In this episode, Justin and Jared discuss why they think 529 plans are overrated. We discuss the 529 to Roth rollover provision, the state income tax deduction, and the tradeoffs and benefits of locking funds into an account earmarked for education funding.

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Welcome to Financial Planning for Oil and Gas Professionals, hosted by certified financial planners Justin Brownlee and Jared Machen of Brownlee Wealth Management, the only podcast dedicated to those of you in the oil and gas profession to help you optimize investments, lower future taxes, and grow your wealth.

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Welcome back to another episode of FPO Insurance Financial Planning for Oil and Gas Professionals.

This week on the podcast, we're going to talk about why 529s are overrated.

And Justin, we have actually talked about 529s before.

And it's interesting because to date that podcast, there's a big piece of legislation that has come out that we'll talk about.

That's the 529 to Roth rollover.

So when last time we recorded, that piece of legislation wasn't even in existence.

So this will be little bit different conversation because that was a more existential thinking about education in general of like, hey, what is the value of college and how do you fund it?

This is specifically talking about the 529 plan.

Where do you want to start this conversation?

Jared?

There's so much I want to talk about with 529s.

I feel like I have a different answer in terms of do I personally want to allocate funds to 529s?

Should our clients put money in 529 plans?

And then, Jared, I, I really think if we look at five kind of different families, I might have three or four different answers on how to approach 529 planning across five families.

And so there is an element where, hey, there's some universal truths with them.

There's, there's kind of some textbook financial planning answers, but there's a lot of variability and there's just a wide spectrum of how you can approach the decision of how to pay for college.

Would you agree with the assessment that 529s are overrated?

Yes, I think 529s are overrated.

I do.

And to be, to clarify, that doesn't mean they're valueless.

That just means relative to the hype and the energy and attention that's bestowed upon them might be, might be a little overrated for reasons we'll talk about.

Justin, which reason?

You know, I know, I know.

We kind of have a few marked down.

What reason do you want to start with in terms of why, why you think 529 plans are overrated?

I think the biggest thing for me, I mean the number one point for me is when you look at a balance sheet, like your balance sheet, a personal financial plan, look at a personal list of your assets, you're going to look at assets in different tax registrations and different account entities.

And so you might have some funds in a Roth IRA, in a 401, in a checking account, in a CD High Yield Savings account, and then brokerage investing, Jared, at the end of the day, brokerage or non retirement dollars, those are really important dollars for the vast majority of families, even families that are doing very well financially and making, you know, a top one or top 5% income.

So even at the, at the top of the food chain economically there is still enormous competition for those kind of sacred non retirement dollars.

So the question of are you going to allocate them to a 529?

It is a zero sum game, right?

If you're putting, you know, let's just go with the annual gift exclusion.

If you're putting $19,000 into a 529 plan, well, that means that, that $19,000 is not going into something else.

So I think that's my beef with it.

But where would you start?

Yeah, I mean, I think the just the thesis is like 529 plans are more valuable the early you start.

But it's kind of a circular reference because like if I have a 15 year old and I start funding, the value of the 529 plan is less valuable.

But my range of outcomes in terms of what I think this kid is going to do or use the funds for or if they're going to need the funds.

So much more clarity, so much more clarity versus, you know, my son Ellis, who just turned 2, figuring out, you know, this is the time to fund it.

And you and I will talk about our personal approaches, but like, like the time it's best to fund it, it's the hardest to know.

So like figuring out like the range of outcomes is super wide.

So you getting really precise and close to that is just really difficult to do.

It's a good point, but I think we can all agree that Ellis is going Ivy League, right?

Yeah, yeah.

If, if it were up to me, he played lacrosse like I do and you know, I wouldn't have to pay any out of pocket.

But, but so like, so the first part is, so it's really difficult to know.

The next part is the cost of being wrong is high.

Right?

Like, so like, so if you think about like a non529 plan and you're, you say, hey, I'm going to, I'm going to fund a 529 plan.

You have one kid, your kid ends up getting a full ride to play lacrosse somewhere.

And you want to, you know, you want to make distributions from that account for non education purposes.

The appreciation is taxed at income rates and there's a 10% penalty.

Conversely, you know, like if you would have just put that money in a brokerage account, that's tax capital gains, right?

So to put like really crystal clear math on it, make it super simple.

If you have a hundred thousand dollars in an account, 50,000, you contributed 50,000 in appreciation.

If I make a distribution from a broker, let's say that's in a brokerage account and I go and spend it on, you know, down payment for a vacation home, I'm going to pay, you know, the $50,000 in appreciation times 23.8% which is the top capital gains tax bracket with a little surtax on there, estimated taxes of about 11,900 on making that $100,000 available to me, right?

Because 50k is my investment, 50k is the appreciation tax to cap gains rate.

Conversely, if Ellis doesn't use the 529 plan and I have that and I want to use it to fund the second home, okay, 50K in, in my investment, not taxable.

The 50K that was appreciation and it's taxed at income, not capital gains.

And if I'm in the highest marginal tax bracket, that's 39% plus a 10% penalty.

So in that scenario, I'm paying 24,000, an estimated tax rate of $24,000.

So more than double the tax for the same amount of appreciation just because the bucket it's in is tax tax advantage exclusively for education.

So like there's a lot of optionality given up in that scenario to me.

And Jared, your example is so, so helpful.

But your example is also potentially worse than, than it, than it could be in reality, or let me phrase it this way, the capital gains benefit could even be better because you could time the capital gains to where you're not at the highest capital gains tax bracket.

You could time it to where you don't have the extra net investment income tax of 3.8% tacked on there.

Jared, you could also be someone who does annual charitable giving.

And then you could look across your balance sheet and instead of giving cash, you could give that $50,000 appreciated security and then you could just spend the cash.

So there's so many more options when it's in a brokerage account, there's so many more tax options.

There's so many more distribution options.

It's, it's just significantly more liquid.

Right?

Yeah.

And I mean too.

Right.

Like if your kid doesn't go to school, but you want to use it for your kid and your kid wants to buy a home and you want to help with the down payment.

Right.

Like, tough luck.

Yeah, tough luck.

And you have a big penalty there.

But like, you know, you could gift stock in a brokerage account and your kid could have a very different capital gains rate than you do.

Yeah.

Right.

So there's, you see.

So again, it's just, it's not that 529s are bad.

It just really is like they're supercharged if it's education.

And we'll talk about, you know, how some of the benefits are potentially overstated.

But, you know, you really kind of box yourself in.

So there needs to be a high degree of precision and clarity that, that you are going to use this for education.

Yep, that's well put.

All right, Justin, we got to talk about state income tax deduction next because I think like in for our audience, like most of our listeners are from Texas.

They might not live in Texas currently, but, you know, spent a lot of their formative years and money making years in Texas.

And Texas has no state income tax.

And so I think like that's a big con against the 529 plan, in my opinion, 100%.

If we were having this conversation in a high income tax state, Jared, we may not have this conversation.

529 planning is better if you're in a state that has a state income tax and you're able to enjoy a meaningful state income tax deduction through annual 529 contributions.

I mean, Jared, what do you think about this, though?

It also varies widely state to state.

Right.

I mean, there's a big difference between a state that's taxing you at less than 5% on your income versus a state that's taxing you at 12, 13%.

But then there's also even more complexity because regardless of your state's marginal income tax rate, well, they may have governors and limits on the deductibility of 529 contributions.

So you may not be able to do the mega fund for our listeners.

Quick definition there.

Mega funding of 529 is when you lump five years of the annual gift exclusion into one year, Jared.

So what does that even mean?

Right now the annual gift exclusion is $19,000 a year.

So then theoretically you could lump five years of $19,000 gifts.

So that is $90,000 that you could kind of mega fund a 529.

But if you're in a state income tax state that has a limit on 529 contributions, you may not get to realize all 90,000 of a deduction there.

Yeah, yeah.

And like we'll make this super tangible.

Right.

I just Real quick, Jared, apologies to my audience for my math.

95.

It's 95.

95,000.

I can't believe you're just going to let me get away with that.

I see.

Sometimes we'll plant nuggets for hopefully to create engagement.

Right.

I would love, I would.

For somebody to see like, hey, it was 95, not 90.

But yeah, I did notice that.

I was just gonna, I was just gonna let it ride.

What's funny is, you know, the IRS changes the contribution limits on basically every different type of plan, you know, year in, year out.

So it used to be 18,000 and then the math would have been right.

That's the problem with the tax code.

The moment I get my arms around it or get the numbers memorized, it changes.

I think we gotta blame the IRS on this one.

Yes.

I shouldn't be blamed for that math error.

It's all on the irs.

One of the craziest examples of this quick aside, when I was studying for the cfp, they passed Tax Cuts and Jobs act in the middle of it.

Oh my.

So I, But I was, I was phased into the old tax code.

So I was, I was studying tax code that was irrelevant.

That is miserable.

Yeah.

And I knew I was going to have to forget it all.

But like the, the phase in of way the exams worked, I, I spent a good amount of time studying tax code that I knew was no longer relevant.

So that's amazing.

Yeah.

So that's okay.

So let's talk about Arkansas.

Right.

Because like that's where I just moved here from.

And like this is a good example to kind of illustrate this point.

You're talking about of like, hey, it really dependent, right?

Like California, New York.

You're talking about a top marginal bracket of, you know, greater than 10%.

But Arkansas's top marginal bracket is 3.9%.

So like if I do the math.

And of course there's filing caps too.

So you know, married, filing jointly, you can.

$10,000 reduces your state income taxable.

You know, state income tax liability or, or your income for computation of your state income tax liability.

So if I make 18 years of contributions and my effective, you know, that's $180,000 and I'm doing, you know, 10K a year to get the maximum state income tax deduction, but is only 3.9%.

I saved an estimated $7,000 in taxes over 18 years.

Yeah, so you're saving like a couple hundred bucks a year or so.

My time would be better spent signing up for a credit card.

Honest.

One credit card a year, you know, and kind of playing that game, which I would love to have a podcast talk about that because I'm in the weeds.

But like, that's, that's like a really good example of like, okay, what's the return on that?

Like, and then the other problem is I have to make the contributions over 18 years.

We'll talk about it later.

But like, what makes 529 plans really work is having a high percentage of appreciation and using it for education because you, you don't have to pay taxes on the appreciation if it's for education expenses.

You know, if I'm funding 180,000 cumulatively, I'd be much better off from an appreciation perspective if I funded it earlier.

And for what if in lieu of the state income tax deduction.

I want to repeat what you just said in a different way because it's a very important point.

So in this Arkansas example, you would think that the way to optimize your tax situation is to make annual contributions like $10,000 a year so that you're able to enjoy the state income tax deduction for 529s.

But that is not how you optimize a 529 in Arkansas for taxes, most likely depending on market returns.

If you really want to optimize it, you're far more focused not on the annual state income tax deduction.

Instead you're focused on the kind of Roth aspect of a 529.

You put money in and it grows tax free and then you can take it out tax free, assuming it's a qualified educational expense.

So the way to optimize it, if you're trying to optimize for taxes, is really to ignore the annual state income tax deduction on contributions and instead just enjoy that tax free growth.

Which again, I want to kind of make sure we're super, super specific here.

That goes back to the point you made with your son.

It's a really tricky dynamic.

Your son is 2.

And so the way that you really get the Greatest tax benefit is you put a ton of money into a 529 right now or one or two years ago, and you allow more than a decade, more than a decade and a half of tax free.

Compounding that is a greater benefit than a tiny annual deductible portion of a contribution.

Yeah, yeah, that's exactly right.

So it's, you know, there's, there's trade offs in terms of timing.

Right.

And like the, and I would say the state income tax deduction can really cloud your judgment.

And I want to repeat something that you also said five, 10 minutes ago.

That is the conundrum here.

The greatest tax benefit is the way to plan this out is to put a lot of money in a 529 when a child is very, very young.

I'm starting to get on the other end of that spectrum from you, Jared.

My oldest child is 11.

And guess what?

We don't know exactly what higher education is going to look like, but we do have more clarity than we had when our, when our kids were two years old.

And so that's the conundrum.

Greatest tax benefit is put a lot of money in there very, very early.

But to Jared's point, you're just not going to have a whole lot of clarity on what higher education is even going to look like for your child specifically.

And so you might be allocating dollars that, you know, who knows whether they're going to be used or not.

Yeah, yeah.

And I mean, that's the thing is like, you know, I think this conversation is, is the 529 plan worth the restrictions?

Right.

It's like we, we're staunch advocates of, hey, let's fund this expense and like, let's mentally account for it and make sure we're saving towards it.

Assuming you're saving for retirement appropriately.

Right.

Or you, that your retirement nest egg is growing appropriately.

But like, is this, is this container and the constraints that it creates worth, you know, worth it?

And, and I might say, huh, yeah, it's probably, probably what I'd say.

I think that's a really good point.

Another way to phrase this, if you're in a situation where you have, you know, maybe you have enough assets to eventually retire, but you're not going to have significantly more assets than you need, well, then I would make a strong argument to forego 529s.

I would probably make the argument, don't pay for college for your children.

You cannot wake up at 72.

And if you've already retired, you can't find A way to restart your career in most cases and continue earning years, but your children can.

And so you never want to be in a situation where you're allocating dollars to a 529 and that puts you in a precarious situation in retirement.

And so I think it, it all goes back to what we've said.

Excess discretionary dollars for investment are a little bit, quote unquote sacred.

And so you need to be very careful about how you allocate them.

Yeah, and I would say there's a, there's a segment of our audience that isn't solving, hey, I have tons of, I have tons of excess cash flow.

My main problem is like an estate tax problem.

And to that portion of our audience, I would think about tuition, direct tuition payments, right?

Like, like if, if you're in the bucket of hey, I'm just trying to get money tax deferred away, use my annual gift exclusion crummy trust could make more sense because there's more flexibility, you know, not the same constraints or having grandparents pay tuition payments directly, right?

So like if I make an, like, because tuition payments are a non reportable gift.

So if I, you know, if my kid goes to a small school and tuition small, you know, liberal arts college and it's $40,000 a year, I could have a parent, I could have an in law or a parent pay that amount and then also make annual gift tax exclusion and the annual gift exclusion and those don't, you know, those aren't aggregated.

And so there's a kind of a unique wrinkle there where, you know, maybe it does make sense to just pay out of pocket because how, you know, tuition payments are coded from a gift tax perspective.

See that's, that's why this is even more of a hairy topic because there is an element where for the first 10, 15 minutes of our discussion, Jared, I was thinking that, you know, if a family has, let's say it's 50 million or 500 million or 5 billion, well then it does make sense to just allocate to a 529 and put $90,000 in there when a child is very young because you know you have more assets than you're going to spend.

So that's a great way to allocate them wisely.

But the point you're making is something I want our listeners to make sure you understand.

That's a very important point.

Tuition payments are not a reportable gift.

So if you do have a really substantial estate, one of the biggest things you're Trying to think through is how do I get money out of my estate in the most efficient manner?

And let's say you have four kids, maybe you have 10 grandkids, and four of them are in college at the same time, and the total tuition payments on an annual basis are $200,000 a year.

Well, as a grandparent, you can pay those $200,000 tuition payments and it doesn't even count on your annual gift exclusion.

And so all of the sudden, that's a really strategic way to just go ahead, make those payments and still make annual gifts on top of other significant estate planning, obviously.

But that's the fascinating point there.

Even if you have far more assets than you're going to need, it's still a tricky question on what's the most efficient way to approach college funding?

Yeah, yeah, but so like, again, we're not making the claim that 529s are bad, they're just overrated.

When might it be like a valuable tool?

Like what segment of our audience?

And there's probably people thinking about, but what about the Roth IRA?

You know, the Roth IRA rollover of 529 plans?

Like, who are 529 plans a good fit for?

It sounds like we kind of talked about people that are starting early so that, that they have a lot of, you know, a lot of their account balance will be appreciation versus contributions.

Right.

And they have a decent idea that they'll pay some form of higher education.

Who else or what people, in what situation might, might 529s kind of make sense for?

I think it often makes sense for a younger family that has one of these two things that are, that are true of them.

One, they have a really substantial income and a high probability that that high income is going to continue for decades.

And then the other one is you might be a young family that already has really significant assets.

Because in both of those situations, what is helpful with a 529 is you're effectively labeling those dollars, you are allocating those dollars.

You're putting a purpose to those dollars within your balance sheet and you're kind of setting them aside.

I want to add another factor.

So, Jared, we've talked about the unfortunate reality that if you overfund a 529, you're really dinged on it.

So another factor here is if you have four or five kids, it is a no brainer to really mega fund a couple or a few 529 plans.

Our audience, you may already know this, but it is important to remember you can change the beneficiary on a 529, really, whenever you want.

And so it's not a big deal if you end up, let's say your oldest child gets a full ride scholarship and you don't need to use any of that 529 plan.

Well, if you have a lot of kids, you can just change the beneficiary to the next one.

And then I think the other element is, worst case scenario, you can also change the beneficiary and play a very long game and skip a generation.

Right.

And so you could have, maybe it's overfunded for your children, but then you could wait for grandchildren to come along, change the beneficiary to them.

And so that can be a use.

So I think, Jared, the ten second version of what I'm trying to say, a 529 can make sense if you have significantly more assets than you're likely going to need or income mixed with enough children for it to kind of hit the sweet spot.

Yeah, I would say, yeah.

529 beats taxable brokerage, but it's a function of what are the odds these expenses get you this, these funds get used for college, right?

Yep.

And it doesn't have to be your, it doesn't have to be this kid's specific college.

So if you have more kids, odds go down if a private school is also eligible.

So if you have, you know, if you know you're going to send your kids to private school.

Yeah.

You know, the odds of this bucket that you've earmarked for education expenses, you know, if you have a bunch of kids, if you're going to private school, or if you have substantial assets and you can change beneficiaries to, you know, grandkids and you're okay with that outcome and your retirement isn't contingent on doing that.

You know, it could make a ton of sense.

And I just want to talk about the Roth really quick because like, you know, there's a lot of buzz in the media about, hey, there's a Roth conversion option and it's just not that.

Big of a benefit.

I mean, the limit is low.

The cumulative amount you can fund is 35,000, to be clear, which isn't nothing, especially if you get it in while the child is younger, because, you know, compounding can do its thing.

So that's a material amount of money.

But the account must have been opened for 15.

Right.

So I would argue, you know, when does a 529 make sense?

When you start early and when there's a high probability that it's used for education.

So like the Roth rollover is kind of interesting.

And then it has to be made, you know, you can use annual contributions which the current rate is.

The current limit is $7,000 a year.

So five years of $7,000 a year gets you to the 35,000 that you can convert from 529 to Roth.

Again, which isn't, that's, that's a material amount of money.

But again if, if you're trying to fully fund education and you over fund, this isn't going to take all that money out tax free.

Yep.

Right.

So like, so I think it could be helpful.

But again, you want to make a measured approach with college funding because there's not a lot of eject buttons that don't involve substantial taxes.

That's a great point and I'm glad you mentioned private school on the K through 12 level.

That is a huge factor that I meant to mention in my prior point.

You're in a situation where your kids are going to go to private school.

Well, that makes it much more likely that you're going to be able to spend it.

Jared, I will say that if you have kids that are under five, you're planning on doing private school and you have really significant assets.

I do like the idea of mega funding, but even then if I'm in Texas and there's no state income tax deduction, I am tempted to still maybe cash flow the first few years of elementary school just so that I can still realize some of the actual benefits benefit of a 529 which is tax free growth.

You're not getting a huge tax free growth benefit if the money is in there for 18 months.

You're getting a huge benefit when it's in there for 4 years, 8 years, 12 years, 18 years.

And then when we think about the kind of multiple generation approach to 529 planning, private school is a huge deal there as well.

So let's say that you do significantly fund a 529 and let's say it grows to $400,000 and well, your oldest child gets a full ride and let's say you do need to kind of then wait for them to have kids.

Well, if there's several hundred thousand dollars in a 529 but there's multiple grandkids doing private school for all of K12, then you're okay, that's probably going to be used.

But it goes right back to what we said of it's really hard to plan those things out.

Yeah.

And everybody's approach is different.

Right.

I think, like, I'll kind of end here.

Like, I gotta caveat this with, I have a 529 plan for Ellis.

Right.

And like, what led me to make that decision, I think is principally mental accounting.

Right.

Like, I just love the idea of like having a bucket of money that I know is earmarked for those expenses and I could commingle em with brokerage assets, but I, I don't really want to.

I kind of like having that.

And I'm also, you know, I'm a points nerd.

So, like, I'll over optimize and it's completely dilutive.

But like, the idea of getting the state income tax deduction is not financially meaningful.

But feels nice, you know?

Feels like I'm sticking it to the man a little bit.

Yeah.

But.

But, you know, I think, I think it's personal for everybody.

But.

But now that I'm.

Now that I'm in Texas, I'm a little less inclined to do it.

But I think inertia is a powerful thing.

I'll probably keep funding it just because I am and it's easier and, you know, it's mentally kind of spoken for and accounted for.

Okay, this is helpful.

So you have a 529 and are funding it.

I do not have a 529 for my kids currently.

And will I set one up?

I'm not opposed to it.

And I also look at your situation, Jared, and I think that's fantastic.

Like, I think, I think that is a good financial decision.

So I'm not, you know, I'm not, I'm not wholly against them by any means, but for me, it goes back to the competition of discretionary non retirement dollars.

And right now it doesn't make sense.

We want to pursue other things, but I, I don't think that's a universal answer.

Yeah.

And I mean, I think that's, that's where we'll kind of land the plane is like, it's, it's very personal.

But, you know, I, I think to say, hey, this is the best account.

I'm, I'm funding college.

This is the account I need to use.

I think it's a.

It's simple, but.

But it might not be optimal.

So think about you, your situation, what you want, how you want to provide for your kids, what that looks like, and the probability that this account gets used for education and that it doesn't undermine your ability to retire successfully.

Well, awesome.

That's we'll wrap it up there.

Always love chatting about education and especially love your vantage point because we're have different approaches and different age kids, so it'll be fun to kind of see.

Every five years you probably need to check in and see how our how our stances change because it's evolving.

As tax laws change, our kids get clarity and so it'll be fun ongoing conversation.

I'm sure when we record an updated one in five years, there'll be new tax law to talk about.

So until next time, it'll be great.

Emails Future for Future podcast episodes podcastrowealthmanagement.com thanks.

We'll see you next time.

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