Using MD 529 beats taxable even with penalty?

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mattz0rt
Posts: 3
Joined: Thu Mar 15, 2018 4:31 pm

Using MD 529 beats taxable even with penalty?

Post by mattz0rt »

Hi all,

So I'm running some numbers, and it seems like the MD 529 plan wins out versus a standard taxable account even for non-education purposes. I'm doing an 18-year time horizon investing $5k each year, and I'm coming out ahead $3k versus a taxable account ($153k vs $150k). MD does give a state tax deduction for up to $2.5k contributions per beneficiary (hence the $5k contrib for the two of us), but this still seems weird... am I missing something?

Here's the sheet with my calculations: https://docs.google.com/spreadsheets/d/ ... sp=sharing (make sure you do "File->Make a copy" to make changes)

Some things to keep in mind:
- I'm assuming a yearly transfer to CA's 529 plan to reduce fees (529 still wins even w/o this trick)
- I'm assuming the state deduction is invested into a taxable account
- I'm assuming I'll be retired in 18 years, hence the 0% long-term capital gains tax and 12% marginal tax bracket at withdrawal. (529 still wins increasing these to 15% LTCG and 22% tax bracket)
- Increasing the expected real returns from 6% to 8% makes the taxable account win, but I think this is unlikely

Am I missing anything here?
rkhusky
Posts: 10182
Joined: Thu Aug 18, 2011 8:09 pm

Re: Using MD 529 beats taxable even with penalty?

Post by rkhusky »

Does MD claw back the tax deduction if you move the funds to a different state?
Mako
Posts: 337
Joined: Wed Feb 28, 2007 9:34 am
Location: MD

Re: Using MD 529 beats taxable even with penalty?

Post by Mako »

rkhusky wrote: Thu Aug 27, 2020 6:47 am Does MD claw back the tax deduction if you move the funds to a different state?
No (at least when I checked last--probably in 2018).
petulant
Posts: 1901
Joined: Thu Sep 22, 2016 1:09 pm

Re: Using MD 529 beats taxable even with penalty?

Post by petulant »

Mako wrote: Thu Aug 27, 2020 8:26 am
rkhusky wrote: Thu Aug 27, 2020 6:47 am Does MD claw back the tax deduction if you move the funds to a different state?
No (at least when I checked last--probably in 2018).
The website savingforcollege.org does indicate Maryland has a recapture provision.
petulant
Posts: 1901
Joined: Thu Sep 22, 2016 1:09 pm

Re: Using MD 529 beats taxable even with penalty?

Post by petulant »

Given how close these are, it really puts in perspective people's worries about what happens to a 529 account if their kid doesn't actually go to college.
scophreak
Posts: 125
Joined: Tue Jan 12, 2016 1:17 pm

Re: Using MD 529 beats taxable even with penalty?

Post by scophreak »

What about the lost TLH opportunities of a taxable account? I would imagine that could be a fairly significant factor over 18 years.
Mako
Posts: 337
Joined: Wed Feb 28, 2007 9:34 am
Location: MD

Re: Using MD 529 beats taxable even with penalty?

Post by Mako »

petulant wrote: Thu Aug 27, 2020 8:31 am
Mako wrote: Thu Aug 27, 2020 8:26 am
rkhusky wrote: Thu Aug 27, 2020 6:47 am Does MD claw back the tax deduction if you move the funds to a different state?
No (at least when I checked last--probably in 2018).
The website savingforcollege.org does indicate Maryland has a recapture provision.
savingforcollege says this about the plan:
"The principal portion of nonqualified withdrawals from this plan are included in Maryland taxable income to the extent of prior Maryland tax deductions. Rollovers are not subject to recapture."

It seems we are talking about rollovers so it seems alright.
petulant
Posts: 1901
Joined: Thu Sep 22, 2016 1:09 pm

Re: Using MD 529 beats taxable even with penalty?

Post by petulant »

Mako wrote: Thu Aug 27, 2020 11:28 am
petulant wrote: Thu Aug 27, 2020 8:31 am
Mako wrote: Thu Aug 27, 2020 8:26 am
rkhusky wrote: Thu Aug 27, 2020 6:47 am Does MD claw back the tax deduction if you move the funds to a different state?
No (at least when I checked last--probably in 2018).
The website savingforcollege.org does indicate Maryland has a recapture provision.
savingforcollege says this about the plan:
"The principal portion of nonqualified withdrawals from this plan are included in Maryland taxable income to the extent of prior Maryland tax deductions. Rollovers are not subject to recapture."

It seems we are talking about rollovers so it seems alright.
Well that seems like quite the workaround; I see what you're saying. Is there any risk that this gets tightened up later though?
SS Rambo
Posts: 170
Joined: Wed Jan 29, 2020 10:55 am

Re: Using MD 529 beats taxable even with penalty?

Post by SS Rambo »

scophreak wrote: Thu Aug 27, 2020 8:41 am What about the lost TLH opportunities of a taxable account? I would imagine that could be a fairly significant factor over 18 years.
Considering the apples to apples nature of OP’s comparison, and the fact that 529s only allow funds, I assume that’d be their strategy for the taxable as well. A lifecycle fund or a 2 or 3 fund portfolio. You don’t have much TLH opportunity there, so I don’t see that being a consideration.
is50xenough
Posts: 122
Joined: Sat Jul 28, 2018 1:37 pm

Re: Using MD 529 beats taxable even with penalty?

Post by is50xenough »

mattz0rt wrote: Wed Aug 26, 2020 8:53 pm Hi all,

So I'm running some numbers, and it seems like the MD 529 plan wins out versus a standard taxable account even for non-education purposes. I'm doing an 18-year time horizon investing $5k each year, and I'm coming out ahead $3k versus a taxable account ($153k vs $150k). MD does give a state tax deduction for up to $2.5k contributions per beneficiary (hence the $5k contrib for the two of us), but this still seems weird... am I missing something?

Here's the sheet with my calculations: https://docs.google.com/spreadsheets/d/ ... sp=sharing (make sure you do "File->Make a copy" to make changes)

Some things to keep in mind:
- I'm assuming a yearly transfer to CA's 529 plan to reduce fees (529 still wins even w/o this trick)
- I'm assuming the state deduction is invested into a taxable account
- I'm assuming I'll be retired in 18 years, hence the 0% long-term capital gains tax and 12% marginal tax bracket at withdrawal. (529 still wins increasing these to 15% LTCG and 22% tax bracket)
- Increasing the expected real returns from 6% to 8% makes the taxable account win, but I think this is unlikely

Am I missing anything here?
Am I correct that if you take your table out to 25 years it gets better, ie more equal? Wonder if you might extent your table to 30 or 35 years? Also you might reword some of the cells so that clear what to edit depending on state tax benefits, etc. I played a bit and guessed what you meant. Meaning instead of penalty make it penalty if funds withdrawn for non-education uses, what is 'cg' tax, etc
rkhusky
Posts: 10182
Joined: Thu Aug 18, 2011 8:09 pm

Re: Using MD 529 beats taxable even with penalty?

Post by rkhusky »

Big legislative boo-boo.

Should have limited it to one match per taxpayer.
scophreak
Posts: 125
Joined: Tue Jan 12, 2016 1:17 pm

Re: Using MD 529 beats taxable even with penalty?

Post by scophreak »

SS Rambo wrote: Thu Aug 27, 2020 12:24 pm
scophreak wrote: Thu Aug 27, 2020 8:41 am What about the lost TLH opportunities of a taxable account? I would imagine that could be a fairly significant factor over 18 years.
Considering the apples to apples nature of OP’s comparison, and the fact that 529s only allow funds, I assume that’d be their strategy for the taxable as well. A lifecycle fund or a 2 or 3 fund portfolio. You don’t have much TLH opportunity there, so I don’t see that being a consideration.
I'm not a TLH expert, but my understanding is that it is still certainly possible with mutual funds. As an example, one could sell a fund that tracks the S&P500 (e.g. VFIAX) and purchase a fund that tracks a similar (though different) index. Though not identical, I believe that this is generally deemed acceptable (or at least not really challenged by the IRS up to this point) and could provide substantially similar performance. Happy to be corrected on this if I'm wrong.
SS Rambo
Posts: 170
Joined: Wed Jan 29, 2020 10:55 am

Re: Using MD 529 beats taxable even with penalty?

Post by SS Rambo »

scophreak wrote: Thu Aug 27, 2020 1:08 pm
SS Rambo wrote: Thu Aug 27, 2020 12:24 pm
scophreak wrote: Thu Aug 27, 2020 8:41 am What about the lost TLH opportunities of a taxable account? I would imagine that could be a fairly significant factor over 18 years.
Considering the apples to apples nature of OP’s comparison, and the fact that 529s only allow funds, I assume that’d be their strategy for the taxable as well. A lifecycle fund or a 2 or 3 fund portfolio. You don’t have much TLH opportunity there, so I don’t see that being a consideration.
I'm not a TLH expert, but my understanding is that it is still certainly possible with mutual funds. As an example, one could sell a fund that tracks the S&P500 (e.g. VFIAX) and purchase a fund that tracks a similar (though different) index. Though not identical, I believe that this is generally deemed acceptable (or at least not really challenged by the IRS up to this point) and could provide substantially similar performance. Happy to be corrected on this if I'm wrong.
True, but you would need the very first period of your 18 year investment to be a down period. Otherwise you’re not going to have a loss to claim, just a reduction in gains.

And if that were the case, and the money had been put into a 529, you could do the same things. Pull it out penalty free since it’s below the basis and claim the loss. You’d have the pay back the state tax deduction, making it identical to the taxable account option.

Your understanding of TLH is correct, it’s just very hard to realize with funds. And in this situation not a factor.
scophreak
Posts: 125
Joined: Tue Jan 12, 2016 1:17 pm

Re: Using MD 529 beats taxable even with penalty?

Post by scophreak »

SS Rambo wrote: Thu Aug 27, 2020 3:19 pm
scophreak wrote: Thu Aug 27, 2020 1:08 pm
SS Rambo wrote: Thu Aug 27, 2020 12:24 pm
scophreak wrote: Thu Aug 27, 2020 8:41 am What about the lost TLH opportunities of a taxable account? I would imagine that could be a fairly significant factor over 18 years.
Considering the apples to apples nature of OP’s comparison, and the fact that 529s only allow funds, I assume that’d be their strategy for the taxable as well. A lifecycle fund or a 2 or 3 fund portfolio. You don’t have much TLH opportunity there, so I don’t see that being a consideration.
I'm not a TLH expert, but my understanding is that it is still certainly possible with mutual funds. As an example, one could sell a fund that tracks the S&P500 (e.g. VFIAX) and purchase a fund that tracks a similar (though different) index. Though not identical, I believe that this is generally deemed acceptable (or at least not really challenged by the IRS up to this point) and could provide substantially similar performance. Happy to be corrected on this if I'm wrong.
True, but you would need the very first period of your 18 year investment to be a down period. Otherwise you’re not going to have a loss to claim, just a reduction in gains.

And if that were the case, and the money had been put into a 529, you could do the same things. Pull it out penalty free since it’s below the basis and claim the loss. You’d have the pay back the state tax deduction, making it identical to the taxable account option.

Your understanding of TLH is correct, it’s just very hard to realize with funds. And in this situation not a factor.
Again, perhaps I'm misunderstanding a bit here (and you appear to have a reasonable understanding) - why is TLH inherently different with funds than individual stocks? As an example: I purchase $10k worth of a Russell 3000 index fund. Two years later, those shares are now worth only $8k after a market downturn (say, due to something like COVID). At that time, I sell the R3000 shares and realize a $2k loss. I immediately purchase $8k of a Wilshire 5000 index fund. Wouldn't that be the definition of a TLH using mutual funds?

TLH opportunities would only increase as additional tax lots are acquired with the new yearly $5k investments specified by the OP. Is this correct thinking or am I missing something?
Mode32
Posts: 190
Joined: Mon Mar 02, 2020 1:24 pm

Re: Using MD 529 beats taxable even with penalty?

Post by Mode32 »

Don’t most 529 plans have higher ER for the same fund, and it still works better?
SS Rambo
Posts: 170
Joined: Wed Jan 29, 2020 10:55 am

Re: Using MD 529 beats taxable even with penalty?

Post by SS Rambo »

scophreak wrote: Thu Aug 27, 2020 3:36 pm
SS Rambo wrote: Thu Aug 27, 2020 3:19 pm
scophreak wrote: Thu Aug 27, 2020 1:08 pm
SS Rambo wrote: Thu Aug 27, 2020 12:24 pm
scophreak wrote: Thu Aug 27, 2020 8:41 am What about the lost TLH opportunities of a taxable account? I would imagine that could be a fairly significant factor over 18 years.
Considering the apples to apples nature of OP’s comparison, and the fact that 529s only allow funds, I assume that’d be their strategy for the taxable as well. A lifecycle fund or a 2 or 3 fund portfolio. You don’t have much TLH opportunity there, so I don’t see that being a consideration.
I'm not a TLH expert, but my understanding is that it is still certainly possible with mutual funds. As an example, one could sell a fund that tracks the S&P500 (e.g. VFIAX) and purchase a fund that tracks a similar (though different) index. Though not identical, I believe that this is generally deemed acceptable (or at least not really challenged by the IRS up to this point) and could provide substantially similar performance. Happy to be corrected on this if I'm wrong.
True, but you would need the very first period of your 18 year investment to be a down period. Otherwise you’re not going to have a loss to claim, just a reduction in gains.

And if that were the case, and the money had been put into a 529, you could do the same things. Pull it out penalty free since it’s below the basis and claim the loss. You’d have the pay back the state tax deduction, making it identical to the taxable account option.

Your understanding of TLH is correct, it’s just very hard to realize with funds. And in this situation not a factor.
Again, perhaps I'm misunderstanding a bit here (and you appear to have a reasonable understanding) - why is TLH inherently different with funds than individual stocks? As an example: I purchase $10k worth of a Russell 3000 index fund. Two years later, those shares are now worth only $8k after a market downturn (say, due to something like COVID). At that time, I sell the R3000 shares and realize a $2k loss. I immediately purchase $8k of a Wilshire 5000 index fund. Wouldn't that be the definition of a TLH using mutual funds?

TLH opportunities would only increase as additional tax lots are acquired with the new yearly $5k investments specified by the OP. Is this correct thinking or am I missing something?
I think you understand it well, you've got the mechanics of the strategy well understood. My two points in response to this thread are:

1) It's not an advantage of the brokerage account exclusively; the 529 could do the same thing (mainly in a lump sum scenario, which I realize this is not)
2) You are right the separate tax lot and LIFO treatment is an advantage of the brokerage account, if after the date of each purchase a) the drop happens before the gain or b) the drop is greater than all of the gains for that lot. Both of those have a probably less than 50% but you are correct it will probably happen a few times in a sample of 18 tax lot purchases. I should have said earlier that TLC could be a win for the brokerage account, but statistically it is not probable to occur.

With any balanced fund/ETF it is statistically more probably to NOT have TLH opportunities than to have them. When they do happen, yes it is nice to capitalize.

With a portfolio of 2-3 funds (one of them being bonds) you're rolling the dice any of them will ever find themselves in the red. Parts of TLH also reduce your return: you are out of the market as trades settle (you are tempting bullet #3 here) and each harvest takes you into an investment you'd otherwise not choose for 60 days minimum. Just as many ways to hurt as help when TLH with a few funds. It's more of a stock trick when the losses are disparate to the gains. And TLH is a tool when you find yourself in a position that you can usually objectively say you should not have gotten yourself into (high single stock exposure).
kaneohe
Posts: 6690
Joined: Mon Sep 22, 2008 12:38 pm

Re: Using MD 529 beats taxable even with penalty?

Post by kaneohe »

I have to admit that I didn't study your model in detail but intuitively to me the conclusion is surprising since
you have a tax and penalty on the earnings portion of 529 for non-qualified expenses but no equivalent for the taxable account (except for a small tax drag).

A greatly oversimplified model: make one initial deposit and let the amount double over time

1) Taxable acct...... initial 10K doubles to 20K. CG =10K but no tax (0% bracket). End result =20K or slightly less
due to tax drag.
2) 529 acct..........initial 10K doubles to 20K. Gain=10K. 12% tax and 10% penalty on gain leaves 7.8K of gain
and 10K initial = 17.8K. State tax saving of 8% on initial contribution= 0.8K which doubles to 1.6K with no tax
on CG. Total end result = 17.8K + 1.6K = 19.4K which is less than the taxable acct.
petulant
Posts: 1901
Joined: Thu Sep 22, 2016 1:09 pm

Re: Using MD 529 beats taxable even with penalty?

Post by petulant »

mattz0rt wrote: Wed Aug 26, 2020 8:53 pm Hi all,

So I'm running some numbers, and it seems like the MD 529 plan wins out versus a standard taxable account even for non-education purposes. I'm doing an 18-year time horizon investing $5k each year, and I'm coming out ahead $3k versus a taxable account ($153k vs $150k). MD does give a state tax deduction for up to $2.5k contributions per beneficiary (hence the $5k contrib for the two of us), but this still seems weird... am I missing something?

Here's the sheet with my calculations: https://docs.google.com/spreadsheets/d/ ... sp=sharing (make sure you do "File->Make a copy" to make changes)

Some things to keep in mind:
- I'm assuming a yearly transfer to CA's 529 plan to reduce fees (529 still wins even w/o this trick)
- I'm assuming the state deduction is invested into a taxable account
- I'm assuming I'll be retired in 18 years, hence the 0% long-term capital gains tax and 12% marginal tax bracket at withdrawal. (529 still wins increasing these to 15% LTCG and 22% tax bracket)
- Increasing the expected real returns from 6% to 8% makes the taxable account win, but I think this is unlikely

Am I missing anything here?
One problem. You've got a common error in calculating taxable account returns--one I've made before as well. You've got a dividend drag on the return for the taxes you pay each year, but the basis at the end of the period is the original contribution. In reality, the portion of the return distributed as dividends and creating a tax drag also creates a new basis. Hence, the tax at the end will not be .862*(BAL-90000). There are a couple ways to fix the error, but the easiest would be to keep a second column tracking the basis over time in the form of previous year balance + new contribution + previous year balance * div yield - tax drag. It looks like fixing the error tightens the race a little but doesn't put the taxable account ahead.
petulant
Posts: 1901
Joined: Thu Sep 22, 2016 1:09 pm

Re: Using MD 529 beats taxable even with penalty?

Post by petulant »

kaneohe wrote: Thu Aug 27, 2020 7:07 pm I have to admit that I didn't study your model in detail but intuitively to me the conclusion is surprising since
you have a tax and penalty on the earnings portion of 529 for non-qualified expenses but no equivalent for the taxable account (except for a small tax drag).

A greatly oversimplified model: make one initial deposit and let the amount double over time

1) Taxable acct...... initial 10K doubles to 20K. CG =10K but no tax (0% bracket). End result =20K or slightly less
due to tax drag.
2) 529 acct..........initial 10K doubles to 20K. Gain=10K. 12% tax and 10% penalty on gain leaves 7.8K of gain
and 10K initial = 17.8K. State tax saving of 8% on initial contribution= 0.8K which doubles to 1.6K with no tax
on CG. Total end result = 17.8K + 1.6K = 19.4K which is less than the taxable acct.
Key elements to whether it works are the cumulative return, size of tax drag, and tax arbitrage between working years and retirement years. In your simplified example, you've assumed a large cumulative return, no tax drag, and no tax arbitrage. OP assumed a smaller cumulative return (effectively 81%), annual tax drag on dividends, and tax arbitrage avoiding taxes during working years into the 15% capital gains bracket but paying all penalties or capital gains taxes later in the 12% income tax bracket or 0% capital gains bracket.
Topic Author
mattz0rt
Posts: 3
Joined: Thu Mar 15, 2018 4:31 pm

Re: Using MD 529 beats taxable even with penalty?

Post by mattz0rt »

Mako wrote: Thu Aug 27, 2020 11:28 am savingforcollege says this about the plan:
"The principal portion of nonqualified withdrawals from this plan are included in Maryland taxable income to the extent of prior Maryland tax deductions. Rollovers are not subject to recapture."

It seems we are talking about rollovers so it seems alright.
Thanks for looking at this, I didn't even consider the possibility. Glad to hear its safe.
is50xenough wrote: Thu Aug 27, 2020 12:39 pm Am I correct that if you take your table out to 25 years it gets better, ie more equal? Wonder if you might extent your table to 30 or 35 years? Also you might reword some of the cells so that clear what to edit depending on state tax benefits, etc. I played a bit and guessed what you meant. Meaning instead of penalty make it penalty if funds withdrawn for non-education uses, what is 'cg' tax, etc
Thanks for the suggestions, I extended out the timeframe on a different tab to 30yrs and surprisingly it actually gets much worse for the 529. This seems to be due to the 529 accruing more gains, which means a higher penalty and income tax at withdrawal. Only by lowering the income tax to 0% do I get the 529 back in the green. I guess this isn't a good choice for people retiring late with high withdrawals.
Lol, not being very sly about it at all.
Mode32 wrote: Thu Aug 27, 2020 5:06 pm Don’t most 529 plans have higher ER for the same fund, and it still works better?
Yea the total ER for the MD 529 is 0.26%. I'm mitigating this by accounting for a yearly rollover to the CA 529, which only charges 0.06%. It looks like the main driving reasons for the 529 winning out in certain situations is the lack of taxable dividend drags, the state tax deduction, tax arbitrage between working and retirement years.
SS Rambo wrote: Thu Aug 27, 2020 5:24 pm 1) It's not an advantage of the brokerage account exclusively; the 529 could do the same thing (mainly in a lump sum scenario, which I realize this is not)
2) You are right the separate tax lot and LIFO treatment is an advantage of the brokerage account, if after the date of each purchase a) the drop happens before the gain or b) the drop is greater than all of the gains for that lot. Both of those have a probably less than 50% but you are correct it will probably happen a few times in a sample of 18 tax lot purchases. I should have said earlier that TLC could be a win for the brokerage account, but statistically it is not probable to occur.

With any balanced fund/ETF it is statistically more probably to NOT have TLH opportunities than to have them. When they do happen, yes it is nice to capitalize.

With a portfolio of 2-3 funds (one of them being bonds) you're rolling the dice any of them will ever find themselves in the red. Parts of TLH also reduce your return: you are out of the market as trades settle (you are tempting bullet #3 here) and each harvest takes you into an investment you'd otherwise not choose for 60 days minimum. Just as many ways to hurt as help when TLH with a few funds. It's more of a stock trick when the losses are disparate to the gains. And TLH is a tool when you find yourself in a position that you can usually objectively say you should not have gotten yourself into (high single stock exposure).
Appreciate the discussion SS Rambo and scophreak, it does seem like TLH would be harder in the 529 given its limited fund selection and lack of tax lots. In the CA 529 plan they do have two similar index funds (US equity vs US large cap) that might qualify for some simple TLH. It does seem tricky though to model the differences, would be open to any suggestions there.
petulant wrote: Thu Aug 27, 2020 7:23 pm One problem. You've got a common error in calculating taxable account returns--one I've made before as well. You've got a dividend drag on the return for the taxes you pay each year, but the basis at the end of the period is the original contribution. In reality, the portion of the return distributed as dividends and creating a tax drag also creates a new basis. Hence, the tax at the end will not be .862*(BAL-90000). There are a couple ways to fix the error, but the easiest would be to keep a second column tracking the basis over time in the form of previous year balance + new contribution + previous year balance * div yield - tax drag. It looks like fixing the error tightens the race a little but doesn't put the taxable account ahead.
Nice catch, thanks. I fixed the problem and now the difference went down from 2k to 1.3k.
rkhusky
Posts: 10182
Joined: Thu Aug 18, 2011 8:09 pm

Re: Using MD 529 beats taxable even with penalty?

Post by rkhusky »

mattz0rt wrote: Thu Aug 27, 2020 8:23 pm Appreciate the discussion SS Rambo and scophreak, it does seem like TLH would be harder in the 529 given its limited fund selection and lack of tax lots. In the CA 529 plan they do have two similar index funds (US equity vs US large cap) that might qualify for some simple TLH. It does seem tricky though to model the differences, would be open to any suggestions there.
There is no point in TLH'ing in a 529 since you can't deduct losses in a 529 (or other tax-advantaged account) off your taxes. Those posts must have been talking about TLH'ing in a taxable brokerage account.
kaneohe
Posts: 6690
Joined: Mon Sep 22, 2008 12:38 pm

Re: Using MD 529 beats taxable even with penalty?

Post by kaneohe »

petulant wrote: Thu Aug 27, 2020 7:32 pm
kaneohe wrote: Thu Aug 27, 2020 7:07 pm I have to admit that I didn't study your model in detail but intuitively to me the conclusion is surprising since
you have a tax and penalty on the earnings portion of 529 for non-qualified expenses but no equivalent for the taxable account (except for a small tax drag).

A greatly oversimplified model: make one initial deposit and let the amount double over time

1) Taxable acct...... initial 10K doubles to 20K. CG =10K but no tax (0% bracket). End result =20K or slightly less
due to tax drag.
2) 529 acct..........initial 10K doubles to 20K. Gain=10K. 12% tax and 10% penalty on gain leaves 7.8K of gain
and 10K initial = 17.8K. State tax saving of 8% on initial contribution= 0.8K which doubles to 1.6K with no tax
on CG. Total end result = 17.8K + 1.6K = 19.4K which is less than the taxable acct.
Key elements to whether it works are the cumulative return, size of tax drag, and tax arbitrage between working years and retirement years. In your simplified example, you've assumed a large cumulative return, no tax drag, and no tax arbitrage. OP assumed a smaller cumulative return (effectively 81%), annual tax drag on dividends, and tax arbitrage avoiding taxes during working years into the 15% capital gains bracket but paying all penalties or capital gains taxes later in the 12% income tax bracket or 0% capital gains bracket.
Petulant, thanks..........good points......I was doing the lazy man's no-spreadsheet model assuming the tax drag effect was small and negligible. It is small but not negligible if the two cases are close as this one seems to be (about 2% difference) .
the way
Posts: 342
Joined: Sat Oct 26, 2019 6:00 pm

Re: Using MD 529 beats taxable even with penalty?

Post by the way »

mattz0rt wrote: Wed Aug 26, 2020 8:53 pm - Increasing the expected real returns from 6% to 8% makes the taxable account win, but I think this is unlikely

Am I missing anything here?
It makes sense since the penalty is on the gains, while the state tax deduction is on the (initially) larger contributed amounts. E.g. if you ran the example for just 1 year, the 529 should easily win. But the longer you run it (or the larger you set your annual returns to be), the more the penalty and taxes will hurt the 529.
SS Rambo
Posts: 170
Joined: Wed Jan 29, 2020 10:55 am

Re: Using MD 529 beats taxable even with penalty?

Post by SS Rambo »

rkhusky wrote: Thu Aug 27, 2020 9:13 pm
mattz0rt wrote: Thu Aug 27, 2020 8:23 pm Appreciate the discussion SS Rambo and scophreak, it does seem like TLH would be harder in the 529 given its limited fund selection and lack of tax lots. In the CA 529 plan they do have two similar index funds (US equity vs US large cap) that might qualify for some simple TLH. It does seem tricky though to model the differences, would be open to any suggestions there.
There is no point in TLH'ing in a 529 since you can't deduct losses in a 529 (or other tax-advantaged account) off your taxes. Those posts must have been talking about TLH'ing in a taxable brokerage account.
Correct, unless the account has a net loss in total. But even then you’d give up your state tax benefit.
rkhusky
Posts: 10182
Joined: Thu Aug 18, 2011 8:09 pm

Re: Using MD 529 beats taxable even with penalty?

Post by rkhusky »

SS Rambo wrote: Thu Aug 27, 2020 11:57 pm
rkhusky wrote: Thu Aug 27, 2020 9:13 pm
mattz0rt wrote: Thu Aug 27, 2020 8:23 pm Appreciate the discussion SS Rambo and scophreak, it does seem like TLH would be harder in the 529 given its limited fund selection and lack of tax lots. In the CA 529 plan they do have two similar index funds (US equity vs US large cap) that might qualify for some simple TLH. It does seem tricky though to model the differences, would be open to any suggestions there.
There is no point in TLH'ing in a 529 since you can't deduct losses in a 529 (or other tax-advantaged account) off your taxes. Those posts must have been talking about TLH'ing in a taxable brokerage account.
Correct, unless the account has a net loss in total. But even then you’d give up your state tax benefit.
If you are talking about deducting a loss after liquidating a 529 as a miscellaneous deduction, that is gone (i.e. misc itemized deductions are no longer allowed - https://www.irs.gov/publications/p529 - note that is is not a publication about 529 plans).
catchup
Posts: 251
Joined: Sun Apr 20, 2008 12:15 pm

Re: Using MD 529 beats taxable even with penalty?

Post by catchup »

One consideration if rolling over to another state 529 every year:

If you put 5000 in and remove 5000 during the same calendar year, say 2020, it may turn out to be a net 0 contribution to your 529. If you wait until the next calendar year 2021 to roll over the 5000, you may need up contribute 10,000 that year to net 5000 in contributions.

We are moving out of Maryland this year, will contribute by rolling into our MD 529s for 3 kids. We will wait at least 12 months and then roll out of Maryland into Nevada (Vanguard). Maryland won’t claw back the tax refunds. But this is different than rolling out of Maryland during the same calendar year that you are contributing. You may get away with it, but it Would smell fishy, at the very least.
is50xenough
Posts: 122
Joined: Sat Jul 28, 2018 1:37 pm

Re: Using MD 529 beats taxable even with penalty?

Post by is50xenough »

mattz0rt wrote: Thu Aug 27, 2020 8:23 pm savingforcollege says this about the plan:

is50xenough wrote: Thu Aug 27, 2020 12:39 pm Am I correct that if you take your table out to 25 years it gets better, ie more equal? Wonder if you might extent your table to 30 or 35 years? Also you might reword some of the cells so that clear what to edit depending on state tax benefits, etc. I played a bit and guessed what you meant. Meaning instead of penalty make it penalty if funds withdrawn for non-education uses, what is 'cg' tax, etc
Thanks for the suggestions, I extended out the timeframe on a different tab to 30yrs and surprisingly it actually gets much worse for the 529. This seems to be due to the 529 accruing more gains, which means a higher penalty and income tax at withdrawal. Only by lowering the income tax to 0% do I get the 529 back in the green. I guess this isn't a good choice for people retiring late with high withdrawals.
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Thanks for responding to my query. I guess one lesson is that if you overfund, once education for sure done, and if no other relatives to give to, cash out. But I think there are still complexities. For example playing with the tax rates which is likely. Meaning kid goes to college when tax rate is relatively high but then 529 cashed out when tax rate is low. So capital gains during high tax rate period (say working years) and cash out in retirement.

That is why clearly labelling all cells so folks can play with and adjust to their personal situation.

A nice piece of work however to give idea of impact of overfunding as one example. Or just for folks who want to argue 529 vs just put in taxable.

Did I miss it as to whether your spreadsheet would allow for combination education and cash out on 529? Meaning you have $200,000, take out $150,000 for education over 4 years, then sometime later cash out the remaining $50,000 plus further capital gains.
is50xenough
Posts: 122
Joined: Sat Jul 28, 2018 1:37 pm

Re: Using MD 529 beats taxable even with penalty?

Post by is50xenough »

is50xenough wrote: Thu Aug 27, 2020 12:39 pm Am I correct that if you take your table out to 25 years it gets better, ie more equal? Wonder if you might extent your table to 30 or 35 years? Also you might reword some of the cells so that clear what to edit depending on state tax benefits, etc. I played a bit and guessed what you meant. Meaning instead of penalty make it penalty if funds withdrawn for non-education uses, what is 'cg' tax, etc

Thanks for the suggestions, I extended out the timeframe on a different tab to 30yrs and surprisingly it actually gets much worse for the 529. This seems to be due to the 529 accruing more gains, which means a higher penalty and income tax at withdrawal. Only by lowering the income tax to 0% do I get the 529 back in the green. I guess this isn't a good choice for people retiring late with high withdrawals.
In this model, this works better if tax rate is low and returns low since penalty less. However, overfunding is often discussed for high earners. In fact, several analyses although I look some aspects of yours given how you look at it but found these....

https://www.whitecoatinvestor.com/tax-b ... cs-series/

https://www.whitecoatinvestor.com/why-5 ... ealth-ira/

This one makes sound really positive to use the 529 but I don't see discussion of penalty effecting higher balance.
https://www.fiphysician.com/the-fire-529/

Finally, there is this one that argues for overfunding in that 529 way ahead of brokerage but they don't give all steps and input so not sure if this is correct especially given your spreadsheet and tinkering.

https://rpgplanner.com/529-plan-opportunity/

I thought about my comment above, if one overfunds a 529 as opposed to a taxable brokerage with plan to use for college but only use part, say 50% like the Fred and Wilma example in the last link I provided, the use of the 529 for education has much benefit over the taxable brokerage and might make up for the part taken out for non-qualified expenses.

If folks agree, and I would love to hear comments, then in early retirement, one might liquidate the 529 before, say, doing Roth conversions to avoid even more growth---would this be best approach? And yes, I'm sure depends on specifics, size of 529, size of IRAs, tax bracket, etc.
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