Overfunding a 529 plan? The results may surprise you
The results are in: A new J.P. Morgan study finds that a 529 account is the most tax-efficient way to save for a student’s education—but only if that account is depleted by the time the student completes their education.1
Further, our analysis of the 529 plans’ 25-year history found that these accounts:
- Work best as a vehicle for funding the education of a single beneficiary and/or relatives of the same generation
- Are not a good way to create an educational nest egg for multiple generations
Indeed, if one’s aim is to build wealth for multiple generations, the most tax-efficient choices would be the pay-as-you-go approach to funding education–or creating Uniform Transfers to Minors Act (UTMA) accounts for members of younger generations.
The tax cost of overfunding a 529 account
Some taxpayers have deliberately overfunded 529 accounts, thinking they would benefit multiple generations by doing so. This can be a mistake—as they’ll find themselves facing an unpleasant (i.e., taxable) choice when the initial beneficiary finishes school:
- They could take back the money in the 529 account, or give it to the student. However, in both cases, taxes and penalties must paid on the earnings at the recipient’s ordinary income tax rate.
- Or, they could pass the account on to a lower generation (e.g., grandchildren). But there would be a tax price for this option as well. The initial beneficiary might have to use some of the $12.06 million gift tax exclusion when a new beneficiary is named.
Weigh your options
Consider the choices a father (Tom) had for funding the education of a daughter (Jane) born on January 1, 1997, the first full year after Section 529 of the Internal Revenue Code was enacted. Tom could have:
- Taken a pay-as-you-go approach—Paid Jane’s higher education costs as she incurred them, understanding the risks involved. (Would he still have enough money? Would he still be alive?)
- Funded an UTMA account—Funded the account annually with the annual exclusion amount ($10,000 in 1997, now $16,000). Jane would have gained full control of any assets in the account when she turned 21 (per the law in most states).
- Set up a trust for Jane’s benefit—Funded a trust each year with the annual exclusion amount, accepting that trusts (especially smaller ones) are costlier to create and administer than UTMA accounts. A grantor trust (i.e., the grantor pays the tax on trust income) would be more tax efficient than a non-grantor trust (the trust or beneficiary pays the taxes).
- Funded or super-funded a 529 account—Funded a 529 account with the annual exclusion amount. Or, as the law allows, super-funded a 529 account with five times the annual exclusion amount. Tom chose to super-fund in 1997, 2002, 2007, 2012 and 2017.2
* After Jane's schooling is complete
Source: J.P. Morgan as of 5/15/2022
Note: This data reflects two assumptions: 1) Jane went to an average-priced college as a full-time student for four years starting in 2015, when she turned 18; and 2) Tom made the maximum contribution to the account each year.
The tax bill comes due
When Jane graduated, Tom had to deal with the assets remaining in the account. One potential option—to name as a new beneficiary another child or relative in the same generation as Jane—was not available to him. Thus, Tom’s choices were:
- Take the distribution himself. Tom could take back the assets and pay taxes on the earnings (not on the original contribution), which would be subject to income tax at ordinary rates, plus a 10% penalty. If Tom is in the highest tax bracket (which he would be if he were single and his taxable income exceeded $539,000 in 2022), that would mean a 37% levy on the earnings, plus the penalty.
- Distribute everything to Jane. The advantage here is that Jane would probably be in a lower tax bracket than Tom. If she were earning the average salary of a recent college graduate (around $55,000), she would be in the 22% bracket. Thus, even if Tom were to distribute to her all $347,000—not all of which would be considered earnings subject to tax and penalty—it is possible that none of that distribution would be subject to tax at 37%.3
- Name a new beneficiary in a lower generation (presumably a grandchild). The problem with this approach is that proposed regulations would consider this change a gift by Jane of the account balance (not just the earnings) to the new beneficiary. As such, it would consume some of Jane’s lifetime gift-tax exclusion (currently, $12.06 million)—although the impact of the gift would be ameliorated by Jane’s use of her $16,000 annual exclusion. Our analysis shows this is economically among the least-attractive alternatives.
** After 529 assets distributed or beneficiary changed
Source: J.P. Morgan as of 5/15/2022
Note: Data assumes that Tom and Jane are in the same tax bracket.
A more tax-efficient path
In sum: A 529 account is the most tax-efficient education savings alternative, but only if the account is exhausted when the student’s education is completed.
If a significant balance remains when a student’s education is completed (as in our example): After factoring in the taxes and penalties due after a distribution to either Tom or Jane, or after naming Jane’s child as a beneficiary, the pay-as-you go method is actually the most tax-efficient approach.
Remember the states
One additional thought: States treat 529 accounts differently. For example, some states allow for state income tax deductions for the amount contributed; others don’t. Similarly, only some states allow for tax-free payments of up to $10,000 of qualified education expenses for kindergarten through 12th grade (a provision Congress adopted in 2017). In considering the impact of 529 accounts on family wealth, bear in mind the impact of state tax laws as well.
We can help
Your J.P. Morgan team can help you evaluate various options for funding education expenses for younger family members. For more information, ask your J.P. Morgan team for a copy of The Well-Prepared Family: Funding Education.
Depending upon the laws of the home state of the customer or designated beneficiary, favorable state tax treatment or other benefits offered by such home state for investing in 529 Plans may be available only if the customer invests in the home state‘s 529 Plan. Any state-based benefit offered with respect to a particular 529 Plan should be one of many appropriately weighted factors to be considered in making an investment decision; and you should consult with your financial, tax or other adviser to learn more about how state-based benefits (including any limitations) would apply to your specific circumstances.
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