College savings: a trick to get more out of your 529 plan

The 529 plan, used for college savings, has a little known option that lets you contribute up to five years of gift-tax exempt funds at once. If you have the cash available to fund a 529 plan this way, it's a pretty powerful college savings tool. 

Reuters/Brian Snyder/File
Graduating students attend the 363rd Commencement Exercises at Harvard University in Cambridge, Massachusetts, 2014. Full freight at Harvard University currently costs more than $58,000 per year for tuition and fees.

Like many of you, Mrs. Bootstrap and I have children who we hope to send to college. And like some of you, we have a significant amount of liquid cash and investments. Mathematically, it would probably make a lot of sense to front-load the 529 plans for our two girls, or at least one of them.

Here’s how it works: The 529 plan (or Qualified Tuition Program in IRS-speak) has a little known and less used five-year, front-loading option. With this option, you can put up to five years of gift-tax-exempt funds into your 529. The current gift tax exemption is $14,000, so this allows you to deposit $70,000 per parent or $140,000 total. Given that the funds in a 529 grow tax-deferred if used for education purposes, this is a pretty powerful tool.

If a $70,000 contribution grows at a modest 5% annually, you will have just over $168,000 in your account come time for college. For comparison purposes: Full freight at Harvard University currently costs more than $58,000 per year for tuition and fees, and the average state school costs more than $21,000 per year for out-of-state students. With a single contribution, you could send your child to virtually any school they chose in 18 years.

Despite these powerful benefits, I don’t know anyone who has taken advantage of the lump-sum option. Here are the reasons I think people shy away from it:

  • No cash: the most obvious reason. Not many folks have a cool 70 grand lying around. Usually it is fully invested for other long-term goals like retirement, or locked up in 401(k)s or IRAs.
  • Fear of penalties: This is a powerful deterrent. Any funds put into a 529 are subject to penalty if used for non-qualified purposes (there are a few exceptions). What most people don’t realize is that penalties apply only the earnings. For example, imagine you have a 529 plan with $100,000 in it, of which $50,000 is contributions and $50,000 is earnings. If you withdraw $10,000 for your African safari, then $5,000 is subject to taxes and a 10% penalty. So you get your principal back tax- and penalty-free. Not a nice thing to have happen, but not the worst consequence in the world either.
  • Hope: I think this is the big one. It certainly is for us. While we want to take advantage of the 529, our hope is that at least one of our children is the next champion Olympic swimmer, or at least run-of-the-mill genius. According to a recent study, colleges are awarding more merit-based awards, as opposed to need-based aid. This is an arms race to attract the “best of the best” student to their schools.

Logically, I know that most financial aid goes to the neediest students and the “best” students. That leaves average students of above-average income more likely to shoulder the burden by themselves. This is where many of us will fall. That means we could benefit by using the lump-sum contribution option.

But we probably won’t. Sometimes it’s not about the odds. Chalk this one up to the all too common foible of hope over experience.

Learn more about Brian on  NerdWallet’s Ask an Advisor.

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