What are the pros and cons of a California 529?

August 24, 2022

What are the pros and cons of a California 529?

All of us want to give our children the best chance at life. Part of that is trying to ensure that they have as many options open to them as they go out into the world. For many, the hope is that their children will pursue post-secondary education in some form, whether it is a college, trade school, or university. Sometimes, parents want their child to be able to enrol in a particular type of elementary school. In California, one of the financial tools available to save up for a child's education is the 529 plan.


What Is the California 529 Plan?

The 529 plan is a state-sponsored investment tool through which you can invest funds that will one day go towards future tuition, fees, books, equipment, supplies, and related expenses. The California 529 lets you contribute up to a particular amount every year in each 529 account without affecting the size of your lifetime gift tax exclusion or requiring you to pay federal "gift" taxes. The investment growth from a 529 is tax-free (state and federal). You cannot contribute any more money to the 529 once the account balance hits $529,000, although the balance can still go up due to the growth of investments. 


The beneficiary is usually a child or grandchild, but can technically be anyone, even you. They don't even have to be part of your family. When it comes time for the beneficiary to go to school, you can withdraw a maximum of $10,000 for each of them annually to pay for qualified expenses without the earnings portion incurring tax liability. If withdrawals go towards expenses that are not qualified, the earnings portion will be considered income and taxed. Additionally, you may have to pay a further 10% in federal tax and 2.5% in state tax. The school can be public or private — or even religious — and does not necessarily have to be located in California. Apprenticeship programs also qualify.


Tax laws have recently been amended to include more qualified expenses under the California 529. For example, if you are an individual, you are allowed to gift a maximum of $15,000 per plan per year without incurring a penalty. A couple can gift up to $30,000. Alternatively, you could opt to contribute up to five years' worth ($75,000 for an individual contributor and $150,000 for a couple) in one year — per 529 plan and beneficiary. On the flip side, you will not be allowed to provide any more annual gifts to that person on a tax-free basis for five years. Of course, you could opt to use some of your lifetime gift tax exemption, or see if the amount of the gift tax exclusion goes up.


What Are the Benefits of a California 529?

Apart from being able to use it for your own continuing education, there are a few key benefits of investing in a 529 plan. They include:


  • More favorable treatment when it comes to federal financial aid, compared to things like a Uniform Gift to Minors Act ("UGMA") or Uniform Transfer to Minors Act ("UTMA") accounts. The latter tools are "student owned", whereas the 529 is technically owned by the parent. Pursuant to the financial aid formula, only around 5.6% of assets held in a 529 — vs. 20% of the money in a custodial account — get counted towards the family's expected monetary college contribution each school year.


  • No additional 10% federal tax to withdraw the same amount as a scholarship received by the beneficiary, even if the money is not going to qualified expenses. While the earnings portion of the withdrawal is taxable as income, the part that is the "return of your principal" is not. That withdrawn money can go into another person's education funds or be used for unrelated financial objectives you might have.


  • You can transfer wealth through a 529. By contributing to a 529 plan, parents/grandparents decrease the size of their taxable estates (and related tax burdens). 


Are There Disadvantages With a California 529?

There are a handful of downsides associated with a California 529 plan.


  • The contributions to a 529 are not themselves tax deductible in state or federal tax regimes. Any investment growth, however, is not subject to tax liability.


  • You can only have the tax benefits if withdrawing funds for qualified educational expenses. The UGMA and UTMA investments, for example, are trust accounts that are more "flexible" when it comes to withdrawal. With a 529, if the monies are earmarked for non-qualified expenses, you must pay a further 10% federal tax and 2.5% state income tax on the earnings portion of the withdrawal. There are further penalties for withdrawing more than the allowed amount as well.


  • It is actually possible to lose money in a California 529 plan. California 529 plans should really be started early and may not provide the ideal investment diversification. If started closer to the end of high school, the 529 could suffer from market volatility and might not be able to bounce back before the funds are needed. Some states offer Federal Deposit Insurance Corporation (FDIC) insurance for 529 plans, but California does not.


California 529 Plans for Non-California Residents

Although all states have their own version of the 529 plan, anyone in any state can avail themselves of a California 529 plan. You don't have to be a California resident to open a 529 account. However, there are certain benefits only open to Californians. For new accounts, contributions up to $200 are matched dollar for dollar through the 2022 Matching Grant Program. All one needs to do is to set up a minimum $25 automatic monthly contribution. The account holders must be California residents at the time of enrolment, with an SSN or federal tax ID number, and make no more than $75,000 income a year. Furthermore, in California, 529 funds are not counted towards Medi-Cal and other state benefit eligibility.


If you have any questions about investing for your or someone else's future education, speaking to your lawyer or financial advisor is highly recommended.

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