Using A 529 Plan For Generational Wealth Transfer Purposes

If you’re a parent, you might consider starting a 529 plan for generational wealth transfer purposes in addition to paying for your child’s education. Even if you are not a parent yet, you should consider opening up a 529 plan. You can open the 529 plan in your name and change the beneficiary later.

There’s a decent chance the estate tax threshold will eventually come down from its current all-time high of $12.92 million per person in 2023. Further, the number of millionaires in the world is expected to continue growing.

Therefore, using a 529 plan to reduce the value of your estate may help you save on taxes. After all, who wants to pay a 40% death tax rate? It’s better to help fund a loved one’s education in a tax-efficient manner.

529 Plan Quick Overview

To recap, 529 plans are funded with after-tax dollars just like a Roth IRA. The money gets to grow tax-free. All money taken out—including investment gains—is tax-free as long as it is spent on qualified education expenses such as tuition, room and board, books and supplies.

If the money is used for non-educational purposes, you must pay income taxes on the growth plus a 10% penalty. Your original capital contributions are not subject to income taxes or a 10% penalty.

Let me share our original intent for our son’s 529 plan. Then I’ll discuss how the example might evolve for tax-efficient wealth transfer purposes. I’m convinced every parent and parent-to-be should contribute to a 529 plan.

See: Everything To Know About A 529 Education Savings Plan

A 529 Plan For Education First

When our son was born in 2017, we both superfunded his account for a total of $150,000. My mother then contributed another $56,500 over four calendar years to equal a total contribution of $206,500. Given my wife and I superfunded the account, we aren’t allowed to contribute again for five year (2022).

Our 529 plan is up about 41% to $292,000. This is just enough to pay for four years of private college tuition, room, and board today. Sadly, by the time our son goes to college in 2035, four years at a private university will likely cost closer to $600,000, including room and board.

No Merit-Aid Likely, Hence Funding A 529 Plan

Given my wife and I are of average intelligence, it is unlikely our son will get much in merit scholarships. I got a $500 international merit grant for studying abroad in China. My wife also got a $500 grant, mostly because she grew up in a low-income household. Thankfully, William & Mary cost less than $5,000 a year in tuition when we attended.

Further, given we are an overrepresented minority, it is unlikely colleges will look favorably upon our children. This combination of average intelligence and overrepresentation results in us finding different ways to provide for our children.

We’ll also preach the benefits of going to a less expensive public university. However, for financial planning purposes, we conservatively estimate he will attend the most expensive school possible and receive zero free money.

Below is a chart that shows $85,846 of the total 529 plan amount is considered tax-free gains. These gains can be used to pay for college or private grade school.

A 529 Plan To Transfer Wealth To The Next Generation

Given the absurd and rising cost of a college education, I never thought about using a 529 plan as a wealth transfer vehicle. We’re just trying to keep up. However, given billionaires pay such a low percentage of their wealth in taxes and some billionaires have used a Roth IRA to earn millions of tax-free gains, I’m inspired.

Why can’t average people also take full advantage of tax-advantageous financial vehicles? We should and we can!

Here’s an imperfect example of how a 529 plan can transfer wealth in a tax-efficient manner.

529 Plan For Generational Wealth Transfer Purposes

Let’s say my wife and I contribute a combined $30,000 a year for 13 years starting in 2022. If the 529 plan’s fund returns 6% per annum a year, it will grow to $1,223,000 by 2035.

Once an estimated $600,000 of the 529 plan is used up for our son’s college, the 529 plan’s beneficiary can be changed to anybody else we like. Now, instead of starting off at a $0 balance as our son did in 2017, the new beneficiary can start with a $623,000 balance.

Let’s say the new beneficiary is a newborn granddaughter. With zero contributions for 18 years and a 6% compound annual return, the $600,000 will grow to $1,778,000. At a 7% compound annual return, the ending 529 balance grows to $2,105,000.

With whatever is left over after paying for college, the beneficiary can be transferred again.

Essentially, with a 529 plan, you can create a family education endowment that could last several generations if properly managed.

529 Contribution Limits

Unfortunately, it’s currently not possible for us to contribute $30,000 a year to our son’s 529 plan until the year 2035. Once a 529 plan hits a certain amount, contributions are no longer allowed.

Limits vary by state, ranging from $235,000 to $529,000. Where we live in California, the limit is $529,000.

This amount represents what the state believes to be the full cost of attending an expensive school and graduate school, including textbooks and room and board. The limits should go up over time to account for inflation.

Your 529 plan can certainly grow beyond your state’s limit. However, you just can’t contribute any more money to them once that limit is reached.

We could probably contribute $30,000 a year for five years until our son’s 529 reaches the $529,000 limit. This assumes a 6% compound annual growth rate from the plan’s current $292,000 value.

One loophole around this 529 limit for contribution is to create multiple 529 plans. There is no limit to the number of 529 plans you can have.

If you are blessed to live long enough to have 10 grandchildren, you can open up a 529 plan for each grandchild. Or, you can open up multiple 529 plans for all your school-age relatives.

Finally, you are allowed to open a 529 plan for an unborn child. The beneficiary just has to be living. Once the child is born, you can then change the beneficiary.

Open Multiple 529 Plans To Reduct Your Estate’s Value

Let’s say President Biden ends up lowering the estate tax threshold to $5 million per person and $10 million per couple. When you and your wife pass, your estate is worth $12 million. As a result, your estate will face a ~40% tax bill on $2 million. That amount equals ~$800,000.

Instead of paying an $800,000 tax bill, open up ten 529 plans for your 10 grandchildren. Then superfund each of them $150,000 to reduce your estate’s value by $1.5 million. This will save your estate about $600,000 in taxes.

To get your estate down to $10 million and pay no estate taxes, you and your wife can then spend $500,000 on one big massive family vacation. It’s not hard to spend $100,000 a month on a nice beachfront property rental in Hawaii. The YOLO Economy is here to stay. You might as well live it up in your golden years with so much money.

Alternatively, you could superfund another six 529 plans for your nieces and nephews who always wrote hand-written thank you notes after each birthday. Therefore, if you have a rich uncle or aunt, you should really consider developing a closer relationship with them. You might even want to send them this post!

How Much A 529 Plan Reduces Your Estate’s Value

One thing to realize is that not only do your 529 plan contributions reduce your estate’s value, your 529 plan returns must also be included when estimating your estate’s value reduction.

For example, let’s say we contribute $30,000 a year to our son’s 529 plan until it reaches $529,000. It then grows for the next 10 years with zero contributions at a 6% compound annual growth rate. The 529 balance will grow to $947,000. Out of the $947,000, $356,500 is capital contribution.

To only use $356,500 to calculate how much our estate’s value will decline is incorrect. Instead, we must model in an estate value reduction of $947,000. With this proper figure in mind, we can then make proper adjustments to our investments and spending.

If we did not invest $356,500 in a target date fund over a 10-year period, we probably would have invested $356,500 in various investments that would hopefully generate between 5% – 8% a year.

My mother may have likely done the same with her $56,500. At this stage in our financial lives, we like to invest mostly in hard assets for steady single-digit returns.

If your estate is over the estate tax threshold or is on track to breach the estate tax threshold, then opening up many 529 plans and contributing as much as possible to each is a smart move.

Using A 529 Plan Beyond Paying For College

Not only can a 529 plan pay for qualified college expenses, it can now be used to pay up to $10,000 in student debt. Depending on the resource you check, the average student loan debt is between $17,000 – $38,000.

Further, you can use 529s to pay up to $10,000 a year toward private elementary or high schools. In addition, you can use a variant of a 529 plan to pay for the education expenses of special-needs students.

So long as you’re taking a class to further your education, a 529 plan can be used to pay for such expenses. Cooking classes, language classes, and music classes from accredited institutions all qualify for 529 payments.

There is even a special exception if your child is awarded a college scholarship. In that instance, the child may take out money equivalent to the scholarship amount from the 529 without triggering the 10% penalty, but he or she would owe taxes on gains.

Finally, you can use a 529 plan to pay for a Master’s degree or PhD.

New 529 Plan Rollover Rules Due To Passage Of Secure 2.0 Act

Before the Secure 2.0 Act was passed, families were hesitant to open or further fund 529 plans out of fear the leftover funds would be trapped unless they take a non-qualified withdrawal and assume a penalty.

Money withdrawn from a 529 plan must use for qualified educational expenses. If not, you’ll pay ordinary state and federal income taxes (at the beneficiary’s tax rate) on the money, as well as a 10% penalty. 

Now, the penalty can be waived if your kid wins a scholarship, gets into one of the U.S. military academies, receives support from an employer or for several other reasons – but that’s just the 10% penalty. You’ll still need to pay the tax bill.

Conditions Of Rolling Over 529 Into A Roth IRA

With the passage of the Secure 2.0 Act, you can rollover left over 529 funds into a Roth IRA account. First is that the amount rolled over can’t be more than the Roth contribution limit, which is $6,500 this year. You also can’t roll over more than $35,000 total in the beneficiary’s lifetime. You also can’t roll over contributions or earnings from the past five years.

Another condition is that the 529 plan must have been open for at least 15 years. Experts are unsure whether changing the account beneficiary requires a new 15-year waiting period.

However, the rollover 529 plan contributions aren’t subject to the Roth IRA income limits of $153,000 for single filers and $228,000 for joint filers this year.

The more Congress expands the options for how to use a 529 plan, the more valuable a 529 plan becomes. n in the future.

Related: Recommended 529 Amounts By Child’s Age – A Guide

A 529 Plan For Noneducation Expenses

Just like with a Roth IRA, withdrawing capital contributions to a 529 plan do not face a 10% penalty. Contributions were already made with after-tax dollars. Therefore, if you find yourself in an emergency, you can easily tap your 529 plan contributions if needed.

If you need more capital than just your contributions, then you must pay taxes on the gains plus a 10% penalty. Although a 10% penalty is unfortunate, hopefully, the years of compounding will help offset this pain. Please double check if you can only withdraw capital contributions!

If you find yourself out of a job and need funds, withdrawing from a 529 plan while you’re in a low tax bracket can make sense. If your child decides not to go to college or ends up getting a full ride, you could withdraw from your 529 plan after you retire. Presumably, you will be in a lower tax bracket.

Just beware that some states include additional penalties when withdrawing 529 funds for non-educational purposes. For example, California imposes an additional 2.5% state income tax penalty on the earnings portion of non-qualified 529 plan distributions.

Related: Legitimate Reasons To Withdraw From A 401(k) Or IRA

Exceptions To The 529 Plan Withdrawal Penalty

There are situations in which the 10% penalty is waived for non-qualified 529 plan distributions. However, the earnings portion of the distribution is still subject to income tax. That said, if you are in such a dire situation, then you will probably be in a low tax bracket.

• A beneficiary dies or becomes disabled
• A beneficiary receives a tax-free scholarship
• Beneficiary receives educational assistance through a qualifying employer program
• Beneficiary attends a U.S. Military Academy
• The qualified education expenses were used to generate the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC)

How Much To Contribute To A 529 Plan

Obviously, the more you use your 529 plan, the less you will have to transfer wealth to the next generation in a tax-efficient manner. Therefore, you’ve got to continuously make calculations regarding your estate’s ultimate value upon death, your child’s educational interests, and the future cost of education.

It is impossible to get all the variables right. However, with the right amount of planning, you can certainly reduce your estate’s tax liability upon death.

If you find your estate to be way above the estate tax threshold already, then you can be fairly certain that every dollar you contribute to a 529 plan reduces your estate tax by 40 cents.

For generational wealth transfer purposes, here’s the roadmap:

• Contribute to the maximum 529 plan limit
• Hope your 529 plan grows faster than the cost of education cost
• Create a workhorse genius child who gets a lot of grant money to reduce your forecasted cost of education
• Change beneficiaries or list backup beneficiaries once your child is finished with their education

Using a 529 plan for generational wealth transfer purposes is smart if your estate is large. Even if your estate is forecasted to be below the estate tax threshold, tax-free growth is great.

Related: Open Up A Roth IRA For Your Children

Education Is Key To Financial Freedom

After graduating from college, I told myself I’d never go back! Then after getting my MBA, I finally started to appreciate education more. Today, I believe a great education is the foundation for achieving financial freedom. And once you achieve financial freedom, you can easily take more steps to live your ideal life.

I’m now focused on building our children’s 529 plans until the maximum limit. With two children or more, it’s easy to miss a year or forget to contribute the maximum gift tax limit. Therefore, make sure you stay on the ball.

I view having a 529 plan as a key weapon to combat egregious college tuition inflation. A robust 529 plan is also a good hedge against misfortune.

At the end of the day, one of a parent’s key responsibilities is to provide their children a solid education. Taking things a step further by creating generational wealth with a 529 plan is another benefit. It means you’ve adopted a Legacy Retirement Philosophy to help your descendants succeed.

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For more nuanced personal finance content, join 50,000+ others and sign up for the free Financial Samurai newsletter. I’ve been writing about personal finance since 2009. Using A 529 Plan For Generational Wealth Transfer Purposes is a Financial Samurai original post.