We have questions regarding 529 plans on a weekly basis in our communities. This is not surprising, as planning for children’s educational expenses is an important financial priority for many physician families. This article covers some of the most common questions we see about 529s, including what funds can be used for, which states offer the best plans, and superfunding options.
Before we delve into 529 plans, a reminder that you should always take care of your retirement prior to funding your children’s education. While there are loans available to finance education, there is no guarantee that anyone will subsidize your needs in retirement, so we are big believers in the first financial priority being to contribute to your retirement accounts. After that, 529s are an excellent vehicle for tax-free growth of contributions intended to be used for educational purposes.
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Introduction to 529 Plans For Physicians
A 529 account is a state-sponsored plan designed to encourage you to save for and invest in educational expenses, such as college tuition or books. These are typically used by physicians for children’s college savings, but can also be used in other ways. Your contributions are made in post-tax dollars, so this is not a tax deduction. However, when used for qualified educational expenses, the amount contributed as well as the gains on those contributions are distributed tax free.
We often talk about the power of compounding growth, which is especially powerful in accounts that grow tax-free such as 529s and Roth accounts. It’s also why it’s a good idea to fund 529 plans as much as you can as early as possible, allowing for maximum tax-free growth.
How Much Can I Contribute?
In 2023, the contribution limit was $17,000 per parent, per child before worrying about the annual gift tax. This means if you are married and have two children, you can contribute up to $17,000 into a plan with one child as the beneficiary and another $17,000 into a different plan for the second child. Your spouse will also be able to do the same, for a total of $34,000 per child per year.
(Note: if you’ve made other gifts to the beneficiary outside of the 529 plan, those amounts will reduce your 529 plan contribution limit, as it’s all compiled together on the gift tax form you file.)
There’s also an option to superfund 529 plans, which we cover below.
Ownership Structure for 529 Plans
Let’s say you want to establish an account to start saving for your newborn daughter (congratulations!). The account ownership will belong to you if you are the one who opens it, but you will select your daughter as the beneficiary. The parent does not have to be the owner of an account. A grandparent, aunt, or other family member can also open and fund the account, naming your daughter as the beneficiary. You can also open up an account listing yourself as a beneficiary if you don’t currently have kids, then transfer it later.
One of the advantages to this structure is that if your child doesn’t end up using all of the funds, or doesn’t use them at all, you have the ability to change the beneficiary to another child in the future, or to another family member or yourself. The account can be transferred, penalty and tax free, to other family members besides children.
The owner of the account maintains control of the use of the funds. Unlike some other college savings accounts, such as an UTMA, the ownership does not switch over to the beneficiary at an established age. This is an important point for physicians to consider when offered the UTMA as an alternative, as you may not want your child to have access to a large amount of money at a relatively young age, as once that money is relinquished to their control, they can do anything they want with it, and even use it as an excuse to not continue their education, which would defeat the purpose of saving for college.
Since you are the owner of the account and are listing a beneficiary, this is where the annual gift tax limit comes into play that we mentioned above. Any contribution made over the annual gifting limits, minus the superfunding exclusion below, is subject to gift tax laws.
529 Plans Versus Prepaid Tuition Plans
529 plans differ from prepaid tuition plans. With prepaid tuition plans, you typically pay future college expenses at the current tuition and fees rates. We recommend 529 plans over prepaid tuition plans as they have more opportunities for use, a wider range of options, and better tax advantages overall.
Prepaid tuition plans also generally have residency requirements, limiting you to purchasing the prepaid plan for the state you live in. 529 plans don’t carry the same restrictions. While 529 plans are still state-sponsored, you can pick a plan from any state. Your selection of which state’s 529 plan to use doesn’t dictate while the funds must be used. For example, a New York 529 plan doesn’t not have to be used to go to college only in New York.
529 Plan Options
As mentioned above, 529 plans are state-sponsored, which means each state has their own, different plan.
Each state 529 plan has different fees and available investment options. When assessing fees while shopping around, consider not just the stated account fees but also the expense ratios of the funds available within the plan. These fees are internal to the funds, so you never see them taken directly out of your account (they are withheld before gains and dividends are made by the fund manager). They can add up and drastically lower your potential for compounding growth before you withdraw funds.
Several states offer more than one plan. Typically, multi-option states offer a higher fee broker option that’s more a managed account and a lower fee, DIY approach. If you’re comfortable doing a little more research upfront, we recommend the cheaper DIY option, especially since it’s a tax-advantaged account. For resources on learning about investing, visit our investing page and our books page. Many physicians elect to be fairly aggressive in their asset allocation choices for 529 plans, favoring the potential for large tax free returns and being comfortable with the risk that if the investments underperform, they will have to pay for some college expenses out of pocket separate from the 529s.
Some states offer matching grant programs. There are different rules for each program, but it’s similar to an employer match on sponsored retirement plans like the 401(k). For every amount you contribute (up to a certain limit), they match a portion or all of your contributions. Research the specific grant program details for your state, if any, as many states limit factors such as beneficiary’s age and income.
Some states also offer state income tax deductions or credits.
Best States for 529 Plans
If your state offers matching options or income tax deductions or credits, it’s often best to use your state’s plans. Of course, look at the plan features overall. A small matching program on a high-fee investing plan option often isn’t worth the potential losses in long-term tax free gains.
If your state doesn’t offer benefits for using their 529 plan, then it often makes sense to shop around.
In our Facebook communities, the following states are often recommended for physicians for their overall benefits and options:
If you’re overwhelmed with the process, reach out to a financial advisor from our database to help you assess the different options and guide you to the best fit.
What 529 Plans Can Be Used For
These plans were originally designed for college savings only, but tax laws have expanded over the years, making them a great savings tool for parents. Different types of expenses you can use a 529 plan for now include:
Withdrawing funds from a 529 for uses other than these can come with a tax penalty, but fortunately the government has expanded over the years different ways to spend 529 plans.
The tax penalty - 10% of the money withdrawn for non-eligible purchases, along with your regular income tax - is a hefty fine, so we don’t recommend dipping into 529 plans for other expenses. We’ll cover options for overfunded plans below.
Covered College Expenses
529 plans can be used for:
College tuition and fees
Other college expenses (under certain limits), such as
Food and meal plans
Textbooks and supplies
Technology items required by their program of study (laptops, software, etc.)
Student loans (there is a limit, so make sure you check the rules)
Other Educational Expenses
While the 529 plan was originally set up as a college savings plan, it has since expanded to include tax- and penalty-free use for these other qualified expenses:
Trade school and vocational school tuition and fees
Some business expenses (purchased while they’re still in school; restrictions apply)
Private elementary or secondary school tuition (up to $10,000 per year)
Homeschooling expenses (in some states)
Superfunding 529 Plans
One of the nice features for high-income, high-investing individuals is the ability to superfund 529 plans. This feature allows you to contribute up to five years of contributions at once. With the $17,000 annual limit per child per parent, this means you can contribute up to $85,000 per child per parent once every five years.
As a reminder, the $17,000 limit is per person to each person. So if you are married, you and your spouse can both superfund $85,000, for a total of $170,000 per child every five years.
Superfunding pro-rates your contribution over the five-year period. So doing a large contribution up front affects your gift tax limits for the following four years until that five-year term is complete. If you plan to superfund, we recommend doing as much up front as you think you’ll need. If you aren’t in the position to do that this year, you can do the regular contribution this year and then superfund next year (or the year after) once you’ve had enough time to plan and save.
Remember, the contribution limit for 529 plans is dedicated by annual gifting limits, so if you make other gifts outside of the 529, this will affect how your superfunding is prorated. In this situation, you may benefit from discussing your options with an accountant.
What Happens If You Overfund 529 Plans
With the option of frontloading tens of thousands of contributions with the superfunding loophole, you might be concerned about overfunding the plan and having to withdraw with penalty and interest later. Good news: there are plenty of ways to help get unused funds out of a 529 plan if the beneficiary ends up not needing or using them.
Transfer to a Different Beneficiary
You are able to transfer 529 funds easily to other family members. One small caveat is the generation-skipping tax, which states that if the new beneficiary is two or more generations apart from the previous beneficiary, gift tax rules will apply and could limit the amount you can transfer.
Student Loan Repayment
The SECURE Act allows up to $10,000 to be used from a 529 plan for the purpose of student loan repayments. Just note, this is not an annual limit, this is a lifetime limit per beneficiary. So, for example, if you transfer the account from your name after repaying $10,000 to your student loans to your husband’s name, he could also repay $10,000 of his student loans.
New Roth IRA Rollover Option Coming
Starting in 2024, the SECURE Act also allows you to rollover unused 529 plan funds into a Roth IRA, which is also tax-free growth and distribution (past a certain age restriction). The graphic below summarizes some of the rules and restrictions for this new future.
If the beneficiary receives scholarships, you can withdraw an amount equal to the value of the scholarship without having to pay the penalty, though you will have to pay taxes on the earnings, so this isn’t one of our favorite options.
As high-income earners, physicians often have to get more creative when assessing tax optimization opportunities. 529 plans are a great way to help with your estate planning when it comes to children and grandchildren. We want to make sure you solidify your financial independence, but then we recommend exploring 529 plans as a great way to help save with a tax-advantaged strategy toward future educational expenses.