How good is a 529?

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invest0
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How good is a 529?

Post by invest0 »

Hi all, Bogleheadism has been good to us and I'm just now discovering 529s... is my logic here full of holes?

SCENARIO:

My wife and I are based in Illinois (where there's a state tax credit for 529s) and are scraping the highest income tax bracket. We currently max out my 401(k) and our Traditional IRAs each year. We're both in our mid-30s with a 1-year-old and 3-year-old daughter.

Brightstart Illinois has relatively low-cost Vanguard target-date funds (auto-balanced at I believe a 0.12% fee).

HYPOTHESIS:

It's now worth it for us to put a significant amount of funds into 529s each year (after maxing IRA and 401(k)), even if our daughters don't go to college, and/or even beyond what college might feasible cost, for:

#1 the Illinois state tax credit on up to $20K per kiddo per year (and limiting it to $15K per year, per child, per parent to avoid the Gift Tax).
#2 so these funds can grow tax-free, even if fully taxable and hit with a 10% penalty at the end (if our kids don't attend college)

DETAILS:

Here's where I'm sort of struggling here... what does that math equation to estimate our break-even scenario look like for this? How have others contested with this possibility? Is there some minor detail that makes 529s actually a bad deal that I'm just overlooking?

Or, should we go wild and add 30K per year, every year, to both 529s? If so, what is that point? It does seem like deposits should probably wane at least a ways before they turn 18 and we're staring down college with some clues on what they want to do + with a big overshot of realistic tuition in the bank.
Soon2BXProgrammer
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Re: How good is a 529?

Post by Soon2BXProgrammer »

if they don't go to school, its a horrible account.

conceptually from a taxes perspective, its a non deductable ira with an added penalty. a standard taxable account is a much better idea. (if no college)
Tingting1013
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Re: How good is a 529?

Post by Tingting1013 »

What does the gift tax have to do with 529s?
Soon2BXProgrammer
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Re: How good is a 529?

Post by Soon2BXProgrammer »

Tingting1013 wrote: Sun Jan 03, 2021 6:38 pm What does the gift tax have to do with 529s?
While the "owner" might be the parent, you are actually using the gift exemption to the beneficiary with every contribution. Its classified as a present interest gift to the beneficiary.
Last edited by Soon2BXProgrammer on Sun Jan 03, 2021 6:41 pm, edited 1 time in total.
Normchad
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Re: How good is a 529?

Post by Normchad »

It’s good, not great. Max out everything else before loading it up.......
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willthrill81
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Re: How good is a 529?

Post by willthrill81 »

invest0 wrote: Sun Jan 03, 2021 6:27 pm Hi all, Bogleheadism has been good to us and I'm just now discovering 529s... is my logic here full of holes?

SCENARIO:

My wife and I are based in Illinois (where there's a state tax credit for 529s) and are scraping the highest income tax bracket. We currently max out my 401(k) and our Traditional IRAs each year. We're both in our mid-30s with a 1-year-old and 3-year-old daughter.

Brightstart Illinois has relatively low-cost Vanguard target-date funds (auto-balanced at I believe a 0.12% fee).

HYPOTHESIS:

It's now worth it for us to put a significant amount of funds into 529s each year (after maxing IRA and 401(k)), even if our daughters don't go to college, and/or even beyond what college might feasible cost, for:

#1 the Illinois state tax credit on up to $20K per kiddo per year (and limiting it to $15K per year, per child, per parent to avoid the Gift Tax).
#2 so these funds can grow tax-free, even if fully taxable and hit with a 10% penalty at the end (if our kids don't attend college)

DETAILS:

Here's where I'm sort of struggling here... what does that math equation to estimate our break-even scenario look like for this? How have others contested with this possibility? Is there some minor detail that makes 529s actually a bad deal that I'm just overlooking?

Or, should we go wild and add 30K per year, every year, to both 529s? If so, what is that point? It does seem like deposits should probably wane at least a ways before they turn 18 and we're staring down college with some clues on what they want to do + with a big overshot of realistic tuition in the bank.
If your daughters don't incur any college expenses (or don't get a 'full ride' scholarship that allows you withdraw a commensurate amount of 529 funds), a 529 will underperform everything else out there, including a taxable brokerage account, by a significant margin. That said, there are many ways to use 529 funds without paying the 10% penalty.
Change the beneficiary to a family member.
Make themselves the beneficiary.
Use the funds for apprenticeships.
Pay off student loan debt.
Put the funds toward K-12 education.
https://www.usnews.com/education/best-c ... 20earnings.

If your daughters do incur college expenses and you do wind up funding them yourself, then in your situation, a 529 will very likely be the superior means of investing for that expense.

Most here, including myself, believe that you should not try to fund your kids' college expenses unless your own retirement is already fully funded. This is because it's easier for them to find alternate means of funding those expenses than it is for you to fund your own retirement. And neither you nor them likely want you to become a boomerang parent.

We are not utilizing a 529 account for our daughter for reasons I outlined in this thread. Perhaps you might find it useful.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings
vasaver
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Re: How good is a 529?

Post by vasaver »

Get even crazier...and superfund them.

"allows you to contribute up to $75,000 for each beneficiary in a single year without federal gift tax consequences "

https://www.brightdirections.com/benefi ... dvantages/
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UpsetRaptor
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Re: How good is a 529?

Post by UpsetRaptor »

I ran the math recently in another recent 529 thread for my personal scenario (note: different state from IL) comparing 529 with state tax deduction vs taxable for qualified/nonqualified withdrawals. I found that the "breakeven point" was about 33% qualified vs non-qualified withdrawals. In other words, if more than one third of the withdrawals come out qualified, I come out ahead using the 529 vs having used taxable. So that makes me feel better about leveraging the 529 to the top of the state tax deduction. Even if half the withdrawals come out unqualified, I'll still come ahead vs taxable.
Pandemic Bangs
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Re: How good is a 529?

Post by Pandemic Bangs »

So good that it's derided as a give-back to the rich even though it was designed for the middle class.

For us it's a "Roth IRA for college," assuming you start early enough (we did). We're not eligible for Roth and can not access it via backdoor. Plenty of tax-deferred and taxable but zero Roth space. That, coupled with our (modest) state tax deduction made 529s a no-brainer. Investment returns more than doubled our saved-for-college dollars over the past dozen or so years.

If you start late and therefore need to invest conservatively, it's pretty useless apart from the tiny state tax deduction. Just ties up your money in exchange for no real return.
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KlangFool
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Re: How good is a 529?

Post by KlangFool »

OP,


1) Why do you need to save for a college education?


2) If your annual saving is high enough, you can pay for the college education from your annual saving.


3) If your taxable account is big enough, you can pay for the college education from your taxable account annual dividend/distribution.


4) How many kids do you have?


5) Assuming 30K per year, it is 120K per kid.


6) Let's assume that you have 2 kids.


7) Are you willing to pay 2x 4 X 30K = 240K for your kids' college education if your whole portfolio is only

A) 240K?

B) 480K?

C) 1 million?

when your kids go to college? What is your number?


KlangFool
NS_Bane
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Re: How good is a 529?

Post by NS_Bane »

UpsetRaptor wrote: Sun Jan 03, 2021 6:50 pm I ran the math recently in another recent 529 thread for my personal scenario (note: different state from IL) comparing 529 with state tax deduction vs taxable for qualified/nonqualified withdrawals. I found that the "breakeven point" was about 33% qualified vs non-qualified withdrawals. In other words, if more than one third of the withdrawals come out qualified, I come out ahead using the 529 vs having used taxable. So that makes me feel better about leveraging the 529 to the top of the state tax deduction. Even if half the withdrawals come out unqualified, I'll still come ahead vs taxable.
Can you please confirm? The earnings portion of non-qualified 529 distributions are reported on Schedule 1, line 8 of IRS form 1040, and are taxed at the same rate as wages. Assuming OP is not quite at the highest tax bracket, those non-qualified distributions would be taxed federally at 35% with a 10% penalty, i.e. 45%. That’s not including the state taxes he would owe, as well as Medicare taxes.

I’m having a hard time understanding at what point it makes sense to use 529 over a brokerage account if any money is withdrawn as a non-qualified distribution.
welldone
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Re: How good is a 529?

Post by welldone »

OP, the Illinois deduction is $10k per year, up to $20k per year if you are married filing jointly. It is NOT $20k per kiddo, per year (I wish, lol).

It is still worth doing for the deduction, but you can only get a deduction on up to $20k per year. Full stop. Though, to be clear, it is only worth doing it for the deduction if you actually will use it for qualified educational expenses.
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UpsetRaptor
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Re: How good is a 529?

Post by UpsetRaptor »

NS_Bane wrote: Sun Jan 03, 2021 7:28 pm
UpsetRaptor wrote: Sun Jan 03, 2021 6:50 pm I ran the math recently in another recent 529 thread for my personal scenario (note: different state from IL) comparing 529 with state tax deduction vs taxable for qualified/nonqualified withdrawals. I found that the "breakeven point" was about 33% qualified vs non-qualified withdrawals. In other words, if more than one third of the withdrawals come out qualified, I come out ahead using the 529 vs having used taxable. So that makes me feel better about leveraging the 529 to the top of the state tax deduction. Even if half the withdrawals come out unqualified, I'll still come ahead vs taxable.
Can you please confirm? The earnings portion of non-qualified 529 distributions are reported on Schedule 1, line 8 of IRS form 1040, and are taxed at the same rate as wages. Assuming OP is not quite at the highest tax bracket, those non-qualified distributions would be taxed federally at 35% with a 10% penalty, i.e. 45%. That’s not including the state taxes he would owe, as well as Medicare taxes.

I’m having a hard time understanding at what point it makes sense to use 529 over a brokerage account if any money is withdrawn as a non-qualified distribution.
Here's the post with the math. Again, this is for my personal situation (not OPs), so I assumed 22% not 35% federal, but added 6% state so the 529 unqualified distributions came out at a total of 38% tax. Back of the envelope, if I use 529 to state tax deduction limit and compare it to just using straight taxlable, if there's a negative of x for every unqualified dollar that comes out, there's a positive of 2x for every one that comes out qualified, for a breakeven ratio of roughly 33%.

viewtopic.php?f=10&t=334478&p=5696663#p5696663

Just to re-iterate, these numbers are all just for my personal situation, and don't necessarily extrapolate to all.
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vineviz
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Re: How good is a 529?

Post by vineviz »

UpsetRaptor wrote: Sun Jan 03, 2021 7:39 pm
NS_Bane wrote: Sun Jan 03, 2021 7:28 pm
UpsetRaptor wrote: Sun Jan 03, 2021 6:50 pm I ran the math recently in another recent 529 thread for my personal scenario (note: different state from IL) comparing 529 with state tax deduction vs taxable for qualified/nonqualified withdrawals. I found that the "breakeven point" was about 33% qualified vs non-qualified withdrawals. In other words, if more than one third of the withdrawals come out qualified, I come out ahead using the 529 vs having used taxable. So that makes me feel better about leveraging the 529 to the top of the state tax deduction. Even if half the withdrawals come out unqualified, I'll still come ahead vs taxable.
Can you please confirm? The earnings portion of non-qualified 529 distributions are reported on Schedule 1, line 8 of IRS form 1040, and are taxed at the same rate as wages. Assuming OP is not quite at the highest tax bracket, those non-qualified distributions would be taxed federally at 35% with a 10% penalty, i.e. 45%. That’s not including the state taxes he would owe, as well as Medicare taxes.

I’m having a hard time understanding at what point it makes sense to use 529 over a brokerage account if any money is withdrawn as a non-qualified distribution.
Here's the post with the math. Again, this is for my personal situation (not OPs), so I assumed 22% not 35% federal, but added 6% state so the 529 unqualified distributions came out at a total of 38% tax. Back of the envelope, if I use 529 to state tax deduction limit and compare it to just using straight taxlable, if there's a negative of x for every unqualified dollar that comes out, there's a positive of 2x for every one that comes out qualified, for a breakeven ratio of roughly 33%.

viewtopic.php?f=10&t=334478&p=5696663#p5696663

Just to re-iterate, these numbers are all just for my personal situation, and don't necessarily extrapolate to all.
I did the math quickly, so YMMV: I think the OP will come out ahead by taking advantage of the state tax deduction as long as the account is overfunded by less than 100%. In other words, if more than 50% of the distributions are qualified then the compounded effect of the state tax deduction would outweigh the excess taxes and penalties.

It’s even more favorable if ownership of the remaining 529 balance is transferred to the beneficiary, since the newly graduated child would presumably be taxed at a lower rate than the OP.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
Atilla
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Re: How good is a 529?

Post by Atilla »

If nothing else you can do what I did - cash flow tuition, but launder it through a 529 using a stable value fund to get the state tax deduction.

Deposit cash a couple months before tuition is due. Take it out to pay tuition and get the state income tax break with no risk.
mookie
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Re: How good is a 529?

Post by mookie »

Here is an argument for overfunding a 529:
https://www.kitces.com/blog/using-a-fam ... -planning/
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UpsetRaptor
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Re: How good is a 529?

Post by UpsetRaptor »

vineviz wrote: Sun Jan 03, 2021 7:57 pm
UpsetRaptor wrote: Sun Jan 03, 2021 7:39 pm
NS_Bane wrote: Sun Jan 03, 2021 7:28 pm
UpsetRaptor wrote: Sun Jan 03, 2021 6:50 pm I ran the math recently in another recent 529 thread for my personal scenario (note: different state from IL) comparing 529 with state tax deduction vs taxable for qualified/nonqualified withdrawals. I found that the "breakeven point" was about 33% qualified vs non-qualified withdrawals. In other words, if more than one third of the withdrawals come out qualified, I come out ahead using the 529 vs having used taxable. So that makes me feel better about leveraging the 529 to the top of the state tax deduction. Even if half the withdrawals come out unqualified, I'll still come ahead vs taxable.
Can you please confirm? The earnings portion of non-qualified 529 distributions are reported on Schedule 1, line 8 of IRS form 1040, and are taxed at the same rate as wages. Assuming OP is not quite at the highest tax bracket, those non-qualified distributions would be taxed federally at 35% with a 10% penalty, i.e. 45%. That’s not including the state taxes he would owe, as well as Medicare taxes.

I’m having a hard time understanding at what point it makes sense to use 529 over a brokerage account if any money is withdrawn as a non-qualified distribution.
Here's the post with the math. Again, this is for my personal situation (not OPs), so I assumed 22% not 35% federal, but added 6% state so the 529 unqualified distributions came out at a total of 38% tax. Back of the envelope, if I use 529 to state tax deduction limit and compare it to just using straight taxlable, if there's a negative of x for every unqualified dollar that comes out, there's a positive of 2x for every one that comes out qualified, for a breakeven ratio of roughly 33%.

viewtopic.php?f=10&t=334478&p=5696663#p5696663

Just to re-iterate, these numbers are all just for my personal situation, and don't necessarily extrapolate to all.
I did the math quickly, so YMMV: I think the OP will come out ahead by taking advantage of the state tax deduction as long as the account is overfunded by less than 100%. In other words, if more than 50% of the distributions are qualified then the compounded effect of the state tax deduction would outweigh the excess taxes and penalties.

It’s even more favorable if ownership of the remaining 529 balance is transferred to the beneficiary, since the newly graduated child would presumably be taxed at a lower rate than the OP.
Makes sense. Knowing my #s, and the OP's higher tax bracket, I would have guessed a roughly 50% breakeven ratio.

Great idea regarding having any overfunded amount come out to the child once past the kiddie tax stipulations. I hadn't thought of that. Thx.
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gasman
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Re: How good is a 529?

Post by gasman »

Normchad wrote: Sun Jan 03, 2021 6:41 pm It’s good, not great. Max out everything else before loading it up.......
Agree with maxing everything else before funding. But I think they are great if you are committed to paying for your kids (or other beneficiaries) educations. Especially if those costs are anticipated to be significant.
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invest0
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Re: How good is a 529?

Post by invest0 »

NS_Bane wrote: Sun Jan 03, 2021 7:28 pm Can you please confirm? The earnings portion of non-qualified 529 distributions are reported on Schedule 1, line 8 of IRS form 1040, and are taxed at the same rate as wages. Assuming OP is not quite at the highest tax bracket, those non-qualified distributions would be taxed federally at 35% with a 10% penalty, i.e. 45%. That’s not including the state taxes he would owe, as well as Medicare taxes.

I’m having a hard time understanding at what point it makes sense to use 529 over a brokerage account if any money is withdrawn as a non-qualified distribution.
My question in a nutshell. Some other (valid) clarifications made by others above, the advantages appear to be:

#1: A $10,000/year Illinois state tax credit tax deferral (if adding deposits each year), as I'm understanding it. Since a non-qualified distribution appears to invalidate those tax credits, but then, there's that Boglehead adage that "a tax delayed is a tax avoided"... since a greater sum can then be invested in the interim.

#2: As I understand it, funds in a 529 grow tax-deferred. It seems that this also compensates for some of that 10% tax penalty that would be coming at the end.
HopeToGolf
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Re: How good is a 529?

Post by HopeToGolf »

Our 529 is about 50% earnings and 50% contributions. One thing that recently surprised me was if we paid capital gains on the earnings (i.e. saved in taxable), the taxes would be ~7% of the balance. The dollar amount is not much to get excited about. The account will not be used for a few more years so the numbers will change a little but I was surprised that the tax savings was not as significant as I was thinking it would be when I opened the account 10-13 years ago.

Don’t get me wrong, I will take the free money but relative to the account balance, potential college cost, non-college expense portfolio, income, etc. the tax savings is a rounding error. I think where the 529 could get very interesting is as a generational college fund starting with potential grandchildren. If we continued to fund the vehicle until we die and then will it to the offspring to be used by future generations, I imagine you can get into a scenario where the returns and tax savings fund the college education for generations.

For the OP, follow the advice you will get in this thread but if you are at the top tax bracket, if you plan to use the 529 for your kids (~20 year time horizon), the tax savings from the vehicle will likely not be that interesting. Do take all the tax savings you can get though. I am positive I have made larger errors related to putting funds into the market or asset allocation that cost me more money than I will save in taxes on the 529.
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gasman
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Re: How good is a 529?

Post by gasman »

invest0 wrote: Sun Jan 03, 2021 9:03 pm
NS_Bane wrote: Sun Jan 03, 2021 7:28 pm Can you please confirm? The earnings portion of non-qualified 529 distributions are reported on Schedule 1, line 8 of IRS form 1040, and are taxed at the same rate as wages. Assuming OP is not quite at the highest tax bracket, those non-qualified distributions would be taxed federally at 35% with a 10% penalty, i.e. 45%. That’s not including the state taxes he would owe, as well as Medicare taxes.

I’m having a hard time understanding at what point it makes sense to use 529 over a brokerage account if any money is withdrawn as a non-qualified distribution.
My question in a nutshell. Some other (valid) clarifications made by others above, the advantages appear to be:

#1: A $10,000/year Illinois state tax credit tax deferral (if adding deposits each year), as I'm understanding it. Since a non-qualified distribution appears to invalidate those tax credits, but then, there's that Boglehead adage that "a tax delayed is a tax avoided"... since a greater sum can then be invested in the interim.

#2: As I understand it, funds in a 529 grow tax-deferred. It seems that this also compensates for some of that 10% tax penalty that would be coming at the end.
They grow tax deferred. But, Distributions are tax free if used for qualified expenses. That's why I think that they are great If you are committed to using the dollars for qualified educational expenses for your kids, yourselves, or other beneficiaries.
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vineviz
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Re: How good is a 529?

Post by vineviz »

invest0 wrote: Sun Jan 03, 2021 9:03 pm
NS_Bane wrote: Sun Jan 03, 2021 7:28 pm Can you please confirm? The earnings portion of non-qualified 529 distributions are reported on Schedule 1, line 8 of IRS form 1040, and are taxed at the same rate as wages. Assuming OP is not quite at the highest tax bracket, those non-qualified distributions would be taxed federally at 35% with a 10% penalty, i.e. 45%. That’s not including the state taxes he would owe, as well as Medicare taxes.

I’m having a hard time understanding at what point it makes sense to use 529 over a brokerage account if any money is withdrawn as a non-qualified distribution.
My question in a nutshell. Some other (valid) clarifications made by others above, the advantages appear to be:

#1: A $10,000/year Illinois state tax credit tax deferral (if adding deposits each year), as I'm understanding it. Since a non-qualified distribution appears to invalidate those tax credits, but then, there's that Boglehead adage that "a tax delayed is a tax avoided"... since a greater sum can then be invested in the interim.

#2: As I understand it, funds in a 529 grow tax-deferred. It seems that this also compensates for some of that 10% tax penalty that would be coming at the end.

Yes, I think you've got it pretty much right.

If you invest $20,000 in a 529 plan today and we assume 15 years of compound growth at 6% you'll end up with $46,931. Let's say you spend half of that on a qualified education expense and withdraw the other half as a non-qualified withdrawal. The tax rate on the qualified withdrawal is 0%, obviously, and the tax rate on the non-qualified portion is federal tax rate + state tax rate + penalty: 37% + 4.95% + 10% = 51.95%. This rate applies only to the earnings portion of the non-qualified withdrawal, for a tax of $7,750 (including the pro-rata clawback of the initial deduction). Your total net cash at the end of all this is $40,181. If you can successfully transfer the balance to the child and they are in a 22% or 24% tax bracket after graduation, the tax burden would be even less.

Compare to investing in a taxable account (assuming you'd maxed out the Roth space already). Initial investment is only $19,010 because you lost the tax deduction for the contribution. Same growth rate as above gets you to $45,559 in 15 years. Tax rate is 24.95% (LTCG + state income tax) for a total tax of $6,624. Your total net cash at the end is $38,934.70.

There's always some uncertainty around tax planning, of course, but if you can manage it so that the qualified withdrawals are at least 42% of the 529 balance, you should come out ahead by using the 529 plan.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
vasaver
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Re: How good is a 529?

Post by vasaver »

vineviz wrote: Sun Jan 03, 2021 9:39 pm
invest0 wrote: Sun Jan 03, 2021 9:03 pm
NS_Bane wrote: Sun Jan 03, 2021 7:28 pm Can you please confirm? The earnings portion of non-qualified 529 distributions are reported on Schedule 1, line 8 of IRS form 1040, and are taxed at the same rate as wages. Assuming OP is not quite at the highest tax bracket, those non-qualified distributions would be taxed federally at 35% with a 10% penalty, i.e. 45%. That’s not including the state taxes he would owe, as well as Medicare taxes.

I’m having a hard time understanding at what point it makes sense to use 529 over a brokerage account if any money is withdrawn as a non-qualified distribution.
My question in a nutshell. Some other (valid) clarifications made by others above, the advantages appear to be:

#1: A $10,000/year Illinois state tax credit tax deferral (if adding deposits each year), as I'm understanding it. Since a non-qualified distribution appears to invalidate those tax credits, but then, there's that Boglehead adage that "a tax delayed is a tax avoided"... since a greater sum can then be invested in the interim.

#2: As I understand it, funds in a 529 grow tax-deferred. It seems that this also compensates for some of that 10% tax penalty that would be coming at the end.

Yes, I think you've got it pretty much right.

If you invest $20,000 in a 529 plan today and we assume 15 years of compound growth at 6% you'll end up with $46,931. Let's say you spend half of that on a qualified education expense and withdraw the other half as a non-qualified withdrawal. The tax rate on the qualified withdrawal is 0%, obviously, and the tax rate on the non-qualified portion is federal tax rate + state tax rate + penalty: 37% + 4.95% + 10% = 51.95%. This rate applies only to the earnings portion of the non-qualified withdrawal, for a tax of $7,750 (including the pro-rata clawback of the initial deduction). Your total net cash at the end of all this is $40,181. If you can successfully transfer the balance to the child and they are in a 22% or 24% tax bracket after graduation, the tax burden would be even less.

Compare to investing in a taxable account (assuming you'd maxed out the Roth space already). Initial investment is only $19,010 because you lost the tax deduction for the contribution. Same growth rate as above gets you to $45,559 in 15 years. Tax rate is 24.95% (LTCG + state income tax) for a total tax of $6,624. Your total net cash at the end is $38,934.70.

There's always some uncertainty around tax planning, of course, but if you can manage it so that the qualified withdrawals are at least 42% of the 529 balance, you should come out ahead by using the 529 plan.
This is exactly why we have numerous 529 accounts. We will use the accounts with the most growth for qualified expenses - this way if money is left over we can make non-qualified withdrawals from the accounts with minimal (or negative) growth.
Soon2BXProgrammer
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Re: How good is a 529?

Post by Soon2BXProgrammer »

vasaver wrote: Sun Jan 03, 2021 10:01 pm
vineviz wrote: Sun Jan 03, 2021 9:39 pm
invest0 wrote: Sun Jan 03, 2021 9:03 pm
NS_Bane wrote: Sun Jan 03, 2021 7:28 pm Can you please confirm? The earnings portion of non-qualified 529 distributions are reported on Schedule 1, line 8 of IRS form 1040, and are taxed at the same rate as wages. Assuming OP is not quite at the highest tax bracket, those non-qualified distributions would be taxed federally at 35% with a 10% penalty, i.e. 45%. That’s not including the state taxes he would owe, as well as Medicare taxes.

I’m having a hard time understanding at what point it makes sense to use 529 over a brokerage account if any money is withdrawn as a non-qualified distribution.
My question in a nutshell. Some other (valid) clarifications made by others above, the advantages appear to be:

#1: A $10,000/year Illinois state tax credit tax deferral (if adding deposits each year), as I'm understanding it. Since a non-qualified distribution appears to invalidate those tax credits, but then, there's that Boglehead adage that "a tax delayed is a tax avoided"... since a greater sum can then be invested in the interim.

#2: As I understand it, funds in a 529 grow tax-deferred. It seems that this also compensates for some of that 10% tax penalty that would be coming at the end.

Yes, I think you've got it pretty much right.

If you invest $20,000 in a 529 plan today and we assume 15 years of compound growth at 6% you'll end up with $46,931. Let's say you spend half of that on a qualified education expense and withdraw the other half as a non-qualified withdrawal. The tax rate on the qualified withdrawal is 0%, obviously, and the tax rate on the non-qualified portion is federal tax rate + state tax rate + penalty: 37% + 4.95% + 10% = 51.95%. This rate applies only to the earnings portion of the non-qualified withdrawal, for a tax of $7,750 (including the pro-rata clawback of the initial deduction). Your total net cash at the end of all this is $40,181. If you can successfully transfer the balance to the child and they are in a 22% or 24% tax bracket after graduation, the tax burden would be even less.

Compare to investing in a taxable account (assuming you'd maxed out the Roth space already). Initial investment is only $19,010 because you lost the tax deduction for the contribution. Same growth rate as above gets you to $45,559 in 15 years. Tax rate is 24.95% (LTCG + state income tax) for a total tax of $6,624. Your total net cash at the end is $38,934.70.

There's always some uncertainty around tax planning, of course, but if you can manage it so that the qualified withdrawals are at least 42% of the 529 balance, you should come out ahead by using the 529 plan.
This is exactly why we have numerous 529 accounts. We will use the accounts with the most growth for qualified expenses - this way if money is left over we can make non-qualified withdrawals from the accounts with minimal (or negative) growth.
Another hedge strategy: load your 529 up with your bonds. reduce your bond exposure everywhere else. it makes the penalty less of an issue. and bonds return nothing, and even if you have a return the penalty percentage wise will be super small.
SchruteB&B
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Re: How good is a 529?

Post by SchruteB&B »

Atilla wrote: Sun Jan 03, 2021 8:10 pm If nothing else you can do what I did - cash flow tuition, but launder it through a 529 using a stable value fund to get the state tax deduction.

Deposit cash a couple months before tuition is due. Take it out to pay tuition and get the state income tax break with no risk.
Agreed, especially with Illinois’ generous tax credit, definitely worth the effort IMO to launder it through the IL 529. They don’t have a stable value plan but there is a Vanguard money market. It wouldn’t even need to be in there for a couple of months as Illinois has no minimum time for how long fund need to be in the 529 before being withdrawn.
2tall4economy
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Re: How good is a 529?

Post by 2tall4economy »

Related question - I was thinking of transferring from brightstart to Fidelity 529 after I collect the tax credit.

The fine print says that IL reserves the right to claw back the tax credit if you do that though. Anyone done it and had them actually claw back the tax?

I would think after 3 years they can't claw it back since the tax year is closed and it's not fraudulent...
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Pandemic Bangs
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Re: How good is a 529?

Post by Pandemic Bangs »

2tall4economy wrote: Fri Jan 15, 2021 4:49 pm Related question - I was thinking of transferring from brightstart to Fidelity 529 after I collect the tax credit.

The fine print says that IL reserves the right to claw back the tax credit if you do that though. Anyone done it and had them actually claw back the tax?

I would think after 3 years they can't claw it back since the tax year is closed and it's not fraudulent...
This link was helpful -- state-by-state on the clawbacks:

https://www.savingforcollege.com/articl ... ther-state

Does not answer your exact question about how aggressive states are. I have assumed that this happens at the level of the transfer of the account balance. It's a potential concern for us.
Soon2BXProgrammer wrote: Sun Jan 03, 2021 10:05 pm
...load your 529 up with your bonds. reduce your bond exposure everywhere else. it makes the penalty less of an issue. and bonds return nothing, and even if you have a return the penalty percentage wise will be super small.
But doesn't that kind of defeat the purpose...? I guess if it's most of your bond holdings and you are really good about realigning the rest. I don't see that plan being implemented successfully for most run-of-the-mill 529 users with a distant horizon. But an interesting thought.
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Soon2BXProgrammer
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Re: How good is a 529?

Post by Soon2BXProgrammer »

Pandemic Bangs wrote: Sat Jan 16, 2021 12:13 pm
Soon2BXProgrammer wrote: Sun Jan 03, 2021 10:05 pm
...load your 529 up with your bonds. reduce your bond exposure everywhere else. it makes the penalty less of an issue. and bonds return nothing, and even if you have a return the penalty percentage wise will be super small.
But doesn't that kind of defeat the purpose...? I guess if it's most of your bond holdings and you are really good about realigning the rest. I don't see that plan being implemented successfully for most run-of-the-mill 529 users with a distant horizon. But an interesting thought.
As an example my portfolio is about 50% pretax, 40% roth and 10% taxable... my entire "bond" holding is in pretax. I am 75% stock/25% bonds, so roughly half of my pretax account is bonds. I am sabotaging my pretax returns so that I can defer more pretax. in good markets, my roths grow so much faster being 100% equities, vs the pretax account.

I have 2 529's that are at about 80-90% funded for in state tuition. If/when due to investment returns bypass 100%, i'll load up all excess as bonds and "move" my bonds from pretax to the 529 penalty account.
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