What Bernie Sanders Can Teach You About 529 Plans

You are probably familiar with who Democratic presidential candidate Bernie Sanders is, but you are likely less familiar with what he has to do with 529 college plans. Let me explain.

Although he, to my knowledge, has not proposed anything relating specifically to these tax-free college savings plans, his proposed changes regarding the government funding of college tuition underscore a critically important aspect of 529 plans. For anyone who is saving to pay for the future college costs of their children, his plan merits special consideration.

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The Anti-Alchemist

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I have jokingly critiqued that some of those in my profession are anti-alchemists. In the medieval period, there were magicians called alchemists, who, through their secret mystical powers, could create wealth by converting base medals into gold.

These financial advisers, I argued, were anti-alchemists because of their magical ability to destroy wealth by converting low-tax, capital-gains income into highly taxed ordinary income, through the use of nondeductible IRA contributions. For the uninitiated, these are contributions to a traditional IRA for which an individual is disallowed a deduction on their personal income tax returns for a variety of reasons. Despite one’s being disallowed the deduction for contributing to the IRA, however, one still has to pay ordinary income taxes on the growth and income earned on that money when it is withdrawn from the IRA. In most cases, this has the effect of turning investment growth and income that could have been taxed at relatively low, long-term capital-gains tax rates into ordinary income, which is taxed at relatively high rates.

What does this any of this have to do with 529 college savings plans and college savings strategies, you may ask? Unfortunately, contributions to 529 accounts can have the same anti-alchemist effects as nondeductible IRA contributions. Of course, one of the truly great benefits of these plans is that money can be withdrawn from them tax-free when it is used to pay for qualifying education expenses. This is an excellent tax benefit because it essentially means that the income earned from investing within these accounts avoids taxation. Like any gift horse you receive from the government, however, it pays to look it in the mouth, inspect its teeth, and send biopsies off to the lab.

The Downside of 529 Plans and What Bernie Sanders Has to Do With It

The problem arises when you withdraw money from the plan and use it to pay for things other than qualifying education expenses. In this case, the portion of the withdrawal that represents investment gain is taxed as ordinary income, instead of potentially low-tax capital gain and qualifying dividend income, with an additional 10% penalty tax being applied to the investment income to boot.

This is where our friend Bernie Sanders’ government funding of college tuition comes into the picture. Although many people tend to downplay the likelihood of his proposal ever becoming law, the prospect underscores one of a myriad of reasons parents with college-bound children may find they have more money in a 529 account than they’ll need to pay for a student’s qualifying education expenses.

What if the beneficiary for whom the account was set up doesn’t go to college? What if the beneficiary receives a scholarship? Although overfunding of 529 plans due to scholarships typically results in the waver of the 10% penalty, when the overfunding is withdrawn from the account, the investment gain is still taxed at ordinary income rates causing a less-than-ideal tax result.

The outcome of this overfunding in many cases is that one pays more taxes by saving in one of these plans than would have been paid by investing in a regular brokerage account. When you also factor in the limitation placed on the investment choices within 529 accounts, these factors can combine to make them a bad savings strategy in hindsight.

What It All Means

Don’t get me wrong. Using a 529 college savings plan to save for college expenses is great idea for many parents. I’m simply underscoring the importance of understanding the pros and cons of these accounts.

One approach to deal with the risk of potentially overfunding these accounts could be to split college savings contributions between a 529 plan and a traditional brokerage account, separate from one’s other brokerage accounts. This would significantly lower the likelihood of overfunding the account, while still providing some potentially significant tax savings.

Another approach is to plan on changing the beneficiary of the account to another person who is related to the child for whose benefit the 529 account was set up, such as a sibling, in the event the account ultimately proves to be overfunded.

Ultimately, the most important thing to understand is that 529 accounts receive their name from the section of the Internal Revenue Code (tax laws) through which they were created and to whose rules they are subject. Like anything related to taxes, it helps to have a qualified adviser explain these plans to you, to consider the pros and cons as they relate to your specific situation, and to help you decide on whether and how these college savings plans should be part of a tax-efficient college savings strategy.

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Michael Rose, CFP is president of Forthright Investments, LLC. He holds a B.S. in Finance and a M.S. in Taxation from Bentley University.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Michael is president of Forthright Investments, LLC, a money management firm located outside of Boston, Massachusetts. He spends his time providing investment management, tax planning, and personalized financial advice to individuals and families. Michael holds a B.S. in Finance and a M.S. in Taxation from Bentley University. He is a Certified Financial Planning (CFP®) professional.