Parents: Stop Contributing to 529 Plans for College. Use This Superior Method Instead.

by | BiggerPockets.com

You’ve just had a child or you’re watching your child grow up. “College savings” is lingering in the back of your mind. How do you save for college? What vehicles exist? How much should you save?

There are four methods that I find folks generally use to research college savings plans, usually in this order: (1) ask mom and dad; (2) Google it; (3) ask friends or neighbors in passing; (4) ask a competent financial advisor or CPA. Sometimes clients will come to me before tapping into any of the other three resources above. As a result, they don’t waste time utilizing poor college savings methods.

I always suggest to my clients that they consider who they take advice from. Are mom and dad in a similar financial and income position to you? Do your friends own real estate and a business? If the answer is “no,” then why are we taking financial advice from these folks?

Today, I’m going to bust the myth that 529 plans are great college savings tools. I’m going to show you a much better method that only real estate investors and business owners can use. But first, let’s talk about why 529 plans are good.

The Pros of Using 529 Plans

  • Tax-Deferred: Your contributions to 529 plans often qualify for a state level tax deduction. Limits are generally imposed, so you will need to check with your state to understand what those limits are.
  • Account Earnings: Similar to other types of accounts, your 529 plan monies can be invested in various assets (i.e. stocks/bonds) and grow at a tax deferred rate.
  • Generous Maximum Contribution (Front Load Contributions): Most states place a limit on the total contribution limit per 529 plan, but they are very high (think $400,000). On an annual basis, there is generally not a limit on the maximum amount of contributions you can make except for the plan’s total contribution limit. You may not receive a tax benefit for your total contribution if you contribute large amounts. Check with your state.
  • Multiple Plans: There is no limit to the number of 529 plans you are allowed to have. You can have multiple 529 plans in multiple states, though you may only receive tax breaks for contributions to your home state’s 529 plans.
  • Anyone Can Contribute: Anyone has the ability to contribute to your child’s 529 plan. These contributions are considered gifts so the gift tax rules must top of mind, but if you can convince family or friends to contribute to your child’s 529 plan, it can happen!
  • No Expiration: 529 plans never expire and you can change the beneficiaries whenever you’d like. If one of your children does not use the entire amount of funds within the 529 plan, the beneficiary can be changed to the next child. Any remaining funds in the 529 plan can be saved and used for future grandchildren.
  • No Genius Penalty: If your child is a genius (I hope they are!), your 529 plan will allow you to withdraw an amount equal to the scholarship received by your child without paying a penalty. However, when you withdraw those funds, you may owe taxes on the withdrawal. So the smarter your child is, and the larger the scholarship amount, the more you can withdraw from the 529 plan without penalty.

private-money-meeting
Related: 4 Tips for Recent College Grads Seeking Financial Freedom

The Cons of Using 529 Plans

  • The Tax Benefits are Nominal: You have to pay tax on the contributions at the federal level, meaning you do not get a federal tax deduction for contributing to a 529 plan. This is not tax efficient, as federal tax deductions are much more valuable than state tax deductions. We want to maximize our tax efficiency with each dollar, and contributing to a 529 plan will not allow you to do that. Additionally, the absolute value of earnings on your contributions, while tax deferred, are so small that that the tax “savings” are moot. Run a few examples in a handy spreadsheet, and you’ll see what I mean.
  • Funds Must be Used for Qualified Education Expenses: You can only use the funds in a 529 plan for “Qualified Education Expenses.” Though the list of constituting Qualified Education Expenses is rather large, you still must prove that the funds were used for Qualified Education Expenses.
  • You Lose Flexibility: My clients know that I’m huge on structuring your tax and financial position to allow for flexibility and adaptability. When you contribute to a 529 plan, you lose flexibility of utilizing those funds because you can only use them for Qualified Education Expenses; otherwise, you’re facing penalties for withdrawing the funds. Maximizing flexibility will allow you to maximize your tax efficiency, and unfortunately, a 529 plan will not allow that to happen.
  • Who Has the Education Crystal Ball? No one knows what higher education will look like in 10-15 years when your children go to college. Further, we have no idea how much or how little it will cost. Why lock into something that looks good today but may archaic when (and if) your children go to college?
  • Your Child May Not Go to College: What if your child decides not to go to college? What if college is for the STEM folks and everyone else can go to trade school? You’re pretty much up the creek without a paddle. There are too many “what ifs” to derail utilizing a 529 plan.
  • Limited Investment Choices: You likely won’t have access to the entire range of choices you would otherwise have in a different type of account. Again, we want to be as flexible as possible, yet this is another limit.

What Real Estate Investors Should Do Instead

Real estate investors and business owners are a different breed of people. Because you have chosen to expand your income streams, you also receive access to tax strategies that someone with a regular ole W-2 job does not have.

Behold the better college savings plan for you and your child: hire your kids.

You can deduct payments to folks who you hire to work on your rentals or help grow your business. Who says those folks can’t be your kids? When you hire your child in your business, you get to pay them for services rendered and subsequently deduct those payments on the federal and state tax levels.

Again, each dollar we pay our child will qualify for a federal and state tax deduction. We’re already off to a better start compared to a 529 plan.

So, we pay our child for services rendered, but does the child have to file a tax return? Not if you pay them less than $6,350! You see, everyone (yes, everyone) gets a standard deduction of $6,350 (as of 2017). If anyone earns less than their standard deduction, they don’t have to file a tax return. So, your child literally receives tax-free money that you received a federal and state tax deduction for.

college-rental

Related: Leasing a Rental to Your College Kid: Smart Financial Move or Potential Disaster?

Let’s put some numbers behind this: You pay little Sam $6,000 for services Sam provided to your rental portfolio for the year. Your federal tax rate is 33%, and your state tax rate is 8%, so your total tax savings on this $6,000 is $2,460 ($6,000 x .41). Your child receives the entire $6,000 tax free. So by simply paying your child for services rendered to your real estate portfolio, you’ve increased your family’s net worth!

OK, so we’ve paid our child. What’s next? Now we open a Roth IRA in the name of the child. Since you are the fiduciary of the child’s bank account and the Roth IRA, you will direct a $5,500 contribution into the Roth IRA of the child. The cool thing about Roth IRAs is that you can always withdrawn the contributions tax and penalty free. When your child turns 18 and goes to college (if they go to college), they will have a large amount of Roth IRA contributions that they can withdraw tax and penalty free. They can use those funds to pay for their college experience (rents, food, books, tuition) and not just Qualified Education Expenses like a 529 limits you to.

There are also likely to be earnings in the Roth IRA by the time the child goes to college. You can’t withdraw these tax and penalty free unless they are a qualified distribution. However, a first time home buyer can withdraw $10,000 as a qualified distribution from a Roth IRA and not pay taxes or penalties. How awesome is that?

So let’s recap. We paid our child a certain amount for rendering services to our real estate portfolio or business. We get federal and state tax savings on that payment, and the child does not owe any taxes due to the standard deduction. We then open a Roth IRA for the child and contribute up to $5,500 of the child’s payment into the Roth IRA. We do this for a decade, and when the child goes to college, their Roth IRA will act as a sizable college fund. The child can withdraw the contributions made to the Roth IRA tax and penalty free. The child can tap into the earnings portion of the Roth IRA when they purchase their first home.

So, over the years, we’ve sheltered an immense amount of money from federal and state taxes, we’ve created a college fund for our kids, and we’ve taught our kids the value of work.

And as you can see, the more kids you have, the more money you can move.

Drawbacks and Cautions

You may not receive a current federal and state tax deduction if this method results in a passive loss. But that loss will become suspended, so you will be able to take advantage of the tax savings at some point in the future.

You will also need to develop a job description for your child. You will have to make the case that you were either going to perform the child’s work tasks yourself or hire another person to do it. I highly recommend working with an advisor on this.

The money that you pay your child must actually hit their bank account and stay in their bank account or move into their retirement assets. You cannot move money into the child’s account and then use that money for your own use or move that money back into your bank account. This is called tax evasion, which means fraud, and you’ll set yourself up for failure.

You likely can’t pay your one-year-old $6,350 for rendering services to your rental portfolio. Tax court cases support the age of seven for physical labor, so keep that in mind. But that’s not to say we can’t pay your one-year-old for modeling. When the HGTV stars bring their young children on the shows, do you really think their children aren’t being paid for their modeling services? If the HGTV stars have a smart accountant, you can darn well guarantee they are using this method!

Would you consider using this method to help fund your kids’ college?

Let me know your thoughts with a comment.

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

145 Comments

  1. Cory Binsfield

    Clever! I like how you tied in the Roth to create more flexibility. The compounding on a Roth at an early age is huge. Imagine $5,500 per year from age 14 to 18 then never contribute another dime. Balance at age 65 is ober 2.8m. Highly unlikely your child would let it compound that long, but for the that understands the time value of money, a worthy goal.

    I took a different path and plan on using my rental cash flow to pay for all the college. Another technique that many people miss.

  2. Henry J.

    Hi Brandon,
    Great article. One question – doesn’t the child earning usually fall under the parents income tax bracket when the child is considered dependent? Just curious how that works.
    Thanks.
    Henry

  3. Jarrett Coppin

    Excellent article! Love the creativity and it possibly gives your child that much needed “work experience” that’s asked for on job applications.

    Are you able to pull out Roth contributions and not interest penalty free for say, starting a business, if college is not the end goal?

    Cheers

  4. Robert Wazlavek

    Great article! Just wanted to clarify to make sure I’m understanding the gist: the $5500 for the Roth is taken from the $6350 so that the money going into the Roth is effectively 100% tax free (since the $6350 is tax free that year and Roths are taxed the year they’re contributed to).

  5. John Newman

    Great article @Brandon Hall! This is the kind of creative thinking I seek on BP. Now I have a question.

    Is there any way to combine this strategy with tax advantaged account that would allow your child to invest in real estate?

    Thanks.

    • Richard Carlton

      Yes. You can open a truly self directed Roth (or traditional) IRA through companies like MidAtlantic IRA and Equity Trust (there’s a couple more out in CA). You can then buy rental properties in the IRA’s name and the rent money would go directly to the IRA. Money can be withdrawn to repair the rental property from the IRA, but a 3rd party contractor would have to do the work. You can also do private party loans using these self directed IRAs (ie your IRA could earn 8-12% a month by loaning it out to other investors).

  6. Coco W.

    Great eye opener! Now off to find jobs for these kids of mine.
    Do you have sources to support being able to withdraw from 529 to match their scholarship? I’ve never heard of it and would love to see some sources.

  7. Audrey Ezeh

    Thanks for another thought provoking article Brandon. However I am not sure it is really the better way to go, at least not for everyone. We have a 529 for each of our kids and we start at day zero..I mean I literally come home from the hospital, open my lap top and create a 529 account and dump all the cash gifts I get in there…we typically start off each kid with $1000 from the week they are born and over the years we have had varying monthly contributions from as little as $25/month to roughly $330/month today. As a result, my 1st kid is 6yrs old and has about $27,000 in her account (if she were going to college TODAY, that is enough money to go a long way in any public school). Now 6yrs ago, I knew virtually nothing about RE investing but I opened a 529 so I am already 27k ahead. Also I have a duplex right now and total income is $10,200/yr…even if I pay my kids ALL of it which may or may not be ok with IRS (i have no idea), it is still less than the $12k/yr we are contributing to their 529 yearly right now.

    Now of course the more properties I acquire the more I can pay them till I get to the roughly $18k/yr max without them having to file a tax return. That will take years to get there and we all know the power of compounding…I can start off today with less monthly contributions and still come out ahead of the person that starts 10yrs later and contributes more per month.

    Lastly, as you state, you can only withdraw your contributions to a Roth account tax and penalty free (can’t touch the earnings for college expenses) so say in your scenario you contribute $5500/yr for 10yrs, that means my kid will have $55,000 towards college…I’m pretty sure they will have at least 2x-3x that if not more with my current plan. Say, I do have the RE portfolio to support $5500 from day zero to 18yrs, that is about $99k, again, I should have no trouble beating that because my earnings count.

    Again, there are no blanket answers for everyone, but I am pretty comfortable with our 529 plans for our kids. I am a huge fan of diversification so I envision a time when my RE portfolio is large enough I may not need to sock away money in a 529 anymore but for now…it is definitely the way to go for all the pro reasons listed above!

    • Chris Falk

      Audrey, thank you for your post w/an opposing view. I’m disappointed Brandon titled the article the way he did (or let BP do it). It’s I’ll advised to make a blanket statement like his article implies. 529 plans have a LOT of positives as he pointed out. I see the merit of the ROTH for a child & that’s fine but why the dramatic article title suggesting that parents put the brake skills on 529 plans or never start one in the 1st place? There is no black & white better or worst alternatI’ve in this situation. I’ve liked some of Brandon’s articles the past few years but this one misses the mark or at least the way it reads & I’m curious who came up with the title; poor choice.

    • Chris Falk

      Audrey, thank you for your post w/an opposing view. I’m disappointed Brandon titled the article the way he did (or let BP do it). It’s I’ll advised to make a blanket statement like his article implies. 529 plans have a LOT of positives as he pointed out. I see the merit of the ROTH for a child & that’s fine but why the dramatic article title suggesting that parents put the brakes on 529 plans or never start one in the 1st place? There is no black & white better or worst alternatI’ve in this situation. I’ve liked some of Brandon’s articles the past few years but this one misses the mark or at least the way it reads & I’m curious who came up with the title; poor choice.

      • Brandon Hall

        Chris – When you are an RE investor, you have many superior methods over 529 plans. They literally become one of the most tax inefficient vehicles you can possible use once you begin growing an RE portfolio. A Roth IRA is one piece of the puzzle.

        I also have no control over the title. This has been discussed many times in the past.

      • Audrey Ezeh

        Thanks Chris! It is a really disappointing article and I’m troubled by the number of people that are going to implement this strategy. There are many smart ways to save for college, this is not one of them. See my follow up response to Brandon. Inflation is your biggest enemy with this strategy…

    • Brandon Hall

      That’s great yu are using a 529! But as you stated, you started before you were an RE investor.

      When you are an RE investor, 529 plans are one of the most tax inefficient vehicles you can park your money. Roth IRAs are simply one of the many alternative routes you can take when you’re an RE investor.

      • Audrey Ezeh

        Yes i started earlier but even if i started today, i would still run circles around this strategy as I illustrated with my numbers. It really is just a terrible advice to ask people to implement a strategy that does nothing to protect themselves against inflation… just awful. Yes they contribute a significant amount of money over a decade but that $55k will buy way less in 10yrs than it will buy today!! If tuition hikes keep up today’s pace then that money is not going to make a significant dent in college costs.
        If your argument is that 529 plans are not perfect vehicles for college investment then you may have a point but if you are pitching this as better than a 529 plan when it comes to investing for college then you are way off.

        Here is a better strategy…start at day zero and buy a house for your kid. Put a 15yr mortgage on it and let your tenants pay it off. When it’s time for college, the house should have appreciated significantly…sell it or refinance and use the funds to pay for college. If your kid ends up not going to college, you haven’t lost anything and there are no extra taxes or penalties to pay. That’s what i would do today if i were to start over!
        As terrible as your advice is, there are nuggets of wisdom in there…yes you should hire your child and yes you should open a Roth for them but keep it as what it is intended for…a retirement account. They should have 7figures in that account when they are ready to retire and you have not interrupted the earning power by withdrawing your contributions for college and they will thank you for it!

        • Brandon Hall

          Your comment is way off base, sorry. How can you make the argument that a 529 plans is better from an inflation perspective? The inflation adjusted returns can be the exact same, but all these years you’ve received a federal and a state tax deduction for your patents to your child. The Roth will have diverse investment options, sometimes even more than a 529.

          For the first $5500 you’re contributing, the Roth IRA absolutely crushes the 529 plan. Above and beyond that, you’re right the Roth fizzles out because you obviously can’t contribute any more to it.

          A better strategy would be tapping out the Roth and utilizing real estate at the same time.

          There’s really no room for a 529 once you are an RE investor. Too many other superior options are available for use.

  8. Audrey Ezeh

    Forgot to mention…I am in state of NM and unlike most states, there is no limit on the tax benefits…(it is 2k limit in the state of GA, 10k in NY but unlimited in NM). While the tax benefit may be nominal as you say, the more I contribute, the more I save!

      • Audrey Ezeh

        Your strategy calls for withdrawing your contributions to the kid’s Roth and using it to pay for college. If you contribute 20k you can only withdraw 20k …can’t touch the earnings without tax and penalties. Well 20k in 10yrs isn’t going to buy you as much as it will today will it? That’s the inflation effect. I can contribute the same 20k in 529 and be able to withdraw so much more because i can use the earnings for college too. As a retirement vehicle, you can’t beat the Roth because it does protect against inflation when you take your earnings into account. As you say, they are incredibly versatile too…I have so many options in mine…individual stocks, mutual funds, ETFs etc. My kids are getting Roth accounts because they are incredible retirement savings tools and should be taken advantage of when you can contribute directly into it and not back door your way in (which is fine too, just has to be fine carefully).But I’m definitely not going to be using it as a college savings vehicle…makes no sense and totally defeats the purpose. Why sabotage your retirement for college? Of course this is all moot if you have a sizeable RE portfolio then who needs a 529 or Roth? That should be everyone’s goal shouldn’t it?
        Your advice Is flawed and you should accept it.

        P.S: I wonder what’s happening to the ‘reply’ button!

        • Brandon Hall

          You are assuming way too much.

          Yes $20k will not be the same in 10 years, but that $20k has generated earnings on a tax free basis. Those earnings, by the way, you CAN tap into. Get a tax strategist on your side to understand how.

          What if the landscape of education hanged dramatically over the next ten years? What if it only makes sense to attend college for STEM subjects? What if your child therefore doesn’t attend college and becomes an entreprenuer? You’re stuck with your fat 529 plan. Nothing to do except pass it on to an heir (taking another huge gamble on education) unless you cash out and pay penalties.

          This method allows you to receive federal and state tax savings TODAY and stick it in a Roth that will grow over time. The tax savings TODAY almost completely nix your inflation argument.

          If we have inflation of 2.5% annually but I can save 25% (fed tax savings) by moving my money into a child’s name and then their Roth account, I’ve recovered my “inflation hit” for almost a decade.

          Do the math – what you’re saying makes absolutely zero sense. Sorry if you have loads of funds in your 529 but it’s simply a hugely inefficient vehicle.

        • Krista Walker

          I tried to read all of the comments so as to not repeat a question already asked..that being said, do you have to be set up as an LLC to do this? Thanks for the article

        • Chris Falk

          Audrey,

          Brandon has dug his heels in. There’s no point in arguing it any longer IMO. As I said in my original post, there is no 100% black and white right or wrong in this scenario as I see it and the beauty of some of these topics is that we can all agree to disagree at times. At end of day, BP titled the article the way they did and that’s where the “mistake” was made. I don’t spend much time on BP these days as the redundant, dramatic, attn grabbing blog titles get a little old (for me). I highly valued BP when I was trying to get through RE investing 101 but it quickly loses value for the type of passive investing I do and I’ve had multiple conversations with others who’ve backed away for similar reasons. I believe Brandon is very bright and well-meaning and I have no doubt he is a very good CPA based on the other (less dramatic) stuff I’ve read by him and listened to on BP podcasts (before those episodes also became too redundant). Brandon, one thing I will say as this engaging in this back and forth reminds me again why I visit this site so infrequently………the conceited comment directed at me about how I should know that you don’t title the articles, like DUH, is out of line. I’ve never seen or heard that policy so I mentioned it when I critiqued the title of the article. Now I know that the stadd at BP world headquarters title the articles:-)

      • Audrey Ezeh

        I’m still missing the ‘reply button’ on your comments for some reason (unless of course you are blocking it). Anyway in reply to your comment below…sure there is an exception that allows you to avoid the 10% penalty when you use your roth earnings portion for college expenses but you still have to pay income taxes on those withdrawals . 529 withdrawals are tax and penalty free so I get to use all of it to pay for college expenses. ALSO that amount you withdraw counts as income for the next year financial aid does it not? That lowers the amount of aid your child can get and more you gotta pay out of pocket. And you have substantially reduced the amount of money available to your child at retirement.

        The 529 plan is not perfect and yes your child may not go to college but what if they do? You don’t replace an imperfect strategy with one that is even more flawed. Buy a house for your kid and have your tenant pay it off…you got your tax free, penalty free vehicle that is protected regardless of whether your child goes to college or not and you don’t have to sabotage anyone’s retirement to get there.

        • Audrey Ezeh

          Actually i may be incorrect on the taxes on your earnings…will have to look more into that. I do know this is not a strategy i or anyone should be deploying…there are better ways to use RE to fund college expenses.

  9. Angel Gutierrez

    Here’s a novel idea I used on my own kids JUST LIKE it was used on me…

    Wanna go to college ? Then get a job and YOU pay for it… ahhh…. what a concept..?

    I graduated (finally) with a degree in business admin in ’89 after I left the Navy.

    The worst part about the whole time I suffered going to useless classes and professors droning on about nothing is that the degree I finally got…. did ZERO for me in the real world… nothing but a waste of time and money.

    But then again… hopefully it will be different for your kids…

    Mine have seen zero advantage to college being in the “house business “…

    Jus sayin… 🙂

      • Chris Falk

        Geez Brandon. Conceited again. I didn’t get the impression you were like that?? I went to college as well and it benefited me professionally but it’s not for everyone. You are such a student of RE that I imagine you read Rich Dad Poor Dad. As you well know, college just keeps getting more and more expensive and isn’t a good fit for some people. yes, of course, if someone wants to be a CPA then college is a must but look at all the careers in RE that do not require or necessarily benefit from a college degree. You sure you want to post comments like that? With all due respect, makes you sound really arrogant and I don’t think that’s who you are. It’s strange but this thread and your comments have actually motivated me to quit BP and just eat the rest of the pro membership. You are/were the last person I would’ve expected to be so……conceited and arrogant. I’m older than you and been around the block a few times and I while I hate to give unsolicited advice; humility is really important as you progress in your career. Kudos to you for your success to date but keep perspective, Brandon.

        • Brandon Hall

          I think this comment is being misinterpreted. I did not mean for it to come off as conceited but can see how you are seeing it that way.

          My comment was intended to strongly oppose the comment that was strongly against going to college. Skipping college works for a great deal of people but also provides the stepping stones to success for the majority of others.

          I’m the last person to talk about my successes (heck, i don’t even think my current position embodies “success” quite yet) but perhaps I need to work on my quick fire comments and reign them in a bit 🙂

        • Chris Falk

          Hi Brandon – I’m sorry also for snapping at you over the article title and your college comment. I was already a little worked up when I read the college comment as I felt “dumb” for not knowing that BP titles your articles. Now I realize that it makes sense as they are the site admin and want to come up with catchy headlines that will grab reader attn. Regardless I feel like they were a little reckless with the title but onward and upward. I agree that your ROTH plan for kids has a lot of merits and in fact my ex-wife (who works for a CPA) started one for our daughter recently. The aim is not to use it for college since I am designated to cover most of her college-related expenses in the decree and contributions will be relatively limited by the time she is in school (though it’s, of course, an option when the time comes). The key is to start it very early in a child’s life as you mentioned (or as early as you can justify to the IRS that your kids work for you). I think that if I implemented this strategy starting when my daughter was, let’s say, 13 years old (she’s 16 today) then it wouldn’t really provide a WHOLE lot of contributions towards most colleges (yes better than nothing) so in that case the point would be for her to have a ROTH for use later in life, whether that 1st home down payment you mentioned or way down the road in her own retirement). I started a 529 for her w/Vanguard when she was about 3 years old I think and as you know, they offer plenty of prudent investment options w/bare bones fees. Even with my contributions and investment gains (and setbacks around ’08) I doubt the current fund balance will cover 4 years of tuition, books, R&B etc unless she goes to an in-state public school, so in that regard, your crystal ball comment is 100% spot on. I’d LOVE to know today exactly where she is going since the cost of in-state public vs private vs out of state public is like Rolls Royce vs Camry type $ and everything in between!!!! To clarify, you did not suggest in the article that 529s are not qualified to use for trade/vocational school expenses did you? I reread the article this AM and I “read’ it both ways based on the wording. I’m sure you know that 529s can be used for vocational schools the same way as traditional 2-4 year colleges. The list of qualified expenses keeps growing too but you are absolutely right at end of day that if something unforeseen happens in the next 2 years, such that she does not go to any sort of accredited college (or vocational) institution somewhere in the world, I will have a 6 figure 529 sitting @ vanguard that would incur the 10% w/drawal penalty (especially if I re-allocate the funds to a new boat or something instead:-)

  10. Angel Gutierrez

    You don’t need college to learn to buy ugly houses and fix ’em up for profit… it just takes a thick skin(acquired if necessary) and willingness to get dirty.

    The last part knocks out about 75% of the wanna-be’s. 🙂

  11. Alik Levin

    Brandon, outstanding article!
    Can you give some clarity on FICA taxes when the child turns 18?
    I am aware before that no need to withhold or pay FICA taxes, but what happens when the child turns 18 wrt FICA?
    I am taking full advantage of what you outline here. I am a bit confused though wrt FICA taxes and age 18.
    Thank you!
    -Alik

  12. Krishna Pisupat

    Thank you Brandon. This is useful information. However, I got a question. If one pays to her/his kid and that income is NOT included in his tax returns, can he still claim his kid as a dependent in his tax returns? If not, aren’t you going to lose some tax return because of one less dependent?

  13. Jonah Eleccion

    Thank you for sharing this Brandon! I have a 2 year old so I have been thinking of starting the 529 plan but thanks to your article, I now know a much better way to save for her college! This was an eye opener indeed! You are awesome! ??????????

    • Brandon Hall

      You can certainly do that. We have clients that do this. We advise against it though – may as well take that 529 plan money and use it as equity in a property. Child invests along side you. Much more tax efficient.

  14. Tom Cyr

    Brandon, That is a good approach to exceeding the value of the 529. You forgot one other benefit. The IRA is not counted on the FAFSA for assets tapped for tuition. It’s exempt; off the books; under the radar.

    The 7702 does the same thing and provides even more benefits but you have to have an agent who know how to design the product correctly or it will underperform the Roth. I own both but prefer the 7702 except in cases where I have an expectation of an extremely high capital gain. That’s rather limited, especially when I have to remain beyond arms length from the transaction and development activity.

  15. Nathan G.

    Read to the end for a YUUUGE money-making tip!

    1. They are more likely find success if they enter a skilled trade like plumbing or electrical. It would be even better if they could learn to invest in real estate and work with you!

    2. If they decide to attend college, they should pay for it themselves. If they have to pay their way through, they wouldn’t squander money on classes like Sociology of Miley Cyrus or Feminist Dance Theory and we wouldn’t see colleges jack tuition rates 200 – 300% in 20 years. It’s become a money-making scheme for professors and boards that leech off the working class instead of producing.

    3. If you insist on paying, use real estate. Buy a property, teach your child how to manage it, and let them live there for free and use the income to pay for college while you build equity. Or gift it to them at graduation.

    4. If you decide to invest in a 529, pay attention! A new law is making the rounds that would allow you to use a 529 to pay student loan. Why does that matter? Because you can have the student take out loans, allow your 529 to grow for an additional four years while they attend college, and then pay the student loans off with a larger bank account. Let’s say you put $1,000 in to start the account and then $1,000 a year after that. if you cash it in after 18 years, it will have $45,000. If you hold it for four more years while the kid attends college, you’ll have almost $70,000. You may end up with enough to pay for their college and still have leftover for an investment property or a nice graduation gift!

    • Brandon Hall

      This is not an article about whether college is the right choice. So I will only address #4.

      Even with the new law, a 529 plan is one of the most tax inefficient vehicles you can possibly use as an RE investor. Don’t follow the herd.

  16. Adam Ulery

    Thanks for the knowledge share, Brandon! If one were to pay their child $6000 and contribute the max $5500 to a Roth, would you have suggestions about what to do with the remaining $500? Also, if the Roth were a self directed IRA then the child’s investments could include real estate… even better!

  17. Duru Ahanotu

    I don’t think this is either or. Pay the children up to the max you can, and funnel the rest of the money you want to save for college in a 529. Also, given the kids are getting a *salary*, these funds are subject to the desire of the kids to do with their salary as they please. After all, it their salary IS their money the moment it is created…

  18. John Veirup

    Just because your a CPA doesn’t mean your qualified to give advice on if someone should or shouldn’t invest in a 529 plan! You need to have a securities license and if you do it’s irresponsible to give blanket advice in a post like this. Unfortunately there are a lot of people that will take your advice blindly without checking credentials. With he new DOL rules, you keep this up and you’ll lose your job. Next time pose a alternative rather than make a statement like you did.

    • Brandon Hall

      Is this a joke? Please let me know where I advised on security purchase.

      A 529 plan is a vehicle. Just like a 401k and and IRA. I don’t care what you invest in, I just care what vehicle you use. CPAs quarterback this type of tax planning literally every day and there are no rules against it.

      For RE investors, a 529 plan is easily one of the most tax inefficient vehicles you can possibly use. You have many superior alternatives, a Roth IRA is one of them.

      Your comment was off base and pointless.

      • John Veirup

        First of all, I have probably been in the investment industry longer than you’ve been alive kid, so show some respect to people like me and others who disagree with your OPINION. Too many people use blog post to “advertise” their business and prey on naive people. Your 401K post you quote stats without the source, so I always assume anyone who does that the stats are made up. Dalbar, a trusted source would quote a VERY different statistic than the one you quoted on average investor returns. When you tell someone not to invest in one vehicle and you should in another you are giving investment advice. A CPA is allowed to give “INCIDENTAL” advice as it pertains to being a tax advisor , not specific advice like you are in this post. Without knowing a person’s financial situation it is irresponsible to advise them on what’s best!! Most people aren’t in a position to pay for their college dollar for dollar like in a ROTH, and if they were in a good financial situation they would never pull it out to use for college or they would be a fool. And if this is the kind of advice your giving your tax clients I’m sure your going to get sued at some point. This is a real estate blog so stick to real estate posts, that’s assuming you own any.

        • Brandon Hall

          I am a CPA. I advise on tax issues for real estate investors. A 529 plan is a highly inefficient vehicle from a tax perspective for reasons I have made clear in this post.

          I own six units. Thank you very much.

  19. James Koh

    Interesting information, but I’m wondering as a business owner what about employment taxes and workman’s comp premiums that would increase by adding payroll? Is there an exemption on employer tax contributions for wages less than the $6350 per year?

  20. Craig Reynolds

    Brandon, (1) Does the salary come from the business account? If so, how is that account taxed? I’m wondering why SE taxes are not mentioned. (2) Can the business pay the college expenses and be deducted directly from the business? I assume the child must be an employee and the business must be structured, tax speaking, properly for that. Would (2) be feasible from a tax savings perspective while maintaining the desired flexibility?

    • Brandon Hall

      Hi Craig – (1) yes you’d pay via your business account. No mention of SE because your child will not be subject to FICA taxes until they are 18. (2) this would not be allowed as a deduction unless the education furthered their expertise in the current trade. I’ve not see this successfully carried out for the first 4 years of college. Could work as a masters program.

  21. Fernando Fonseca

    Thanks, Brandon. I would also consider putting the money you pay your child into a dividend paying whole life insurance. If you need the money for college take out a policy loan when the time comes. In the meantime, the money grows steadily and you also have a death benefit.

  22. Jason Jennings

    Nice article Brandon. Could I deploy this strategy for my grandchildren? My son and daughter in-law don’t run their own business or invest in real estate. However, I do. I believe they’ve just begun paying into a 529 plan.

  23. Ed Perez

    Great article! We completely stopped contributing to our kids 529 plan some years ago for the simple reason that we didn’t have control on the earning power of the funds in the stock market. My wife and I, instead, opened their own CESA accounts with a self directed company (equity trust) and invested their accounts on RE. Now my three kids get monthly income from their RE properties.

    But first, my wife and I made sure that our own retirement plans (401k plan and IRAs) are being contributed to the max per year, in addition to establishing the emergency funds.

  24. James Martin

    Brandon, I have a question that I am sure you know the answer to. I assume that paying your kids in the fashion that you are describing generates essentially a W2 income (I think that it must in order to use the IRA option).

    If I am paying them in that fashion, isn’t there a payroll tax loss that would occur in the transaction. Wouldn’t the business and the employee split the 15% expense?

    I am just asking so I can make a true apples to apples comparison.

    In the 529 example, that money would come to the owner of the business as passive income (probably with fed and state tax burden, but no payroll tax). In the IRA example, that money would leave the business (with no fed and state tax burden) but be hit with the payroll taxes and reduce the total amount by 15%.

    I THINK that I have this right, but I am not positive. It still may be the best wealth preservation option, but the margin between the two would be reduced some.

  25. Susan Millhauser

    Folks should research and be aware of how custodial IRAs (ROTH and otherwise) and 529 plans are looked at in terms of assets when it comes time to apply for financial aid, grants and scholarships. Also learn how investment real estate is considered in terms of family assets (and Expected Family Contribution) depending on the school. Ivy’s consider more… From an Ivy League univ. website: “Investments in qualified retirement plans, such as an IRA or 401(k), should not be included when reporting parent or student assets on the Free Application for Federal Student Aid (FAFSA). However, student investments in qualified retirement plans must be reported on the xxxx University application.”

  26. konstantin ginzburg

    Brandon, do you have to qualify as a business from IRS perspective in order to take advantage of this strategy? What I mean is both my wife and myself have full time jobs as well as rentals. We cannot claim that we spend more time on real estate than at our full time jobs. I guess this should have no affect on the strategy that you’re suggesting but want to make sure. Thanks! Great advice BTW.

  27. Mary White

    Thanks for the great article. We’re currently paying our children for landscaping, painting, cleaning and flipping rentals and more. I appreciate the tips about keeping the money nice, clean, and traceable using their own bank accounts and retirement accounts. We haven’t opened up Roth IRA’s yet, but will look into it for this fiscal year.
    we stopped contributing to their 529 plans a couple of years ago because I prefer to build their net worth faster than that alone allows. Does the $6350 apply to the 2017 tax year?

  28. Shawn H.

    Brandon great article. We need more posts like this, for people like myself, who are not educated in business/taxes or aware of the options available. I do have a question about the statement ‘the child invests along side you’. How does this work? Thanks

    • William Harkins

      I believe what he was saying is that you will be using the 529 money to invest more into the real estate business which can provide better returns than the 529. So essentially the child’s money will be invested with your money into more real estate.

      I have heard it mentioned in the podcasts but an option once your child is ready to go to college is to refinance a property that has a lot of equity down to 20% and use the equity money to pay for college. So that would be a way of the child investing with you as well.

      Hope this helps.

  29. William Harkins

    Great article. I have read about benefits of creating a Roth IRA for my children at a young age once they are making money. However, it never crossed my mind to use my young baby for modeling! Always imagined I had to wait until they could do physical labor.

    Also, something to note. You can’t put more than what they earned into their Roth IRA each year. So if they are only paid $2,000 you can’t put the maximum $5,500 into their Roth IRA.

  30. Ryan Anderson

    Brandon, this is a great post. There are not that many “no-brainers” that the IRS gives you. Paying your children and contributing to a Roth IRA are two of them. Being able to combine the two for college savings is a great idea.

    A strategy I’m considering is buying an investment property in the college town my children go to. The money in their 529 plans and/or Roth IRA can be used to not only pay for tuition and books but also housing expenses as you mentioned (with some restrictions). This might be a great way to tap into that money to pay yourself back as a parent with a guaranteed rental payment from someone that isn’t going to stiff you. It appears the housing payments are restricted to an amount set by the school however, so it doesn’t appear you can overcharge your child/self. It makes a lot of sense if you have multiple kids going to the same school over a period of years. They can help manage the property, take care of issues, and learn the REI business all while you are recouping some of that money as a rental payment.

    Or I love the other idea you mentioned. If your kids don’t go to college the money in my kids Roth IRA could be used to purchase an owner occupied home since you can pull out up to $10,000 from a Roth for a first time homeowner. This is another big advantage over the 529 since it would allow them to get into the real estate game with that money too.

    I’m pleased to see there are no FICA taxes owed if the parent is paying their child. Am I correct in understanding that you don’t need to 1099 your child? The only paper trail needed is that the money hits their bank account and stays in their name and you have a description of the duties and work done if you are audited?

    Thank you for your time. I apologize on behalf of some of the other people commenting in ignorance with no knowledge of the subject or desire to find a better way. I think most of the members understand an article has to have a catchy title to get readers. The fact that you have no control over the title leaves even less of an excuse for people to get ignorant. Others just appear uninterested in finding a better way. I have been happy with my 529 plans thus far but I’m always looking for a better way.

    • Brandon Hall

      THANK YOU! This is refreshing to hear. Seems like every article I post has haters – either those who have used whatever strategy I’m saying is bad for too long or those who are selling a product I’m saying is bad. It’s nuts! But I like the challenge.

      You are correct in that you don’t need to 1099 your child. Put them on payroll and it will be easy. For a paper trail – yes money must hit their bank account and stay in it. Many parents make the mistake of taking the money back out of the child’s account and putting it into the parent’s account. Don’t do that.

    • Brandon Hall

      The FSLA has an exemption for that. Minors under age 16 working in a business solely owned or operated by their parents or by persons standing in place of their parents, can work any time of day and for any number of hours.

  31. lionel lin

    We paid our child and let her invest that into a roth IRA but my CPA said we needed to pay the social security tax. Another commenter mentioned that as well but I didn’t see that in your article. Social Security tax is an additional “cost” that needs to be figured into this strategy right?

      • lionel lin

        Got this back from my CPA. Thoughts?

        There are two issues at work. The first is the statement “child under age 18 who works for his or her parent in a trade or business”. The parent’s trade or business income is normally subject to self-employment and is reported on Schedule C (self-employment income) or Schedule F (farm income). It is very difficult to get the IRS to accept rental income as trade or business income, even more so now that Obamacare imposes the Net Investment Tax on passive income. The second issue it that your kids have to have self-employment income to make the Roth IRA Contribution. If we were to reclassify your child’s income you would have to liquidate the Roth IRA. The IRS also prefers that quarterly tax returns and W-2 be filed when the child does not pay social security tax.

        • Jane Z.

          I have asked my CPA similar questions several times. His opinion is more or less the same as your CPA. Basically what he is saying is that because rental income is considered a passive activity and the income is reported on our Schedule E, therefore, we could not issue W-2 to the kids. Instead we need to file 1099 and the kids then pay self-employment tax when they file their own income return.

        • Alik Levin

          Consider layered business entity structure:
          * Holding LLC – active income, reports on Schedule C, your kids paid from here w/W-2. Owns Children LLCs, doesn’t own properties. Performs cross cutting management activities such as bookkeeping etc. Can offset losses on regular income.
          * Children LLC’s – hold properties, passive income, reports on Schedule E, owned by Holding LLC. Can’t offset losses on regular income if regular income greater than $100/150K (details omitted for simplicity)

        • Brandon Hall

          Child does not have to have SE tax to contribute to a Roth. Just has to have earned income. Earned income could be SE income or W2 income.

          While there’s definitely structuring that needs to take place, it is not “very” difficult.

  32. Tyler Watts

    Brandon,

    As always I enjoy your post! Even more I enjoy your responses to the comments. Most people seem to get distracted with catchy titles and want to intentionally misinterpret things. Take emotions out of the equation and listen to this dude. He’s not saying do this or do that. He’s breaking out the options so you can be more educated so you can make the best decision for you and your family. As it’s been said a million times, there is not set formula that covers every single person. Everyone has different variables they have to deal with in life that determine their decisions. This one is no different.

    Don’t cut a man trying to toss out education, thank him. Emotions cost you time & money.

    Solid article and keep them coming!

  33. Jane Z.

    Brandon,

    I have discussed this issue several times with my CPA in the past and he seems having different opinion. I just emailed him your article and here is his reply. What is your take on his opinion? Thanks.

    “I feel you were confused that if you should pay social security and medicare taxes for your children. If you issue 1099 to your child, he will always pay self-employment tax (same as social security and medicare taxes) because he is considered self-employed. If you issue W-2 to him from your own business, then no social security and medicare taxes are required. But, the IRS publication says clear, you need to be either sole proprietorship or partnership. But if you have a real estate investment in the form of schedule E, it is considered a passive activity. By definition, it is not a sole proprietorship or partnership. For that part, I am not sure if W-2 to your kids without paying ss and medicare taxes will work.”

  34. Jane Z.

    So you agree with my CPA that as long as we file our rental business on Schedule E, we will not be able to take advantage of what you propose here? What kind of entity/business structure that could allow us to get around this rule?

    Thanks.

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