Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / 529 Plan Mistakes That Cost Parents Thousands
Transcript
- Lucas: If our money conversations have helped you think about a decision differently, the way these stay ad-free is listener support. Buy me a coffee dot com slash fexingo keeps the lights on and the research sharp. Luna: Exactly, and if you find value in these deep dives, that small gesture really does keep the quality high. Thanks for listening. Lucas: Let's get into today's topic. We talk a lot about the benefits of five-oh-two-nine plans, but I want to focus on the hidden traps that cost parents thousands every single year. The biggest mistake isn't failing to save; it's saving incorrectly. Luna: You mean like contributing to the wrong state's plan when you don't live there? Lucas: That is definitely number one, but there is a subtler issue involving the interaction between state tax deductions and federal withdrawal rules. Many parents assume that once money is in the plan, it grows tax-free regardless of how they manage it. That is true federally, but state laws vary wildly on how you claim the deduction. Luna: So even if you get the deduction now, you could still mess up the withdrawal later? Lucas: Precisely. Let's look at a hypothetical family in California versus one in New York. California does not offer a state income tax deduction for five-oh-two-nine contributions. So a parent there might feel free to contribute to any plan, often choosing one with historically strong performance. But in New York, you only get the tax deduction if you contribute to the Empire State Savings Prepaid Tuition Program or the New York 529 College Savings Program. Luna: Right, so if a New York resident contributes to an out-of-state plan, they lose that immediate tax break entirely. Lucas: Exactly. And here is where it gets tricky. Some states allow you to deduct contributions to other states' plans, but they cap that deduction. For example, if a state caps the deduction at ten thousand dollars per individual per year, contributing fifteen thousand means you only get the tax benefit on the first ten thousand. The extra five thousand sits in the account growing tax-deferred, but you paid full price for it upfront. Luna: That feels like a significant opportunity cost. Are people actually doing this? Lucas: All the time. They see the long-term growth potential and ignore the short-term tax inefficiency. The thing is, that ten thousand dollar difference compounds. If you are in a thirty percent marginal tax bracket, you are leaving three thousand dollars on the table every single year. Over eighteen years, that is fifty-four thousand dollars in lost tax benefits, not counting the compound growth on that money. Luna: Wow. Fifty-four thousand is a huge chunk of change. Does the state ever claw back that deduction if you withdraw the money later? Lucas: Usually, no. Most states treat the deduction as an annual event based on the contribution year. However, some states do have recapture rules. If you take a non-qualified withdrawal within a certain window, they may require you to pay back the tax benefit you received. It is rare, but it exists. So you have to check your specific state statutes. Luna: Okay, so step one is checking your state's deduction rules before you open the account. What about the investment side? Are people making mistakes there too? Lucas: Absolutely. The second major trap is ignoring expense ratios. Five-oh-two-nine plans often come with proprietary mutual funds that have high management fees. A parent might see a ten-year return of eight percent and think it is great, but if the fee is one point five percent, the net return is only six point five percent. Meanwhile, a low-cost index fund tracking the same market might charge only zero point zero three percent. Luna: The difference between one point five percent and zero point zero three percent seems small, but over time it eats everything alive. Lucas: It does. In fact, studies show that over a standard eighteen-year college horizon, high fees can reduce your final balance by fifteen to twenty percent. That is money that should have gone toward tuition. Yet many parents stick with the default options because they are afraid to touch what is already working. Fear of change is costing them real cash. Luna: I guess they think, if it ain't broke, don't fix it. But in investing, broken can mean slowly bleeding value through fees. Lucas: Right. And here is a nuance that surprises people. You can often switch investment options within a five-oh-two-nine plan twice per calendar year without triggering taxes. So you can move from an aggressive growth portfolio when the child is young to a conservative bond portfolio as they approach college age. But many families never do it, leaving risky assets in the account right when they need the money most. Luna: That sounds like a classic behavioral error. Everyone talks about rebalancing, but nobody actually does it with college savings. Lucas: Exactly. Now, let's talk about rollovers. Another common mistake is letting excess funds sit idle in a plan when the child doesn't go to college, or goes to a cheaper school. The old rule was strict, but the SECURE Act changed things slightly. You can now roll over up to thirty-five thousand dollars from a five-oh-two-nine plan into a Roth IRA for the beneficiary, provided the account has been open for fifteen years. Luna: Thirty-five thousand is a nice safety valve. But does that help if the kid just decides not to go to college at all? Lucas: It helps significantly. Before the SECURE Act, if the money wasn't used for qualified expenses, you faced a ten percent penalty plus income tax on the earnings. Now, you can transfer that money into a Roth IRA tax-free and penalty-free, up to the limit. It essentially turns unused college savings into retirement savings. It is a brilliant feature that most parents haven't utilized yet. Luna: I love that. It takes the fear out of over-saving. You aren't locking the money away forever. Lucas: But there is a catch. The Roth contribution limits still apply annually. You cannot just dump thirty-five thousand in one year if the annual gift tax exclusion is lower. Wait, actually, the Roth IRA contribution limit is much lower than that. The thirty-five thousand is a lifetime aggregate limit for rollovers, but each annual contribution to the Roth must comply with standard IRA rules, which are quite small unless you use the earned income test or have excess capacity. Luna: Wait, clarify that. Is it thirty-five thousand total over the life of the plan, or per year? Lucas: It is thirty-five thousand total lifetime limit for rollovers from a five-oh-two-nine to a Roth. However, the amount you can contribute to the Roth each year is capped by IRS rules, usually around seven thousand dollars recently, depending on age and income. So it is a great backup, but not a magic bullet for massive balances. Luna: Got it. So it covers the surplus, but not necessarily the whole pot. What about siblings? Can you move money between different kids' accounts? Lucas: Yes, and this is a powerful tool. You can roll funds from one beneficiary's five-oh-two-nine plan to another beneficiary's plan, as long as they are members of the same family. Siblings count. Cousins even count in some cases. This allows you to consolidate underutilized funds into an account for a younger sibling who will need the money sooner. Luna: That makes so much sense. Why would anyone leave money in a dormant account for a kid who graduated five years ago? Lucas: Because they forget. Or they think it is too complicated to move. But the process is usually just a form submission to the plan administrator. There is no tax event when moving between family members. It is purely administrative. Ignoring this is leaving free compounding on the table. Luna: I bet there are hundreds of thousands of dollars sitting in zombie accounts right now. Lucas: Almost certainly. And speaking of forgetting, let's address grandparent-owned accounts. A few years ago, money from grandparents hit the FAFSA form directly, reducing financial aid eligibility by twenty percent. That scared a lot of families. But the rules changed again recently. Luna: Did they remove the penalty entirely? Lucas: Not entirely, but it is less punitive now. Grandparent-owned five-oh-two-nine distributions are no longer reported as student income on the FAFSA. However, the initial contributions are still considered student assets if the money is withdrawn during the base year. It is complex, but generally, it is better for financial aid if grandparents contribute directly to the five-oh-two-nine plan rather than giving cash to the student. The key is timing and ownership structure. Luna: So ownership matters. If the grandparents own it, it's treated differently than if the parents own it. Lucas: Correct. Parent-owned assets are assessed at up to five point six four percent on the FAFSA, while student assets are assessed at twenty percent. So shifting ownership to grandparents can improve aid eligibility, provided you understand the distribution rules. It is a strategic maneuver that requires careful planning. Luna: This is getting technical fast. Is there a simpler rule of thumb for listeners who don't want to hire a CPA? Lucas: Here is my rule of thumb. First, maximize your state tax deduction. If your state offers a deduction, contribute up to the cap. Second, invest those funds in the lowest-cost index option available in that plan. Third, if you have extra money beyond the state cap, consider whether another state's plan offers better investment options, but only if you understand the tax implications. Finally, review the account every year to shift risk as the child ages. Luna: Simple enough. Max the deduction, minimize fees, adjust risk yearly. I can remember that. Lucas: And don't forget the Roth rollover option as a safety net. If the money isn't needed, it becomes retirement savings. It removes the anxiety of 'what if.' That psychological benefit is worth something in itself. Luna: Definitely. Peace of mind is priceless. Especially when college costs are rising faster than inflation. Lucas: They are. According to recent trends, tuition increases are outpacing general inflation by a wide margin. Every dollar you save efficiently is worth more than a dollar saved inefficiently. The math rewards discipline and penalizes neglect. Luna: So the real enemy isn't the market; it's the lack of attention to detail. Lucas: Exactly. Open an account, pick the right state plan, choose low fees, and check it once a year. That is it. You don't need to be a finance expert to win at this game. Luna: Agreed. It is about setting the foundation correctly and then stepping back. Lucas: If you have questions about your specific state's rules, check the plan website or consult a tax professional. But start with that simple framework. It will save you thousands. Luna: Thanks for keeping us grounded on the practical side, Lucas. Lucas: Always. What do you think is the next biggest misconception parents have about education funding? Luna: Probably thinking that scholarships will cover everything. Most families underestimate how competitive aid has become. Lucas: Right. Self-reliance is still the best insurance policy. Thanks for listening, everyone.