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Should You Start a 529 College Savings Plan Before You Have Kids?

Couples with strong cash flows may be eager to start planning for the future. With extra cash laying around, some investors may decide to start a 529 college savings plan for their kids - before they're even born. While the cost of college is certainly significant, super-advanced funding of a 529 plan can leave future parents with few options down the road should their circumstances change. Given the other investment options for surplus savings, it may be best to wait.

A 529 plan is a type of tax-qualified account that allows parents (or grandparents, relatives, etc.) to save for higher education expenses. At a high level, most plans are funded with after-tax dollars and grow tax-free (for federal income and capital gains taxes purposes). If funds are withdrawn to pay for qualified education expenses, the distribution will also be tax-free. This article has a complete discussion on 529 plans.

Like most retirement plans at work, due to the tax-qualified nature of college savings accounts, there are penalties if the funds aren't used within permitted guidelines. 

Downsides of starting a 529 plan too early

Family planning realities

Some couples struggle to get pregnant and do eventually, while others won't be as fortunate. Adoption may be an option for some families, but not all. If a 529 plan was already opened and funded, the account owner will have a few options: withdraw the money and pay a 10% penalty plus tax on investment growth and earnings; give the funds to a niece, nephew, or other relative by changing the beneficiary on the account; use the money for your own qualified education expenses or your spouse's. 

If you need the money 

Like a 401(k) plan, a 529 plan is a type of qualified account to be used for a particular purpose. While you may have cash to spare today, it's important not to underestimate how your life and circumstances can change. For example, when many young couples have a baby, they also buy a new house to accommodate their growing family. If you put a significant amount of money in a college savings plan, those funds aren't available (without tax and penalty) if you need them for a down payment, unexpected medical expenses, to help defray lost wages over an extended maternity leave, and so on.

Under the Secure Act, which was signed December 20th 2019 by President Trump, New parents can now withdraw up to $5,000 from their 401(k), IRA, or other defined contribution plan within a year after they give birth or adopt a child without incurring the 10% penalty. Taxes on investment gains would be due that year as the distribution would be included in your taxable income.

Note that this is not a loan and while the money can be repaid, it isn't required. Technically, each spouse can take out $5,000 from their accounts for a total of $10,000. While it's nice to have options, tapping retirement accounts so early in life can really hurt your savings trajectory. 

Investing extra cash with total flexibility

A brokerage account is the most flexible type of investment account: there are no income limits precluding wealthier individuals from participating and there aren’t any limited on how much (or little) you can save. And unlike 529 plans and retirement accounts, the assets in a brokerage account can be used for any purpose at any time.  

Though there are no tax benefits like a qualified account, a brokerage account is often an important part of helping affluent investors maintain their lifestyle in retirement. Other benefits include tax planning opportunities in retirement and a savings vehicle for financial goals outside of retirement. A brokerage account can help investors maintain flexibility by not locking up too much of their investable assets in qualified accounts. Learn more about the brokerage accounts here.

Options for an Inherited IRA

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