529 Accounts: What if My Kid Doesn’t Go to College?

When talking about saving in 529 plans, my clients often ask me the same question: what if my kids don’t go to college?

They’re rightly concerned money they had earmarked for funding college will be subject to taxes and penalties if it’s used for another purpose. The assumption many make is that it’s better to just save for college in a brokerage account.

The cost of college in the United States has reached frankly outrageous levels. Why that is the case is the topic for a whole separate discussion. But thankfully the federal government allows those who can afford to save for college, a very attractive vehicle with which to do so. It is, of course, the 529 plan.

It allows contributions to be withdrawn tax-free if used for qualified educational purposes. That includes spending on tuition, fees, books, supplies, and room and board to the extent of on-campus costs.

If the funds are withdrawn for non-approved uses, such living expenses by a parent, a 10% penalty is assessed by the IRS on the gains, and normal income tax is also levied on the gains. The contributions are already your money, so they escape penalties and income tax, even when withdrawn for non-approved purposes.

The temptation then is to forgo saving in a 529 plan. In most cases that would be a mistake.

Here’s why.

Let’s assume you’re expecting your first child to be born in August 2020. You intend to save $15,000 each year until your child is ready for college at 18.

Key Assumptions
Years to college18
Annual contribution$15,000
Early withdrawal penalty (gains only)10%
Tax rate during accumulation years 42%
Tax rate during withdrawal years 37%

You expect investment returns to average 6% per year, half of which will be capital gains, while the other half will be interest and dividends. We’ll assume your marginal tax rate during the saving years will be 42%, and 37% during the college attendance years, when you expect to be earning less.

Return AssumptionsPre-taxAfter-tax
Portfolio return6.0%4.03%
Capital gain portion3.0%2.29%
Dividend & interest portion3.0%1.74%

It turns out that, under these assumptions, non-qualified use of the 529 funds after 18 years results in after-tax and penalty proceeds of just $13,001 less than you would have realized from a brokerage account. That’s a compound average annual return of 3.7% vs. 4.0% for the brokerage account, or a return difference you probably wouldn’t even notice on a performance report. As expected, qualified education use generates a nice increment of available college funds over the brokerage option of $77,984.

Saving StrategiesBalancesGain vs. BrokerageCAGR
After-tax contributions$270,0000%
Brokerage account (fully taxed)$385,6014.0%
529 account – qualified educational use$463,585$77,9846.0%
529 account – non-qualified use$372,600$(13,001)3.7%

Let’s take it one more step. If you think it’s just a 50:50 bet that your child will attend college, the expected value of saving in the 529 plan rather than a brokerage account is $32,492. If it’s 90% the expected value is $68,886. Even if you’re fairly pessimistic that college is in your child’s future, the expected value of saving in a 529 plan is still nearly $10,000.

Probability of EnrollmentExpected Value vs. Brokerage

This result does vary by the mix of assumed returns. The closer to zero the capital gain portion of total return is, the lower the disadvantage suffered from a non-qualified use of 529 funds. For example, a 1% average annual capital gain and 5% dividend and interest portion of return generates a slightly better result in the 529 than the brokerage account. If we reverse the two components of return to 5% capital gain and 1% yield, the disadvantage of non-qualified use of 529 funds is just over $26,000, or a 529 return of 3.7% vs. the brokerage at 4.4%. These extremes are unlikely, but worth pointing out.

Note also that I’ve ignored any state tax deduction taken for 529 contributions. Some states give a deduction for contributions, but recapture deductions on non-qualified withdrawals. Details can be found here for your state. North Carolina has no deduction, so it is not an issue for residents of the Tar Heel state. George does, so bear that in mind.

Also remember that 529 plan funds can be used by blood relatives of the intended recipient. So funds saved for a child who decides not to go to college can be used by their more academically inclined siblings.

So if you’re on the fence about saving for college via a 529 account, don’t worry about whether or not your kid will go to college. Either way you’re likely to have saved a lump sum that will be useful for whatever life throws at you.

DISCLAIMER: This article is general in nature and should not be construed as a provision of personalized legal or tax advice, as recommendations regarding investment advisory services, or the solicitation to effect, or attempt to effect transactions in securities. All data, assumptions and calculations are for illustrative purposes only, the author does not guarantee their accuracy, and they should not be relied upon for financial decision-marking. All expressions of opinion herein are subject to change. There is no guarantee that the investment strategies discussed herein will be successful. Investing involves risks including possible loss of principal. Consumers should seek subsequent and direct communication with a properly credentialed investment advisor representative.