At what point do I stop making 529 contributions for my kids?

College costs continue to rise, but proper planning can help ensure you do not overfund a 529 and are left with unintended tax consequences

We get this question a lot. In this rare case, there may be such a thing as "over-saving". Money left over in a 529 may have unintended handcuffs and tax consequences. Truth be told, even the best financial planners struggle with hitting this planning goal perfectly. Cost can vary widely, and there are tons of variables to consider:

• Will the student want to go to a traditional 4 year university? If so, is it in-state, out-of-state, public, or private?

• Will there be any financial aid assistance, scholarships, or grants to offset the cost?

• Do the parents want their student to take ownership of their education and have them take loans, or do work/internships to contribute to the cost?

• What year will we need to start to take withdrawals? If the student is uncertain about a course of study, maybe they do not go to school right away, or they take online classes while working and living at home.

These concerns leave clients hesitant to use 529s as a savings vehicle or continue to fund them once they reach a certain mental "value", despite them being arguably the best tool available to help pay for the mounting cost of education.

So, how do you know when enough is enough?

First, let's revisit why a 529 Plan can be superior to other methods of savings (brokerage, UTMA, etc.) for education expenses.

• 529 savings grow on a tax deferred basis, and withdrawals are made tax-free if the money is used to pay for qualified education expenses (tuition, fees, books, room/board, etc.)

• Let's assume you can afford to put $300 per month into a 529 for 17 years at 6% annual average interest rate (compounded monthly). At the end of the 17 years, you'd have $105,969 ($61,200 principal + $44,769 interest). If you used the entire amount for qualified expenses, you'd get $44,769 in tax free interest. Good deal!

• If you instead put that money into a brokerage account, for example, the return would be the same, but you would owe tax annually on any interest, dividends and realized capital gains.

If you have 529 balances nearing or on track to be considerable assets, I can guarantee you've asked yourself if it's "too much". Here are a few planning takeaways that can help give you answer that questions and provide piece of mind with education planning.

Give Your Kid a Budget: So many clients say things like, "Johnny got into X school and it's $60,000 a year - what are we going to do?" or "Ginny is looking at 12 different schools and the costs are all over the place - I hope we have enough". My first response is always, "have you talked to your child about costs or given them a budget?" Parents avoid this conversation for some reason, which can result in massive planning gaps, and mounting debt for both students and parents. Instead, decide with your planning professional how much you want to contribute for their education in today's dollars (an annual budget for them). Then you can have a concrete plan for how much you want to accumulate in a 529 account. When it comes time to make an education choice, this gives you the most flexibility. You'll feel good that you've reach your planning goal, and then you can have the conversation with your student and tell them what you have set aside for their education. Now they are empowered to make a conscious decision. If they want to go to a $60,000 school and you've budgeted $30,000, involve them in that conversation and work together to create a plan.

When You Hit Your Goal, Invest Any Additional Funds Elsewhere: Once you've attained that planning goal, put any additional funds into a vehicle with less spending constraints, like a brokerage account. There is such a thing as having too much in a 529 account. With a brokerage account, yes, you will pay taxes differently, but now you can use that money for anything. Anything for you, anything for your kids. And that flexibility is powerful.

Play the Long Game: A student's education journey can be long, with changes in schools, plans to attend graduate school, etc. Don't panic if your original plans fall apart. There are a number of options available to you if you have funds left over in a 529 Plan, including:

• Change the Beneficiary: You can change the designated beneficiary to a qualified member of the original beneficiary's family without incurring tax consequences.  The definition of Qualified family members is somewhat broad and includes grandchildren, first cousins, step-relationships, and even sibling’s spouses. 

• Payoff Student Loans: You can use up to $10,000 to repay any student loans of the beneficiary.  An additional $10,000 can be used to repay qualified student loans of each of the beneficiary’s siblings ($10,000 lifetime maximum per person).

• Fund a Roth IRA for the beneficiary:  It’s important to note that the beneficiary still must otherwise qualify to make the Roth IRA contribution in that tax year, which includes having earned income.  You can use 529 funds to make an annual contribution up to the IRS limit each tax year, until the accumulated contributions reach a lifetime maximum of $35,000. 

• Let the Money Sit There: There are currently no rules around you leaving the money in a 529 for any set time period. Life changes. Maybe your student or a qualified member will pursue education at a later time.

• Withdraw The Money: A few key 529 withdrawal rules to remember, include:

  • You never have to pay taxes or penalties on the portion of your 529 account withdrawal that represents your original contribution. 

  • However, withdrawals of the account’s earnings are subject to both taxes and a 10% penalty unless you use them for qualified education expenses.

• There are a number of exceptions that can allow you to escape the 10% penalty (but not the taxes) on the earnings, which include when a student attends a U.S. military academy or receives a scholarship.

As with many goals, proper planning and open conversation result in the best outcomes. With education planning and 529 funding, we've found great success in setting a planning goal, using a 529 to achieve that goal, investing any excess in more flexible accounts, and knowing your options and strategies for any leftover funds.