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Building Wealth by Saving for College?

              Chances are that you put some stock in the value of higher education for creating a fulfilling life, opening opportunities, or at least minting more future fighter pilots.  But college costs more than F-35 parts and Uncle Sam doesn’t dole out rock star pay to fighter pilots (arguably, they deserve it), so how do you pay for college, especially when you have multiple children and only one Post-9/11 G.I. Bill to spread around?  The answer for most people is to save in a 529 plan.  There’s enough 529 basics on the Internet to fill another Internet, so this article is going to look at wealth-building and planning opportunities after a quick primer on 529s.

529 Plan Basics

              A 529 plan is a tax-advantaged education savings plan.  Until the 2017 TCJA tax law, it could only be used for college, and that’s what most Americans will continue to use it for.  Individual states run 529 plans and write their own rules for account sizes, tax benefits, etc.  You can save in any state’s plan or multiple plans.  The plans come in two basic variants.  First, you can invest money into securities (typically mutual funds, ETFs, and target-date funds) and then hope the account value compounds and withdraw the money to pay for allowed expenses (tuition, room, board, books, fees, etc.).  You can self-manage these accounts like an IRA or have a professional manage it.  The second type is essentially pre-paid tuition.  You choose a state (where you hope your 6-month-old will one day attend an in-state school) then make payments at a discount to expected future tuition in exchange for a guarantee from the state that your payments will cover agreed expenses.  For the purpose of this article, I’ll focus on the former style which I’ll call direct investment.

A 529 plan has many advantages over other college savings vehicles and can be compared to a “Roth” account for college.  You pay federal income tax as you earn money, but once you contribute it to a 529 plan, it grows tax-free until distributed.  Distributions for qualified educational expenses are also tax-free.  In 2021, an individual can contribute $15K to a 529 plan without incurring a gift tax issue.  What’s more, the tax code allows a 5-year frontloading of 529 contributions.  If you were paid like a rock star and had two children, you and your spouse could put a total of $150K per child into a 529 plan in the year of their birth.  Five years later, you could repeat the maneuver if desired.  Most pilots won’t touch those numbers, but if you sign the bonus and take $200K up front, a 529 plan could be a good place to stash a chunk of it.  Many states allow taxpayers to deduct a portion of 529 contributions from their state income tax.  This has the effect of an immediate return in the amount of the state tax rate.

529 plans can be used for myriad programs including post-graduate degrees.  If scholarships and the G.I. Bill cover undergraduate degrees, you can fund junior’s medical school too (well, at least some of it).  These plans are also incredibly flexible.  You can change the beneficiary to yourself, your nephew, or even your grandkids.  When you create an account, you are the custodian and you can transfer that custodianship to another person and it’s not a taxable event. More on this later…

Why Use a 529 Plan?

              A 529 plan is a powerful tool to create opportunity for your family tree to achieve educational goals and can be complimentary to the G.I. Bill and other scholarship opportunities.  Here are some of the reasons fighter pilots should consider using 529 plans:

  • Tax-free growth and tax-free distributions for qualified educational purposes. Raiding your retirement accounts to pay for college gives up years of compounding that you’ll want to use to get your dentures refurbished one day.  Saving in a taxable account usually creates annual tax-drag on a portfolio and definitely creates a tax-hit (on previously taxed dollars) when sold for college bills.
  • Beneficiary flexibility. Maybe one of your kids looks like academy material at birth and the other… not so much.  No problem, you can change the beneficiary about as fast as you can type “change the beneficiary.”
  • State income tax benefits. Not all states offer tax deductions, and pilots have a tendency to be residents of AK, TX, FL, NV, SD, WA, WY… But if you pay state income tax, your state’s 529 plan could save you some dough.
  • As mentioned above, if you have the means, you can load up a 529 early in your children’s lives and (hopefully) smoke a lucky until they need the cash.
  • No time limits. Unlike the G.I. Bill which junior must use by age 26, 529 money can grow until you take a distribution.  If the market is down, you can use G.I. Bill or other funds for a given semester or year while letting the 529 money recover.
  • A hedge against the unknowns of college attendance and funding in your family. My crystal ball remains code 3, but it may be worth putting some money in a 529 and the rest in a tax-efficient brokerage account if you’re concerned about under-utilization.

Why Not Use a 529 Plan?

              I’ve worked with several pilots and other families that are skeptical of locking their money into a 529 plan.  I’ll skip discussion of making kids pay their own way because we’re talking about parental strategies here. The main concern I encounter is that if a child doesn’t go to college, or gets a scholarship, then 529 dollars are locked behind a tax door.  This can be true.  The earnings (not principal) in a 529 plan that aren’t used for a qualified education expense (e.g., you withdraw it to buy a sweet Cessna 152 because junior is at the academy) are taxed as both ordinary income plus an additional 10% with some exceptions.  For example, if your child receives a scholarship, then you can withdraw a matching amount from the 529 and only pay income tax, not the 10% penalty.

Barring one of the exceptions, if you invest $50K and it doubles to $100K, when you withdraw $50K to buy the bug smasher, you’ll pay 0% to 37%[1] on the $25K of earnings, plus an additional 10%.  That could be as high as 47% and is clearly much higher than the 0% to 23.8% capital gains taxes you might pay if you invested in a tax-efficient stock, ETF or other security.  But remember, if your 529 alternative is throwing off dividends and capital gains each year—you have to factor that taxation into your calculus too.

Other reasons to skip a 529 could include:

  • Wealthy family will fund college. Did you know that Grandpa can write a check directly to Harvard for your student and there’s no gift tax for Grandpa? Might be time to start buttering up wealth relatives…
  • Desire for more diverse investments. Most 529 plans have a very similar set of mutual fund offerings.  You’re not going to find Bitcoin, publicly traded partnerships, or even single stocks in 529 plans.
  • Insufficient investable income. Most advisors would argue that you can borrow or work through college.  The same is not as true for retirement.  If your maxing out your investable dollars by saving for your retirement goals, it might not be prudent to prioritize college savings.
  • State Limits on Account Size. Some states place limits the amount you can invest or accrue in a 529.  If you had the means to drop seven figures in, you’d have to spread the accounts over several different state 529 plans.  (I’ll take ultra-first world problems for $6,900, Alex…)

Wealth Building and Planning Opportunities with 529 Plans

              In addition to being a tax-advantaged way to save and pay for college, 529 plans offer some unique opportunities to help you build wealth inside your family tree.  First is the cost of a dorm room.  If your student could live in the dorm for $15K per year, you could also use that money to pay rent in an apartment or… a mortgage on a property you own/purchase.  I had to let that one sink in a bit the first time.  Tax-free growth for 18+ years that flows into equity on a property (that’s not encumbered by the 529) and potentially becomes a source of income as you rent rooms to junior’s roommates.  Imagine doing this for each of your kids.  You’re probably wondering if you could do the same with the G.I. housing allowance.  Affirm.

If you’re in the Air Force, you’re familiar with master’s degree whiplash that occurs about every other CSAF (no, you can’t claim it with the VA).  Regardless of whether you need enough masters degrees to use them as coasters at a roof stomp, your kids might need advanced degrees.  If you’re already slaying your retirement savings goals, then posturing your 529 funds for graduate degrees can create decades of growth and alleviate soul-crushing debt for your posterity.  Then again, if they were naughty teenagers, you might have a case to let them suffer a few hundred thousand dollars of graduate degree debt.

Finally, 529 plans can create an educational dynasty or endowment opportunity.  If your kids don’t use up all of the 529 money and you let it keep growing until your grandkids need it… well, the decades are usually kind to those that understand compound returns… When it’s time for your nickel on the grass, custodianship of the account could be transferred down the generations until it’s time for your heirs to use it (still tax-free).  The money you put away today could become your family tree’s ticket to college.

There are a lot of benefits to 529 plans and they extend beyond just getting your kids through a bachelor’s degree. These plans are easy to use, flexible, and can turn tax-advantaged savings into income-generating property.  You do need to take a leap of faith that your kids will need college money or be willing to manage the branches and sequels such as transferring the money to other relatives or grandchildren if they don’t need it.  This article touches on planning opportunities, but there are a lot of devilish details in choosing and using a plan, so definitely consider talking to your financial advisor to help make informed decisions.  If you think a 529 plan might be right for you, remember you didn’t need to start contributing in the delivery room, but it’s probably better to get started today so you can run up the score over the decades.

[1] Actually, it could be even higher if your income drives the 3.8% Net Investment Income Tax and/or .9% Additional Medicare Tax.

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