529 plans overfunding

[rm]

It is difficult to estimate how much my kids will need for education when they are ready. They are 9 and 4 right now. I have funded ~50K for the 4 yr old and ~80K for the 9 year old over the years. Or to put it more correctly, I have ~130K for 2 kids education.

Does it make sense to continue investing a little bit going forward and just bite the 10% penalty on gains if the money is unused? I can't figure out if over or under funding is better. Note we live in california so no tax breaks for us

thank you

[livesoft]

It didn't make sense to me. If one funds 100% of college expenses with 529 plans, then they lose out on other ways to fund college. For example, education tax credits helped us out quite a bit.

I think that families who can afford such large 529 plans can also afford to pay for college out of cash flow. After all, they are contributing the maximum to retirement plans before contributing even 1 cent to a college account. Another benefit is they save the hassle and aggravation of filling out financial aid forms. That's got to be worth something.

[JamesSFO]

Vanguard has a college savings planner that might be useful: http://www.archimedes.com/vanguard/csp.phtml

[JamesSFO]

PS just plugged your numbers into the VG college calculator and if you are looking at 4 yr public, in-state rates you look well funded. For private 4 yr, not so much.

[rm]

livesoft,

My primary reason to fund using 529 versus normal cash flow is the possible means to have earnings which will not be taxed (if used for education). Is there something wrong in my thinking? Please let me know.

[livesoft]

There is nothing wrong with your thinking, but you can have "earnings" not taxed in other ways, namely education tax credits. These tax credits could go away, but I am using them while they exist.

There are other ways to have earnings not taxed. See my tax threads:
viewtopic.php?t=87471
viewtopic.php?t=79510

[NYBoglehead]

If you're not getting any state income tax deduction I vote to let what you have ride until the time for college comes. Don't get too wrapped in having the 529s pay for 100% of the college bill. It looks like you've definitely got at least 2.5 years of a very expensive private school saved for the 9 year old.

[letsgobobby]

Education tax credits phase out with income, while dividends and capital gains are taxable annually at rates as high as 44% federal starting in 4 days. The higher your income - and you live in CA - and the longer you have til college, the more you should fund 529s over taxable. Of course this assumes all retirement accounts are already maxed. Plus you don't yet have enough to pay for even three years of Harvard right now!

[ks289]

I would also vote for cutting down on contributions to avoid possible overfunding the 529s and paying the 10% penalty on gains. Education tax credits may be unavailable because of income limits, so there may not be an available alternative for avoiding taxes on gains. However, the flexibility of now saving outside the 529 may end up paying off if good alternatives become available or if your children do not end up needing all of the funds (athletic scholarships to Stanford? MD/PhD program? ).
I agree with the idea of saving big early though since you never know what your income will be in 9-18 years.

[ram]

It is difficult to estimate how much my kids will need for education when they are ready. They are 9 and 4 right now. I have funded ~50K for the 4 yr old and ~80K for the 9 year old over the years. Or to put it more correctly, I have ~130K for 2 kids education.

Does it make sense to continue investing a little bit going forward and just bite the 10% penalty on gains if the money is unused? I can't figure out if over or under funding is better. Note we live in california so no tax breaks for us

thank you

If other avenues for tax deferred savings are all exhausted then you may want to put more money in the 529 rather than in a taxable account. You most likely will need some more, say 10 K more for the younger one.
Also depends on what your income level will be when kids are in college and what exemptions are available at that income level at that time . Too difficult to predict.

This may not apply. But if you are over funded in 529 K and IF you have adequate other retirement savings, then you do not necessarily have to withdraw at 10% penalty. You may simply pass it on to the grandchildren. In such a case I would not worry too much about a few thousand in overfunding, but would avoid extreme overfunding.

[letsgobobby]

You may simply pass it on to the grandchildren.

Correct, this argues for materially overfunding a 529 (within the letter of the law) assuming you have met all your retirement and other long term needs already. You are creating a tax-free-forever family educational trust.

[sscritic]

You may simply pass it on to the grandchildren.

It all depends how simple the Generation Skipping Transfer tax is. I haven't filed a return for the GST tax yet, but I am definitely looking forward to it.

[letsgobobby]

doesn't changing the owner on the 529 to the parent from the grandparent mean there is no more generation-skipping occurring?

[sscritic]

"You may simply pass it on to the grandchildren." I don't see the word parent in there anywhere.

P.S. There are several lengthy threads on who "owns" a 529 for gift, estate, and generation skipping transfer taxes. My memory is that you were involved, but I am not going to look.

[letsgobobby]

got it, I thought you were throwing in yet another twist.

[jhh9327]

Here is some guidance on beneficiary changes from the NY 529 website. "Potentially" and "may be" certainly does not bring any type of definite answer though.

A change of the beneficiary of a 529 Plan account or a transfer to an account
for another beneficiary will potentially be subject to gift tax only if the new
beneficiary is of a younger generation than the beneficiary being replaced
or not a Member of the Family of the current beneficiary. In addition, if the
new beneficiary is two or more generations below the beneficiary being
replaced, the transfer may be subject to the GST (discussed below).

[sscritic]

This is a tricky issue.

In order to assign the tax liability to the party who has control over the account and is responsible for the change of any beneficiary, the forthcoming notice of proposed rulemaking will provide that a change of DB that results in the imposition of any tax will be treated as a deemed distribution to the AO followed by a new gift. Therefore, the AO will be liable for any gift or GST tax imposed on the change of the DB, and the AO must file gift and GST tax returns if required. This position comports with the income tax provision under § 1.529– 3(c)(1) of the 1998 proposed regulations that treats a change of DB to a new DB who is not a member of the family of the former DB as a distribution to the AO, provided the AO has the authority to change the DB.

http://www.gpo.gov/fdsys/pkg/FR-2008-01 ... E8-859.pdf

These are the proposed regulations published in the Federal Register in 2008. This makes a change of designated beneficiary a two step process in concept: withdrawal by the parent, say, followed by a new gift to the grandchild, which results in the GST being applicable. It also says, contrary to my own assertions in other threads, that the owner is liable, not the old beneficiary (my assertion is still correct under current regulations, I believe).

I haven't found the final regulations. Sometimes these take a while to become final. They may not be out yet. They aren't, according to Virginia's plan:

Federal Tax Treatment in General. IRC Section 529 governs the federal tax treatment of QTPs such as prePAID and the tax consequences for Account Owners and Beneficiaries of such plans. As of the date of this Program Description, the IRS had not issued final regulations governing the application of IRC Section 529 to college savings plans. In January 2008, the IRS issued an Advance Notice of Proposed Rulemaking on proposed regulations for IRC Section 529 plans. There is no specific timetable for the release of new or re-proposed IRC Section 529 regulations. Any changes will likely be applicable to existing accounts.

December 1, 2012 — March 31, 2013 Enrollment Period

So let's just say that NY is correct today but may not be tomorrow with respect to when the GST applies.

P.S. This may be my find of the week.

[inbox788]

Late to the party here, but hope some folks are still around. I'm wrestling with the same question. Didn't see anyone frame it a little different, so I might start a new thread if this old one doesn't get some interest (or if someone knows if this was discussed elsewhere, please let me know).

Simple case of one child going to college in about a decade. Cost today for public school about $30k/year and private school $60k. Assume some average to above average inflation rates, and we're looking at $150k for 4 years at a public institution and $300k at a private one. Add to that possibility of graduate school, and that the amount needed could be another $150k to $300k.

If the child was to get a Ph.D. from Harvard in 8 years, they'd need $600k in the plan (probably exceeding contribution limits, though with growth, might just hit that amount, also ignoring gift tax issues). If the child instead only finished a public college, then would only need $150k, so having $600k would be extreme overfunding.

Now assume 100% gains in the decade for simplicity, so half the final amount is from contributions and the other half from capital gains and an expected future capital gains tax of 20%.

Fund $100,000 in 529 plan, gain $100,000, spend $300,000 on expenses (either private school for 4 years, or college and graduate school in public school). All $200k would be tax free, so need $100k from other (post-taxed) sources.

Or split 50/50 by funding $50k+$50k gains in 529 and $50k+$50k gains in taxable account. Only the $50k gains in the taxable account is taxed, so would have $190k (or $10k less from 20% capital gains tax on $50k), so need $110k extra. The cost of underfunding. Now if student goes to public college instead, then you'd use $100k from 529 and $50k out of taxable account and be left with $40k after taxes cash left over to spend as you wish.

Going back to the overfunded situation and you'd spend $150k out of the $200k in the 529 account. Now you're over $50k. You pay 10% penalty, AND ordinary income tax as well as any state income tax, so you may only wind up with around $25k (more or less depending on state and tax bracket), so that's quite a penalty!

If this is correct, then it makes sense to fund it to the minimum expected completion, which is $150k (or around half that amount if you expect the gains to double over the course). Overfunding only makes sense if there is a high chance of private school and/or graduate school, or if another child (grandchild, other) can benefit from the excess funds. Any goal over $300k, besides being a bit unrealistic for most families, comes with the potential of massive excess funds if child doesn't use it all, and will have very high penalties.

Please point out any flaws and suggestions. Thanks!

[dianna]

It is difficult to estimate how much my kids will need for education when they are ready. They are 9 and 4 right now.... Note we live in california so no tax breaks for us

The question of how much to fund a 529 plan for kids so young is truly a difficult one, IMO. The educational landscape is the US is vast, yet not every graduate is 'guaranteed' a look at a relevant job, not even to mention a job that could cover ordinary expenses. And many people seem to be hoping for a 'correction' in educational expenses that would facilitate good educations being more affordable.

The answer to your question lies in your personal beliefs about where the educational system might be in 10-15 years. Do you see online courses taking off in their effectiveness and offerings, and if yes, at what cost to the student consumers compared to the current traditional education? Will Brick-and-Mortar colleges and universities hold the same value that they did years ago? Will trade schools become 'de rigeur' because their graduates are "job ready" upon graduation?

[letsgobobby]

Going back to the overfunded situation and you'd spend $150k out of the $200k in the 529 account. Now you're over $50k. You pay 10% penalty, AND ordinary income tax as well as any state income tax, so you may only wind up with around $25k (more or less depending on state and tax bracket), so that's quite a penalty!

Only the gains are taxed and penalized for non qualified withdrawals, not the entire balance.

[Grt2bOutdoors]

Going back to the overfunded situation and you'd spend $150k out of the $200k in the 529 account. Now you're over $50k. You pay 10% penalty, AND ordinary income tax as well as any state income tax, so you may only wind up with around $25k (more or less depending on state and tax bracket), so that's quite a penalty!

Only the gains are taxed and penalized for non qualified withdrawals, not the entire balance.

At the rate we are going, gains can become a substantial portion of the overall balance.
I'm going to be answering this question myself in about 5 more years - about continuing to fund.

[dickenjb]

My strategy was to invest many years ago in the Utah plan. Those two plans have sizeable gains. In 2012 I started new plans for both kids in the NY plan. Put it 100% in TBM. At a coupon of 1.5%, this potentially "extra" money won't earn much. You need fixed income somewhere in your portfolio. This way I get the PA state tax deduction and if the money is not needed for QHEE, the 10% penalty on the gains won't sting too much. Even if the PA tax benefit is recaptured, no biggie.

If I were to do it all over again, I would open 2 plans per kid from the get go. Put one 100% in equities and the other 100% in fixed income. Use the equity one first for college costs (assuming it has the bigger gains).

[letsgobobby]

you can run a spreadsheet.

tax-deferred gains of x% over y years then taxed at marginal rates plus penalties on earnings

vs

taxable gains of x% taxed annually (dividends and distributed capital gains) over y years. Don't forget to include the 3.8% Medicare tax.

Depending on the values used for x and y, as well as your marginal rates, one scenario or the other may make more sense.

For us we've decided "overfunding" will likely lead to a higher after-tax return. Also I think there are many ways to use 529 funds so that in the end, most of our withdrawals will be qualified.

[inbox788]

Going back to the overfunded situation and you'd spend $150k out of the $200k in the 529 account. Now you're over $50k. You pay 10% penalty, AND ordinary income tax as well as any state income tax, so you may only wind up with around $25k (more or less depending on state and tax bracket), so that's quite a penalty!

Only the gains are taxed and penalized for non qualified withdrawals, not the entire balance.

Yes, the gains are $100k with $50k remaining unused. Is this the wrong order?
With 10% penalty, typically 25-38% federal tax, 8-10% state tax in high tax states, can yield greater than 50% taxes on the, so you only keep around $25k.

Underfunding means you use taxable account and post tax gains on the shortfall, so you pay extra taxes, but remaining amount avoids penalty and gets federal capital gains (although some states have very high capital gains tax -- is it correct that California is 13.3%?)

Rightfunding requires accurately predicting what our children will do in the future, which is much of the challenge.

[inbox788]

...You need fixed income somewhere in your portfolio.
...
If I were to do it all over again, I would open 2 plans per kid from the get go. Put one 100% in equities and the other 100% in fixed income. Use the equity one first for college costs (assuming it has the bigger gains).

Interesting strategy. You would need to verify that the taxable portion is account specific and not total return. Kind of like the Roth (stock) vs tIRA allocation (bond). I'm thinking of underfunding, so place 100% in equities, correct? Overfunded portion would then go into the fixed income account.

For us we've decided "overfunding" will likely lead to a higher after-tax return. Also I think there are many ways to use 529 funds so that in the end, most of our withdrawals will be qualified.

What marginal rate are you using to come to this conclusion? I believe for most people 25%+ fed tax plus 10% penalty will exceed dividends/capital gains rates in a taxable account.

I'm leaning towards fully funding (slight overfunding) a public education for 4 years and being underfunded for private and graduate school. If finances allow, funding private college or graduate school is an option, but there's a chance of this being overfunding if child doesn't use it for these, and aside from other children/grandchildren, I don't see many other ways of using the tax break.

[letsgobobby]

Your scenario's a little confusing to me. If you fund $100k and have $100k in gains and spend $150k, you have $50k left of which $25k is gain and $25k is contribution. Non qualified withdrawals of any of the remaining $50k will be pro-rated as half contribution, half earnings. If you withdraw $50k, $25k will be taxed and penalized. If you are in the 25% bracket that is 35% of $25k or $8750. That is the total tax and penalty paid across the entire $200k 529. Contrast that with a taxable account, which has taxes taken out every year. The depending on how long you invested the money and what rates of return you earned, one will be better than the other. In other words the benefits of tax-deferred growth may ultimately outweigh the higher rates on withdrawals.

You can have qualified withdrawals for you, your children, your grandchildren, nieces, nephews. You can use the money for undergraduate or graduate school. The money can be used at most American schools and quite a few international schools. All that is required is that the student attend school at least half time. In my view that is a lot of flexibility. Also my marginal tax bracket now is high enough that tax-deferred growth is attractive. And there's a chance I'll be in a lower tax bracket when/if I start needing non-qualified withdrawals. Like if I'm 65, retired, and realize I have too much money in my 529s because my kids are now in their late 20s and done with schooling, I may be in the 15% tax bracket. Etc.

[inbox788]

Your scenario's a little confusing to me. If you fund $100k and have $100k in gains and spend $150k, you have $50k left of which $25k is gain and $25k is contribution. Non qualified withdrawals of any of the remaining $50k will be pro-rated as half contribution, half earnings. If you withdraw $50k, $25k will be taxed and penalized. If you are in the 25% bracket that is 35% of $25k or $8750. That is the total tax and penalty paid across the entire $200k 529. Contrast that with a taxable account, which has taxes taken out every year. The depending on how long you invested the money and what rates of return you earned, one will be better than the other. In other words the benefits of tax-deferred growth may ultimately outweigh the higher rates on withdrawals.

You can have qualified withdrawals for you, your children, your grandchildren, nieces, nephews. You can use the money for undergraduate or graduate school. The money can be used at most American schools and quite a few international schools. All that is required is that the student attend school at least half time. In my view that is a lot of flexibility. Also my marginal tax bracket now is high enough that tax-deferred growth is attractive. And there's a chance I'll be in a lower tax bracket when/if I start needing non-qualified withdrawals. Like if I'm 65, retired, and realize I have too much money in my 529s because my kids are now in their late 20s and done with schooling, I may be in the 15% tax bracket. Etc.

I see the point of confusion. I was erring in spending the contribution first, leaving the full amount remaining taxable. Alternatively, spending the gains on educational expenses doesn't seem to be right either. So it appears it's a proportional spending. Accounting for the contributions and gains, especially if continuing to make contributions while drawing down in the first few years of college make keeping track of what's spent more complicated .

Does it help in any way to add contributions instead of paying separately? - at age 1, contribute $5000, gains $20,000 for total of $25,000 - no additional contributions until - during college years 1-3 contribute $20,000 each year (zero gain/loss), while drawing down $20,000 (or contribute 1 year ahead - or $60,000 at age 15), so $5,000 left after graduation. Now you withdraw remaining $5,000, how much is taxable? Without additional contributions, $1000 contribution is not taxable, while $4,000 is subject to penalties and taxes. On the other hand, aggregating $65,000 total contributions with $20,000 gains changes the taxable ratio. Of course, if you're already overfunded, then there isn't room to stuff the denominator, even if it's not flawed. (you'd never really do this in real life, just trying to understand the way the distributed QTP earnings rules)

Having multiple accounts (may depend if they're in same or different state) can involve aggregating the accounts or not and can further complicate matters. If you're claiming losses, it seems to require aggregation.

http://www.irs.gov/publications/p970/ch08.html

Can't figure out where the $950 comes from ("Sara's Form 1099-Q shows that $950"), maybe a made up number.

"Losses on QTP Investments
If you have distributions from more than one QTP account during a year, you must combine the information (amount of distribution, basis, etc.) from all such accounts in order to determine your taxable earnings for the year. By doing this, the loss from one QTP account reduces the distributed earnings (if any) from any other QTP accounts."

Seems like alternate years to claim loss and another for the gain that is spent on education may be beneficial, but requires correct amounts in the different accounts and good planning.

"Additional Tax on Taxable Distributions" not very clear. "Figuring the additional tax. Use Part II of Form 5329, to figure any additional tax." I couldn't find the calculation details on the 5329 instructions yet. http://www.irs.gov/pub/irs-pdf/i5329.pdf


Going back to the taxable account vs 529, both require post tax contributions. The only benefit of the 529 is the deferred taxes (and tax-free if spent on education) on the gains, which benefit from compounding, so longer time frames is beneficial and should lead to a greater proportion of gains over contributions. Now a buy and hold equity can be considered a tax deferred investment as well with no tax-free benefit, but for now a potentially lower tax rate (capital gains vs ordinary income).

Finally, even with a 15% ordinary income rate, adding the 10% penalty (in what proportion still remains a bit of a mystery to me) is comparable to capital gains, but if that is truly the expected tax rate, then overfunding seems to makes sense, especially if there's a chance of the funds being spent on education. Fortunately or unfortunately, I'm predicting a high or higher marginal tax rate at retirement and working towards that assumption.

[letsgobobby]

Exactly, withdrawals do not seem to require aggregation, but they do require proration within a given account.

[inbox788]

Found a few older threads related that might be of interest:

viewtopic.php?t=46125

viewtopic.php?t=16943

viewtopic.php?t=15835

Agree with sentiments about not overfunding without having an exit plan. Seems like picking 529 investments like Roth is the way to go.

I did see the trick of contributing each year the max to a 529 plan and immediately withdrawing to pay for college for those in states with a state tax benefit. That is, one should always "launder" educational expenses through a 529 plan if possible in many states.