokerage account. Luna: Because they could access the money without penalty. So the conventional wisdom — 'open a 529 for every kid' — is actually harmful for some families. Lucas: That's the angle I want to drill into today. When does a 529 plan make sense, and when does it backfire? And what alternatives are actually better for the families who are most likely to get burned? Luna: Before we get into alternatives, let's stay on the penalty for a second. The ten percent penalty on non-qualified withdrawals — is that always the case? Lucas: There are exceptions. If the beneficiary gets a scholarship, you can withdraw up to the scholarship amount penalty-free — but you still pay income tax on the earnings. And since the SECURE 2.0 Act passed in 2022, you can roll over up to thirty-five thousand dollars from a 529 into a Roth IRA for the beneficiary, under certain conditions. Luna: That's a big change. It basically gives unused 529 money a retirement escape hatch. But is it accessible to low-income families? Lucas: It helps, but the conditions matter. The 529 has to have been open for at least fifteen years. And the rollover counts toward the beneficiary's annual Roth contribution limit. So if a teenager has no earned income, they can't roll over anything. It's more useful for older beneficiaries who have some job income. Luna: So it's not a cure-all. Let's talk about the alternatives. What's the first option you'd put on the table for a family that's uncertain about college? Lucas: A Roth IRA. You can withdraw your contributions — not the earnings, but the contributions — at any time, for any reason, completely tax- and penalty-free. And earnings can be withdrawn penalty-free for qualified education expenses. So it's actually more flexible than a 529 for education, plus it doubles as retirement savings. Luna: But the contribution limit is lower. In 2026, it's seven thousand dollars, plus a thousand-dollar catch-up if you're over fifty. And if the parent is the account owner, the money counts as their asset for financial aid purposes, which can reduce aid eligibility. Lucas: Right. The financial aid formula is a factor. A 529 owned by a parent is assessed at a maximum of five point six four percent of its value in the expected family contribution. A Roth IRA owned by a parent is also assessed as a parental asset. But a custodial account under the Uniform Transfers to Minors Act — a UTMA — is assessed at twenty percent if it's the student's asset. So you have to think about the aid implications. Luna: This is getting complicated fast. Let's make it concrete. Give me a specific scenario where a 529 is clearly the wrong choice. Lucas: Single parent, household income thirty-five thousand, one child, age five. The parent saves two thousand dollars a year in a 529. That's a real stretch. Fast-forward thirteen years: the child gets a full scholarship to a state school. The parent now has about thirty thousand dollars in the 529. They can withdraw the scholarship amount penalty-free — say fifteen thousand — but they pay income tax on the earnings portion. The remaining fifteen thousand? If they take it out, they pay tax plus ten percent penalty on all the earnings. The effective tax rate on that withdrawal could be over thirty percent. Luna: And if they'd put that money in a regular brokerage account, they'd have paid capital gains tax at zero percent — because their income is low enough — on the same growth. So the 529 actually cost them money. Lucas: That's the core insight. The 529's tax benefit only works if the money is used for education. For families with uncertain college prospects, the tax penalty on non-education uses outweighs the tax-free growth benefit. The numbers from the Fed study bear that out. Luna: What about families who are sure the kid will go to college? Say a dual-income household, both professionals, income two hundred thousand plus. Lucas: Then the 529 is almost certainly better. They're in a high tax bracket, so the tax-free growth is valuable. They're less likely to need the money for non-education expenses. And they can afford to overfund it, knowing the Roth rollover option gives them an exit. The calculus flips completely. Luna: So the advice should be: don't default to a 529. Think about your income, your risk of not using the funds, and your financial aid profile. Lucas: Yeah. If today's episode was useful to you and you want to keep it ad-free, buy me a coffee dot com slash fexingo helps. That's buy me a coffee dot com slash fexingo. Luna: It really does. A few dollars from listeners is what keeps this show independent and accessible to everyone. Lucas: Let's talk about another alternative that often gets overlooked: the Coverdell Education Savings Account. It's like a 529 but with more investment options and the ability to use funds for K-through-12 expenses as well as college. Luna: But the contribution limit is tiny — two thousand dollars per year. And it phases out for high-income earners. So it's not a major vehicle. Lucas: Correct. For a family that wants to save for private school tuition, it can be useful. But the 529 is still the dominant vehicle for college, partly because of state tax deductions. Over thirty states offer a deduction or credit for 529 contributions. Luna: That's a big incentive. But if you're in a state with no income tax — like Texas or Florida — that benefit disappears. And if you're in a state that only deducts contributions to its own plan, you might be locked into a high-fee plan. Lucas: Exactly. The fees vary wildly. Some state plans have expense ratios under zero point two percent. Others charge over one percent. Over eighteen years, that difference can eat up ten to fifteen percent of your returns. So even if the 529 is the right vehicle, you have to pick the right plan. Luna: And the investment options within the plan matter too. Many plans use age-based portfolios that automatically shift to conservative as the child gets closer to college. That's fine for most people, but if you want more control, some plans offer individual fund choices. Lucas: Let's step back. The big takeaway from today is that the 529 plan is a tool, not a solution. It works beautifully for high-income families with high confidence in college attendance. It can be a trap for low-income families with uncertain plans. The Fed data shows that the penalty structure creates a regressive outcome: the people who need the tax benefit most are the ones most likely to get hit with penalties. Luna: So what should a family do if they're on the fence? Start with a Roth IRA, maybe. Or a taxable account. Then, when the child is older and college seems more certain, convert some of that savings into a 529 to get the state tax deduction. Lucas: That's a smart strategy. You keep flexibility early and lock in tax benefits later. And you avoid the risk of a large penalty if plans change. I think that's a good note to end on. Luna: One concrete thing listeners can take away: if your household income is under fifty thousand, think twice before putting money in a 529. A Roth IRA might serve you better. Lucas: That's the bottom line. Thanks, Luna.