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.

17 thoughts on “529 Plans: The Beneficiary Loophole & How to Save More for College

  1. I agree with you. It is great way to pass wealth from generation to generation if you have enough savings. Changing beneficary will allow you save more and pass the remaining amount from college expense to another child or another family member of your choice. In general, I get latest about 529 plans from http://www.plans529.com

  2. The other benefit to one 529 account for all children, rather than one for each child, is that you may save of administrative costs. The Utah plan charges $5 for every thousand invested, but caps at $25K (or $125 fee). If you had 3 accounts, you would be paying up to $375 fee annually. For one account, no matter how high the value after $25K, you would only be paying $125, for a savings of $250 per year.

  3. My understanding is that the 529 counts toward the decision for financial aid. Would it be beneficial to save all of the savings with child 2 or 3 as the beneficiary. And split just a portion off when child 1 is ready for college? Would it then appear that child 1 has less savings when applying for financial aid?

  4. Hi Peter,

    Actually, 529 Plans count as parental assets, so regardless of which child they are dedicated for, currently the college expectation of what you should contribute will be the same. Now, this could change over time – after all, financial aid formulas are up to the schools. But for now, most schools place 529 plans in the “parental assets” bucket, and they expect up to a 5.6% contribution of that, per-child, per-year.

    This is the latest information I have on the topic, but please make sure you look into the financial aid policies and formulas for the school(s) you are interested in. These can and do change over time.

  5. Pingback: Don’t Feed the Alligators » Blog Archive » A 529 Plan for Each Child?

  6. Help! I see that the most recent posts are quite some time ago but I have just found out that the 529 that I had set up for my children has been taken and new benficiaries have been added to the 529. My ex husband signed first on the 529 but the funds were transferred from my personal bank to the fund. There was over $30,000.00 in there and now it’s gone. He has distributed the money to his new (now ex) wifes children. I need to find out what the legal ramification of this mess are and if Ican get that money back to my children. Can anyone help?

    • I am not an attorney, but do have a 529 account set up for my kids. 529 accounts are owned by 1 individual and have 1 beneficiary. If you were the owner of the account and your ex-husband logged in, changed the beneficiaries and set up disbursements, then you should discuss with a prosecutor about identity theft.
      If your ex-husband was the owner of the account, then the money would be his and he is free to administer the account as he pleases.
      If the owner is your ex-husband and these assets were “forgotten” during the divorce proceedings, you might want to discuss with your divorce attorney and try to get 1/2 of the account back to you.

  7. Changing beneficiaries works only if you’re switching in the same generation (ie: child to another child, not child to grandchild = taxable).

    • For the purposes of the IRS, this only is triggered with “generation skipping”, ie, child -> grandchild. You can switch from sibling to child with no issues. You can go up grandchild -> child, but not down past 1 degree without triggering.

      • WHat about to a child who is not your own? Who is older than the youngest beneficiary originally named? The children renamed were step children of me ex. All of the money originally placed in the 529 was during our marriage. He then took it and renamed the beneficiaries to other children. The money is gone.

  8. This is a great article. I struggle with the 529 plan. There are good tax incentives (state tax deduction and no taxes on investment gains). Plus the cost of college is out of control and unpredictable. So, you need to save.

    I’m a hard working and fortunate person and I’m now concerned about over saving. I’m now afraid that if my children get scholarships, or my investments perform well (I’ve got another 12 years!), I may have too much money. I’m concerned that the money will be crushed by a 10% distribution penalty if I take it back after my college expenses are paid for.

    How about this – if you do, in fact, over save, couldn’t you designate ANY particular college student as a beneficiary, pay their expenses (say $20k), then have that student pay you the $20k? Is that a way to “wash” the distribution?

    If so, this would seem to set up a business opportunity, to match people with this problem to random college students who have current expenses!

    [I just don’t understand why our government can’t see the burden this unnecessarily complex tax system creates]

  9. This advice does not apply if you live in a state where, if you use your own state’s 529 plan, you can deduct your contributions on your state return. In every state with which I am familiar, the maximum deduction per year is capped, but it is a per-beneficiary cap. The cap varies; in Maryland it’s $2,500 per beneficiary. If I have four children and can sock away $10,000 in 2013, I’ll get the full $10,000 deduction on next April’s return if I have a separate 529 account for each child and deposit $2,500 in each. If I put the whole $10,000 in a single 529 account, $7,500 rolls over to future years and could be lost in any number of circumstances (such as my moving to another state).

  10. can you transfer funds from your kid to yourself and then if decide you are not going to study for that 2nd career , can you then transfer them back to your kid?

  11. All of the gains from the “single account” scheme come from investing sooner. none of the gains come from the fact that it’s a single account. You could have three 529 accounts and divide you contributions equally or unequally, and the total at the end would be the same either way.

    Tom raises a good point that if there is a flat or capped fee, you can save on that fee with a single account. However fees aren’t considered in the original post, and anyways that’s a relatively small difference.

    Ben F raises a significant issue if you live in a state with a tax break or incentive; you may miss out on the incentive if you use this scheme.

    There could also be an issue if you die prematurely. In that case it may have been better for each kid to have had their own account to make your intentions clearer and minimize paperwork.

  12. Ohio is a state that allows for up to $2,000 per year per beneficiary deduction from state taxes. So if you have 2 kids, but want to deduct $8,000 per year for the kids, could you just set up 4 529 accounts (one for each kid, one for the dad and one for the mom) with the intent that come college age for the kids, to transfer the 529 from mom and dad to kids?

    Is that another loophole that can be exploited?

    Thanks.

    • Hi Brian,

      I am not sure what the repercussion is for reassigning the beneficiary for a 529 plan. It seems like a significant loophole if there isn’t some statute to prevent you from taking all of those refunds. As a note, you wouldn’t “transfer” the 529 amount as much as reassign the beneficiary on the account.

      Maybe reassigning the beneficiary has tax consequences in a state that offers tax deductions? Definitely worth investigating before going down this path.

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