What’s a 529 and why do only rich people use them?

Utah's got more going for it than beautiful scenery
Utah’s got more going for it than beautiful scenery

We interrupt this normally no-math zone with a message from a person who wants college to be affordable for everyone, who grew up with no money who now has some money and who learned a few things along the way (like if it works for rich people can it work for you?)

In his 2015 State of the Union address, President Obama suggested elimination of the tax shelter currently afforded 529 college savings plans. Since then, the elimination idea has pretty much disappeared, but what surprised me is that one of the reasons for Obama’s proposed disembowelment of 529 plans is that only rich people use them.

You’ll see as I work this out in my head and here, part of this surprise came in the form of what I’m calling “entitlement busters:” ways I didn’t perceive my own entitlement. But part of my surprise, too, is in a way-too-complicated tax system, a need for all of us to improve our financial literacy, and–back to the original premise–the idea that even if you aren’t rich, a 529 may help you save for your kid’s college years.

First things first: What is a 529?

According to Wikipedia: A 529 plan is a tax-advantaged investment vehicle in the United States designed to encourage saving for the future higher education expenses of a designated beneficiary. My experience is with 529 savings plans, and that’s what I’ll be talking about here.

529 college savings plans are state-based and run, with Michigan the first to the draw in 1996. As I have always seen it, and corroborated by Wikipedia: A prime benefit of the 529 plan is that the principal grows tax-deferred and distributions for the beneficiary’s college costs are exempt from tax.

Statistics support the fact that, indeed, most of the money in 529’s is held by people with high incomes. First privilege buster: If you’re married-filing-jointly income is up to $73,000, or head-of-household income up to $50,000, a 529 plan may not be of much assistance, as you would likely be taxed little or not at all on the growth of your investments.

Can we ask who is rich? Who is middle class?

In April of 2014, US News and World Report reporter Geoff Williams wrote:

One helpful yardstick to judge whether you’re middle class: Median household income was $51,017 in 2012, according to the most recent U.S. census data. Robert Reich, a professor of Public Policy at the University of California-Berkeley and former Secretary of Labor, has suggested the middle class be defined as households making 50 percent higher and lower than the median, which would mean the average middle class annual income is $25,500 to $76,500.

Second privilege buster: It sure looks like 529’s DO cater to at least the upper middle class, and the rich.

Let’s look at a couple of scenarios, anyway.

If you save $5 a week from the time your child is born, given a 7% rate of return you’ll have ~$8,000 when s/he is 18. (You are going to have to do more than put the money in a bank to get a 7% rate of return. Well-run 529 plans. e.g., Utah Educational Savings Plan can help you do this. It doesn’t matter what state you live in, or where your child may attend college. Most plans can be used by residents of another state and for schools all over.)

Back to our saving example: $5/wk = $250/yr X 18 years is $4500. But $8000 is what you’ll have. $3500 is what your money has earned from compounding monetary return on your savings.

Save $10/wk and in 18 years you’ll have $16,000, $9000 of which you actually put away, $7000 of which your money earned (at an assumed investment return of 7%).

Great! But without a 529, you’ll pay tax on the money ($3500, $7000, etc.) your savings have made. Depending on your tax bracket–say 25% for a household income of $75,000, and/or 15% on investment income–you could be paying $500 to $1000 of the money your savings have made in taxes to the feds, money that could have gone to pay tuition, college housing, food, books for your kid.

Enter the 529: Save your children’s future college expense money in a 529, and you don’t pay tax on what your money has earned. The $500 to $1000 goes to your kid’s college costs, and not to taxes.

And no, a $500 to $1000 tax saving isn’t huge, nor is $8000 to $16,000 going to get you far with a kid’s college expenses. But it’s a start, it’s a philosophy (Roxane Gay says growing up in a house where a college education  is presumed is itself an entitlement–of the good variety, I think), and other people in the child’s life (even birthday party attendees, e.g.) can be made aware of the fund and contribute to it as well–again, no wealthy grandparents required, just $5 and $10 deposits over time.

OK, so maybe your complaint is that rich people are using this, too.

I’ve read a couple of times now that President Obama considers singles making over $200,000/yr and couples over $250,000 a year rich. Let’s say he’s right. You’re a family with $250 grand coming in per year. Of course, we don’t know for how many years that’s been the case–maybe you eked it out early on. Maybe you eked it out until last year. But let’s say you had enough money to put away $50/wk per kid for 18 years. (By the way, I’ve been using a compounding interest calculator like the one here to grind out these numbers, all with a single month’s contribution as the initial investment. Another possibility is that you made a several thousand dollar initial investment when you finally had some money coming in.) In 18 years you’d have nearly $100,000, probably close to enough money to send your kid to a 4-year state college.

What kind of tax liability did you, as rich people, avoid using a 529? A good half of that $100,000 was gained in investment return. Say you withdrew $25,000/year for the four years of your kid’s college education; $12,000 each year would be taxable. Your income says you pay at ~the 30% income tax bracket (but likely at the 15% capital gains tax bracket) so you’d pay something like a $2000 tax bill on the $25,000 withdrawn ($12,000 taxable) each year. Without a 529 you, as a rich family, would have $23,000 a year x four years to spend for your kid’s college education, and you’d pay $2000 in taxes each of these years.

With a 529, you pay $0 in taxes and the full $25,000 toward your kid’s educational expenses (and only their educational expenses) each year for four years.

I guess my point is this: What do we want? Is it important to make it more difficult for people we call rich to send their kids to college? What about the people in the huge range of household income from $70,000 up to rich? If a law/a program/certain tax deductions are available to everyone for college expenses, why don’t we all just try to use them to the max?

Should it be less expensive to get a good college education? Yes. Topic for another blog post.

Should people be encouraged to save money for college, and not penalized for savings, for example, by FAFSA (Free Application for Federal Student Aid)? Yes. Topic for another blog post.

Should we simplify our tax code? Oh, my God, yes. Topic for another five blog posts.

Should we increase our financial literacy to include 529’s and what they can mean to some middle or upper-middle class families? Yes. and here’s where to start.

Like I said, I’m open to having my privilege even further exposed and challenged. Let’s begin the conversation that gets all of our kids a decent college education at a reasonable cost.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4 Comments

  1. wow– that was impressive tax! I agree with your conclusions though (why make it harder to save and use the money for school) and I agree that it’s all too darn complicated! I’m seriously impressed (even using that word twice) that you tackled this topic!

  2. “Should we simplify the tax code? Oh my God, yes!” Amen and amen. Statistics show a huge lifetime income gap between college grads and non-college grads, so this is an important conversation, especially in light of the ever sky-rocketing cost of college. The Economist recently had a piece about how college is becoming the bastion of an American aristocracy. That cannot be good and means we must try all the more to get kids from middle and lower income families prepare for and off to college. (another 5 blog posts!)
    Anywho… my tax advisor informed me that money can be withdrawn from an IRA without penalty to help fund education expenses. Of course, these rules are always subject to change but I rather prefer the flexibility of funding my IRA with funds that can be used for either retirement or education purposes. Of course, I used to think a home-equity loan would be useful too until home prices went into the crapper. So who the heck knows how we’re going to afford college for our kids. But, it’s important to think about it and figure out ways to elevate all kids to positions of self-sufficiency. Thanks for sparking this conversation!

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