letsgobobby wrote: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.