529 Plans: The Beneficiary Loophole & How to Save More for College

I haven’t written a lot about 529 College Savings Plans, but my previous post on Picking the Best 529 College Savings Plan has been incredibly popular.  Even now it regularly is one of the top ten posts on the site for page views, over two months after it was written.

Recently, the blog My 1st Million at 33 did an in-depth analysis of whether it was worthwhile to “eat the penalty”, and use the 529 plan as an additional retirement savings vehicle.  The answer there was basically, no – the tax benefit is outweighed in most cases by the income taxes and penalty if you withdraw the funds for non-college expenses.

Since the topic of college savings is particularly interesting to me, I thought I’d follow up here with an insight into a potential loophole in the structure of current 529 plans.  Loophole might be too strong a word – but there definitely is an inherent flexibility in the current 529 plans that most people seem to be unaware of.

The loophole is actually not an accident, but part of the 529 plan design.  You see, one of the big problems with building a savings account for a particular person to go to college is the basic risk that maybe that person won’t go to college.  Maybe they won’t need the money after all, winning a full ride on a football scholarship.  Maybe your investments will do so well, that you will have over-saved.

As a result, 529 plans allow you to do something about it.  You can, once per year, change the beneficiary of the plan to someone else.

This one little ability, however, means that you have a lot of control over the destiny of your 529 plan.

Let’s say you are 20 years old, and you know that you plan to have children someday.  Theoretically, you could open up a 529 plan with a close relative who is someone under 30, and start saving immediately.  Ten years later, when you finally do have a child, you already have an account stocked with 10 years of savings.  You switch the beneficiary to your new child, and voila!  You are 10 years ahead of the curve saving for college.

This example might seem contrived – after all, how many 20 year olds  are interested in pre-saving for their children’s college.  Most 20 year olds are busy trying to pay for their own college.   But I chose it to illustrate the simple fact that you are no longer trapped saving for college for a single person, or even for a single lifetime.

Let’s take a more realistic example.  You are newly married, and you and your spouse have decided that you will likely try to have more than one child.  For this example, let’s just say you plan to have three children, each three years apart.   The ability to change beneficiaries drastically alters your strategy for saving for college.

Instead of starting a college fund for each child when they are born, and trying to equally fund them, the math says you should just over-save for your first child.  Think of it as saving for college for all three of them together, rather than separately.

Any excess you have from the first child can easily be moved to the second, and then the third.  The advantage is that while you’ll have 18 years to save for child 1, you’ll have 21 years for child 2, and 24 years for child 3.  As a result, you’ll need to put less away overall if you let compounding do the work for you over a longer period of time.

I’ve done some quick & dirty models in Excel, and it looks to me like the savings can be fairly substantial – if you have the ability to over-save in your first child’s 529 plan.

I used some simple assumptions – an 8% rate of return, and a contribution rate of $5000 per year, per child.

If you saved for each child separately, you would end up with $207,231 for each in Year 18.  Pretty darn good, except for the fact that you’re putting away $15,000 per year for the middle 12 years.

Instead, if you take advantage of  the ability change beneficiaries, you could instead decide to put $10,000 per year, with the birth of the first child.  Over the course of the 25 years of saving,  you would put away $250,000, lower than the $285,000 contributed in the example above.  But you’d end up with approximately the same amount of money for each child, when you need it for their college tuitions.  (For the sake of simplicity, I assumed that each child would cash out 1/4 of the $207,231 per year from the first example, leaving the remainder to compound for the next year (and next child).

Now, in order to really take advantage of this, there are a couple more steps you need to be aware of.  First,  most 529 plans will not let you contribute past some account value.  It differs by state, but it typically caps off between $250K-$300K.   The money can still compound, but you can’t contribute any more.

None of my examples required contributions for a single child above $250K, but even so, it would be simple enough to just start a new 529 for a different child at the point you max out the first one.  The limit seems to be on contributions, not on total account value, so there seems to be no limit on the power of compounding.

The second issue you’d have to deal with is how to withdraw money to two beneficiaries at once.  In order to handle that problem, you’d have to “split” your 529 plan into two separate plans, either with the same provider, or by moving some of your assets to another state.  Once the plan is split, you can then change the beneficiary on one of the plans.

Another potential use of this ability to change beneficiaries might be as a form of estate planning.  If you are wealthy enough to have taken care of your own retirement needs, and savings for your childrens’ college, you could effectively start early on funding college for your grandchildren.   By changing beneficiaries when needed, you could make a 529 account last almost forever.

From a practical standpoint, I don’t expect a booming market in multi-generational 529 plans.  First, some people have despaired so much at the pace of rising tuition, you could argue that it’s better to not save for college and count on financial aid.  Second, not everyone is as enamoured with the tax protected status of 529 plans, since the government could take that away at any time.

Nonetheless, saving for college is a big enough endeavor that many families find themselves with not enough years to save.  One of the reasons people actually can fund their own retirement is because they use a working career of over 40-50 years to do it, giving their money a chance to compound many times over.

Changing beneficiaries offers people the ability to extend the clock for college savings, which can really help, particularly if you have multiple children.

Run the numbers yourself, and let me know what you think.  I’ve already built out some models that take into account inflation, rising tuition, and rising contributions.  The basic benefit of over-saving for the first child continues to outweigh any of these factors.

Reminder: I am not a financial advisor or tax professional.   Be sure to vet any ideas provided here with appropriate experts in financial planning and tax law before following any the tips outlined above.  Yes, I am posting a disclaimer here.

Update:  Looks like this question has been around for a while.  I found this tip on the Morningstar site saying it’s OK to split a 529 plan in the case of an “over-funded” first child.