Superfunding Vs Annual Funding 529 Plans

You. Today we’re going to talk about 529 plans, whether you should super fund accelerate funding a 529 plan, or whether you should contribute to one annually for any of your kids. So let’s start by just explaining what is a 529 plan? How does it work? And then we’ll get into the methods of funding in a little bit. So, a 529 plan is essentially an investment account that is earmarked for education expenses. So money goes into a 529 plan, the growth is completely tax free. And then if you go to distribute money from a 529, provided the distributions are for qualified educational expenses, all the distributions are tax free. So if you know money is going to be used for education, a 529 is one of the best vehicles that you can accumulate funds towards that goal.

The downside of a 529 is that if money is pulled out of a 529 and it is not used for education, any of the growth of the account is subject to ordinary income tax and a 10% penalty. So let’s just use an example here. Let’s assume $300,000 accumulates inside of a 529 plan. Of that 300,000, 150,000 is your contributions or your basis, and then the other 150,000 is growth. So the actual accumulation of the account, and let’s assume that, hey, you’re the 529 account owner and you’re pulling all 300,000 out. Let’s assume your kids got a full ride scholarship, athletic scholarship, don’t go to school, whatever the case may be. This 300,000, you need to pull all of this out and not use any of it for education. The 150,000 of basis comes out tax free. Penalty free.

So this 150 comes out tax free? Penalty free. The 150,000 of growth, you are subject to a 10% penalty plus ordinary income tax. If we’re the highest bracket, that’s 37%. So, again, 47% of this growth, right around 70,000, is coming out in taxes and penalties. So this would be an inefficient way to use the 529. So we want to make sure that money that goes into the 529 is used for education whenever possible. So the question then becomes, okay, I understand what a 529 is. Now, should I be super funding this or just funding this annually? And it’s important to understand the difference. So, funding of a 529, if you are single, the maximum that you can contribute without impacting any estate or gift tax is 18,000 in 2024.

And if you’re married and combined with your spouse, that number is now 36,000 for the purposes of this conversation, we’re going to assume married just to keep the numbers even. So 36,000 can go a year into a 529 plan, and that’s per kid. So if you have two kids, 36k can go into 529 plan number 136 thousand can go into 529 plan number two. So the question then becomes, what options do I have if I want to fund this? Well, you can put 36,000 a year into the plan, or you can do what’s called a five year acceleration. So instead of just contributing 36,000 a year for five years, you can actually combine with your spouse in 2024, lump sum 180,000 into the 529 for the next five years. So you put 180,000 in.

There’s no more contributions that go in over the next five years, and this money now grows tax free over that five year period. So why would you want to do this? What is the advantage of superfunding this as opposed to just funding 36,000 a year for five years? Well, the earlier this money gets in, because all of the growth is tax free, the quicker that the interest can start accumulating. So why would we want to superfund a 529 plan? Well, let’s assume we put 180,000 into the plan. We assume a 7% rate of return over five years. Our account will go from 180,000 to 252,000. Again, because this money gets in early, the earlier it gets in, the earlier it can start growing, the earlier the interest can start compounding. That’s option number one.

Option number two is, hey, we don’t superfund it, and we fund instead 36,000 a year for five years. We assume the same 7% rate of return. Well, after five years, instead of having 252,000, we’d have 221,000. So the benefit of superfunding is the earlier the money gets in, the quicker it starts to grow, and the quicker the balance can begin to compound. Assuming this, again, very baseline example, 7% rate of return. On both examples, you would have more in the first example if you superfunded the plan, as opposed to if you just contributed to it on annual basis. Potential drawbacks to superfunding number one, you will. The. The nice thing about a 529 in the state of Pennsylvania is that you get a state tax deduction when you make a contribution. So if you superfund it, you only get the PA.

State tax deduction for one year. So you miss out on those other four years of the state tax deduction because there’s no more contributions after you superfund it. And then number two, another drawback would be, hey, if you superfund it and then the market goes down, well, you would have been better off in this point, most likely in situation number two, where you fund it every year and more of a dollar cost averaging strategy. We would really recommend this if the timeline for use of these funds is very long. So if there’s, like, a newborn baby or someone that is very young, superfunding makes a lot of sense because there’s more time for the money to grow and more time to weather any sort of market volatility.

If you’re approaching use of the 529, we’d have to take a serious look as to whether or not superfunding would make sense. This is the benefits and drawbacks of superfunding. A 529 plan could be a very useful tool for your education planning philosophy. So if you have any questions about your 529 plan and how it operates and whether it makes sense to superfund it, please feel free to reach out to a trusted financial advisor.

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