Ask an Expert: Relying on Free Financial Advice Will Cost You
We often see bad financial advice on the internet and social media. Sometimes the advice is just plain wrong.
Let’s walk through an example.
A recent financial advice column in The Cut, “I’m Getting Married and Having a Baby. How Should I Plan?”, illustrates some of the dangers of relying on free advice.
The column does offer some decent information about joint finances for those engaged to be married. When it comes to her take on 529 accounts, however, we see some questionable advice mixed in with clearly incorrect information.
Here is an excerpt of the advice given to a pregnant woman about using 529 plans:
"I also recommend setting up a 529 plan for your child, which you can do as soon as they have a Social Security number. A 529 plan is basically like a 401(k) but for your child’s future education costs instead of retirement — any money you contribute to it is tax deductible, and it also grows tax-free, so the sooner you start funding it, the better. ‘However, it’s important to not overfund this account,’ says Blain Pearson, a professor of personal financial planning at Kansas State University. There’s no limit on how much you can contribute annually, but in most states, you can’t deduct more than $5,000 per year from your taxes (or $10,000, as a married couple filing jointly), so there isn’t much benefit to contributing more than that. And if your child doesn’t wind up needing all the money for school (say they don’t go to college, or they get a full-ride scholarship), then you will get hit with an extra tax penalty when you take the money out for some other use."
Below, I will both clarify and correct some of the information written in the above excerpt.
You Can Actually Open a 529 Account Whenever You Like
You don’t need an offspring’s social security number to open a 529 plan. Simply open one and make yourself the beneficiary. Once you have a child and obtain a social security number (or a direct relative like a grandchild, a niece or nephew is born) just change the beneficiary information in your 529 account. (See more on changing beneficiaries below.)
The columnist is quite correct that “the sooner you start funding it the better.” But if you are either pregnant or fairly certain you will have a child soon and want to save for college, why not go ahead and start funding the 529?
As an example, let’s say you followed the advice in the column and began funding a 529 after your child was born. For simplicity’s sake, let’s say that you continue to contribute $500 monthly for 18 years. Assuming a fairly conservative average rate of return of 5%, your account balance would be $194,645. If you instead listen to us, actual experts, and act on quality advice to start funding a 529 one year before your child’s birth, your account balance after 19 years would be $212,849. That is a difference of $18,204! If you ask me, that “free” advice from a columnist was mighty expensive.
Tax Deductions Should Not Be a Limiting Factor in Your Contribution Amounts
This statement is almost criminal:
“In most states, you can’t deduct more than $5,000 per year from your taxes (or $10,000, as a married couple filing jointly), so there isn’t much benefit to contributing more than that.”
First, plenty of people benefit from using a 529 plan even if their state does not offer a tax deduction for it. Why? One of the main reasons is that your investments grow tax-free over the course of your plan. By tax-free I mean you withdraw funds from the account for qualified college or education expenses without paying federal income tax or federal capital gains tax on the withdrawal.
Also worth noting: 38 states’ 529 plans currently allow education expenses other than college to count as a qualifying withdrawal, which is another misstatement in the advice column. This is a large benefit for most that is likely worth significantly more than a $5000 state tax deduction.
A recent JP Morgan piece illustrates the benefits of using a tax-advantaged 529 plan over a non-tax advantaged account:
In JP Morgan’s example, using a 529 plan instead of a taxable account earns you an extra $41,000 in tax savings. That could pay for two whole years of college. Again, this “free” advice is costing the reader money.
Overfunding a 529 Plan
If you overfund a 529 account, which for the vast majority of people will never happen, you have several options: (1) change the beneficiary to another one of your children, (2) change the beneficiary to a grandchild, (3) change the beneficiary to yourself or your spouse, and use the funds for your own education, or (4) change the beneficiary to another qualifying relative.
Some restrictions may apply to the frequency of beneficiary changes, depending on the state plan you use.
In fact, many ultra-wealthy maximize contributions to 529 plans as a form of intergenerational wealth transfer, and as a way to avoid income and/or estate taxes.
Please note that changing beneficiaries may result in a generation-skipping transfer tax. Please consult with a tax professional before making any changes as only your tax professional knows your full tax situation.
There Are Limits for 529 Plan Contributions
The columnist states that “there’s no limit on how much you can contribute annually.” This is true for every 529 plan, but is also an over-simplification. Every state has a maximum contribution limit per beneficiary ranging from $235,000 (Mississippi) up to $529,000 (California).
While you may never reach that maximum, a contribution to a 529 plan for someone other than yourself is considered a gift by the IRS. Even if no extra tax is due, any gift over $16,000 (per person, per year) necessitates filing a gift tax return1.
What You Should Do Now
If you’d like to read in more detail on planning for your child’s college education, read Advisor Amanda Vaught’s piece: “Give Your Child the Gift of College Education”.
We recommend that you use a financial professional to help plan for your child’s college savings strategy – not an advice columnist.
1This is for educational purposes only and is not tax advice. Always consult your own tax professional.