Do you really want to fund a 529?
Answer: probably not. Don’t get me wrong, I’m with you on your intentions. And your logic is spot on if it’s anything like that of a new (or experienced) parent, which probably goes something like this: “We have children. We want the best for our children. The best includes our children going to college. We want our children to be able to afford going to college. Let’s open a 529 account and start saving, because a 529 account is for college.”
That thought process is great. And it seems quite logical. But I believe there is one minor flaw. It assumes that a 529 account is the best tax advantaged account to accumulate funds to pay for that college education. The reality is that 97%* of us probably should never even consider a 529 account.
To explain why, let’s first remember that a 529 is advantageous for saving for college because it allows us to avoid paying taxes on the investment earnings in the 529 account. It’s a tax advantaged account. But what if there was a way to avoid paying taxes on investment earnings while having flexibility to use your money…for things like a home purchase, a large unexpected expense, or even college tuition when the time comes?
There actually is a way, and it doesn’t involve 529 accounts. Having your money set up in this ‘way’ is what we define as Financial Agility: optimizing returns, taxes, and flexibility so that you’re in the best position to financially react when the future comes your way.
Instead of funding a 529 account, we would suggest first funding your Health Savings Account and Roth IRAs. Both of these accounts are tax advantaged like the 529, but they will provide you with some additional financial agility. We’ve discussed Health Savings accounts in our Thought Leadership series, so we won’t go into detail here. The gist is that you’re going to use your Health Savings Account to actually save money, pay for medical expenses out of pocket, and those unreimbursed medical expenses become future tax-free and penalty-free withdrawals – all while your money is still enjoying tax free returns in the account. Relative to Roth IRAs, your contribution basis (the money you contribute, not the investment earnings portion of your Roth IRA account) is always available to you for withdrawal tax-free and penalty-free in the future. The availability of these funds from your HSA and Roth IRA on a tax-free and penalty-free basis provide you with flexibility. They can be used in the near-term future for college expenses if you need it for that purpose. Not only that, these funds can really be used as a source of near-term emergency funding for any need: home down payment, broken furnace, etc. Of course, the hope is that you don’t need these funds in the near term and you can use them to help achieve your financial independence in the future; but the point is that you’ll have these financial resources and financial agility to react at that future point when it comes.
So unless you’re already contributing the maximum amount to your HSA and Roth IRAs, which is $19,000 in 2019 ($7,000 HSA family maximum, $6,000 for your IRA, and $6,000 for your spouse’s IRA), then it probably doesn’t make much sense to set up a 529 account.
* No official study was performed to validate the “97% of us” figure. 97% is a hyperbolized figure, kind of like a wet finger in the air, although the magnitude is likely accurate.