529 account questions and investing strategies

[FireToBiz]

Hi, I'm 40, I live in California (Bay area, HCOL), got married last year, and we are expecting a baby this January, 4 months away.

Total net worth is ~2.8M. Roughly 700K of NW is in pre-tax 401k, Mega backdoor Roth IRA, and Roth IRA. Yearly expenses are 120K (for now).

I want to make investments into 529 account for my kid. Also FYI, Because I'm 40, when my kid is at the age to go to college, I will be ~59, and I can soon start tapping into my tax-advantaged accounts (mentioning this, because this is a factor in considering not contributing excessively in 529.)

I did read a lot about 529, but I'm also getting mixed signals.

1) I'm in CA. No state tax deduction advantage here. CA 529 account choice here is ScholarShare 529. Is there an advantage to instead contribute to Nevada or Utah 529 plans, which are categorized as gold and silver plans by Morningstar in 2023 (https://www.morningstar.com/personal-fi ... plans-2023)? Also asking, because, I know some people in Bay area invest in out-of-state plans, but I don't know their rationale. If investing in Nevada / Utah plans as a CA resident will not give me tax advantage, then why invest in Nevada / Utah plans, is it because of better fund choices?

2) Does investing in in-state or out-of-state 529 plans have different consequences or contributions or contribution limits to in-state state schools, out-of-state state schools, and private schools? E.g. by the time my kid goes to college, I may still be in CA, and the kid may go to college (public / state or private) in MA.

3) Just to make sure, I can use 529 accounts not just for college, but all school years, right? This I assume includes pre-school, K-12, college, and maybe grad school?

4) What is the annual contribution limit? What is the lifetime contribution limit? More importantly, what is the annual withdrawal limit (to use for kid's education)? I read in a couple of places that the annual withdrawal limit is 10k, which will not work for me, if I'm targeting a private school for my kid that year.

5) Public / state school vs. Private school vs. home not in school zone dilemma: School ratings around my house (rent) zone is 4 / 5 / 7 (K-5, 6-8, 9-12), which isn't perfect. We can stay here for a while, and either send the kid the this public school for K-5 (with rating of 4), or private school (which we can cover). But the question is, I also don't want to excessively contribute to 529, if we will send him to public school (same dilemma for higher grades, except college, which we can go either way). Alternatively, we can move to another location in the city I'm in, with higher school ratings, and send the kid to public schools until college, and then college again can go either way (open to private schools for college). Any suggestions here, as a parent? And as a 529 contributor who probably doesn't want to over-contribute to 529 account?

6) 529 investing strategy and preventing overfunding. In various ways, I will be over-contributing to 529, and I don't want it. I did some back-of-the envelope calculations for investments. Since kid's birth:

a) If I invest 500$ / week for 10 years, and then stop for the next 10 years, assuming 10% YOY growth with good funds, that will end up with 1.2M, which may be overfunding (And yes, I know I will have to withdraw some of it along the way).

b) If I invest 250$ / week for 10 years, and then stop for the next 10 years, assuming 10% YOY growth with good funds, that will end up with 600k, which may still be overfunding.

c) I also considered front-loading before kid's school years. If I invest 500$ / week for 5 years, and then stop for the next 15 years, that will end up with 458k, which I know may be low if the kid ends up going to a private college (I hear 75k-100k / year ranges).

Any suggestions here? I know there are many variables, but did anyone front-load? Are there any annual contribution limits that will invalidate some of these investing plans?

Thanks in advance.

[retired@50]

... assuming 10% YOY growth with good funds,

Assuming 10% growth seems rather optimistic. I'd use a lower number, or perhaps a range like 6-7%.

What do you mean by "good funds"? Are you intending to pick actively managed stock funds with "good" managers or will you be using the Boglehead approach of using stock index funds?

Many of your questions are likely covered here: https://www.savingforcollege.com/

Regards,

[Harmanic]

Many people choose the Utah plan for the investment choices and fees.

[SchruteB&B]

1. I would guess people like the fund choices better. Not sure, but the benefit of not getting a state tax deduction is that you are free to choose whatever 529 plan you like. The federal tax free growth will be the same for you whichever plan you choose.

2. You can use a 529 plan from any state to pay education expenses in any other state.

3. At the federal tax level, you can use 529 plans for K-12 and college and grad school. I don’t think preschool, but I have never checked this.

4. Some 529 plans have different total (not annual) maximum contributions than others, but all the ones I’ve looked at were very high, several million dollars. All 529 plans will be governed by the same federal tax rules regarding annual gift taxes and front loading. The maximum per year that you can withdraw and get the tax free federal treatment of the gains is $10,000 for K-12. There is no limit except for actual costs for college and grad school. I have not looked closely at how it works to use 529 withdrawals in CA for K-12 but my impression is they include it in your state tax and add a penalty.

5. No suggestion

6. Front loading of 529s for a married couple filing jointly is $180,000 in 2024 (18k per person x 2 parents x 5 years of front loading allowed without impacting gift tax)

[HereToLearn]

You can only spend $10K/year from the 529 for K-12 expenses. AFAIK there isn't a limit on the amount you can spend per year on undergrad or grad school.

I have not paid for grad school, so can only comment on undergrad spending. In addition to tuition, room and board charges, you can also use 529 funds to pay for a computer and any necessary software, plus textbooks. Universities include some expenses in cost of attendance that are not eligible 529 expenses, such as mandatory student health fees, student activity fees, the cost of travel to and from school, and student's personal expenses.

[FireToBiz]

1. I would guess people like the fund choices better. Not sure, but the benefit of not getting a state tax deduction is that you are free to choose whatever 529 plan you like. The federal tax free growth will be the same for you whichever plan you choose.

2. You can use a 529 plan from any state to pay education expenses in any other state.

3. At the federal tax level, you can use 529 plans for K-12 and college and grad school. I don’t think preschool, but I have never checked this.

4. Some 529 plans have different total (not annual) maximum contributions than others, but all the ones I’ve looked at were very high, several million dollars. All 529 plans will be governed by the same federal tax rules regarding annual gift taxes and front loading. The maximum per year that you can withdraw and get the tax free federal treatment of the gains is $10,000 for K-12. There is no limit except for actual costs for college and grad school. I have not looked closely at how it works to use 529 withdrawals in CA for K-12 but my impression is they include it in your state tax and add a penalty.

5. No suggestion

6. Front loading of 529s for a married couple filing jointly is $180,000 in 2024 (18k per person x 2 parents x 5 years of front loading allowed without impacting gift tax)

Thank you for your clear answers, this answers most of my questions.

10K withdrawal limit for K-12, and no withdrawal limit for college. Good to know. Because I will be 59 by the time my kid goes to college, I will also have access to my Roth IRA (+ Mega Backdoor Roth IRA).

Interesting point about front-loading 529s. Does this mean I should not contribute more than 18k per year? If I exceed 18k, what happens to excess contribution, do I pay tax on the excess amount, or does it count as gift tax contribution, where the limit is in the order of 12M / 13M?

[FireToBiz]

You can only spend $10K/year from the 529 for K-12 expenses. AFAIK there isn't a limit on the amount you can spend per year on undergrad or grad school.

I have not paid for grad school, so can only comment on undergrad spending. In addition to tuition, room and board charges, you can also use 529 funds to pay for a computer and any necessary software, plus textbooks. Universities include some expenses in cost of attendance that are not eligible 529 expenses, such as mandatory student health fees, student activity fees, the cost of travel to and from school, and student's personal expenses.

Thanks, 10k / year withdrawal for K-12 expenses, and no withdrawal limit for college, good to know.

Yes, I can also use 529 for other small stuff like buying computers, textbooks. Definitely. Thanks.

[FireToBiz]

... assuming 10% YOY growth with good funds,

Assuming 10% growth seems rather optimistic. I'd use a lower number, or perhaps a range like 6-7%.

What do you mean by "good funds"? Are you intending to pick actively managed stock funds with "good" managers or will you be using the Boglehead approach of using stock index funds?

Many of your questions are likely covered here: https://www.savingforcollege.com/

Regards,

Thank you for the link, great resource.

And yes, not fully related to this question about 529, but yes, 7-10% is the expected growth, and I invest in index funds only (3-fund portfolio + SCV tilt), no active management. That's outside the scope.

[newbie20]

There is a new provision that allows the excess 529 funds to be rolled over as Roth IRA (subject to caveats, limitations, etc). I am sure your kid will appreciate the head-start on his/her own retirement if there are funds left over in the 529 plan

https://www.savingforcollege.com/articl ... %20savings.

[aleph0]

10K withdrawal limit for K-12

California does not consider 529 withdrawals for K-12 tuition to be qualified. That means you'll be subject to state income tax on the pro-rated gains portion of any withdrawal you make for this purpose.

You won't pay an additional 10% penalty on that, though, because Federally that would be considered a qualified use.

[toddthebod]

California does not consider K-12 withdrawals as qualified expenses. You will still owe tax on the earnings in addition to a penalty (2.5% of earnings I believe).

Given your level of wealth and age, consider whether a 529 is worthwhile in the first place. Tuition checks are exempt from gift tax and reporting. You can get more money out of your estate by paying tuition out of pocket and making separate annual exclusion gifts to a trust for the child's benefit.

[FireToBiz]

10K withdrawal limit for K-12

California does not consider 529 withdrawals for K-12 tuition to be qualified. That means you'll be subject to state income tax on the pro-rated gains portion of any withdrawal you make for this purpose.

You won't pay an additional 10% penalty on that, though, because Federally that would be considered a qualified use.

Interesting, hold on. CA already doesn't make any state tax deductions for the amount I contribute to 529. Does it also state-tax me on the withdrawals, for the gains of my contributions? Are these withdrawals at least federal-state-tax-exempt?

[toddthebod]

10K withdrawal limit for K-12

California does not consider 529 withdrawals for K-12 tuition to be qualified. That means you'll be subject to state income tax on the pro-rated gains portion of any withdrawal you make for this purpose.

You won't pay an additional 10% penalty on that, though, because Federally that would be considered a qualified use.

Interesting, hold on. CA already doesn't make any state tax deductions for the amount I contribute to 529. Does it also state-tax me on the withdrawals, for the gains of my contributions? Are these withdrawals at least federal-state-tax-exempt?

Withdrawals for K-12 tuition are exempt from federal tax up to $10,000/year.

California will tax you on the earnings portion of those withdrawals plus a 2.5% penalty.

I don't know what "federal-state-tax-exempt" means.

[FireToBiz]

California does not consider K-12 withdrawals as qualified expenses. You will still owe tax on the earnings in addition to a penalty (2.5% of earnings I believe).

Given your level of wealth and age, consider whether a 529 is worthwhile in the first place. Tuition checks are exempt from gift tax and reporting. You can get more money out of your estate by paying tuition out of pocket and making separate annual exclusion gifts to a trust for the child's benefit.

Interesting, K-12 tuition withdrawals are not state-tax-exempt? How about other education related purchases such as laptop, textbooks during K-12?

When you say "You will still owe tax on the earnings in addition to a penalty (2.5% of earnings I believe)." Do you mean state tax only, and is the withdrawal still federal-tax-exempt? And why am I paying a 2.5% penalty on withdrawals for K-12 tuition? This is still education related withdrawal. (This 2.5% penalty is I assume different from the 10% penalty applied for unqualified withdrawals from 529 accounts).

By "You can get more money out of your estate by paying tuition out of pocket and making separate annual exclusion gifts to a trust for the child's benefit.":
- "Paying tuition out of pocket": I'm already taxed 40%-45% in CA, despite maxing out all tax-advantages accounts. Paying tuition out of pocket: I can just as well tap into my taxable brokerage account to pay it, or pay it from my paycheck.
- "Making separate annual exclusion gifts to a trust for the child's benefit": This is the 18k / year gift exclusion, right? Are you suggesting transferring some of my "highly appreciated stocks" to a trust account for my child only, so that I can use it for education on his behalf? That way, the 18k appreciated stock is not taxed?

[FireToBiz]

10K withdrawal limit for K-12

California does not consider 529 withdrawals for K-12 tuition to be qualified. That means you'll be subject to state income tax on the pro-rated gains portion of any withdrawal you make for this purpose.

You won't pay an additional 10% penalty on that, though, because Federally that would be considered a qualified use.

Interesting, hold on. CA already doesn't make any state tax deductions for the amount I contribute to 529. Does it also state-tax me on the withdrawals, for the gains of my contributions? Are these withdrawals at least federal-state-tax-exempt?

Withdrawals for K-12 tuition are exempt from federal tax up to $10,000/year.

California will tax you on the earnings portion of those withdrawals plus a 2.5% penalty.

I don't know what "federal-state-tax-exempt" means.

Got it, thanks for clarification. Interesting. CA doesn't stop surprising me.

And I meant federal-tax-exempt, sorry for the confusion.

[aleph0]

Interesting, hold on. CA already doesn't make any state tax deductions for the amount I contribute to 529.

You're conflating two separate issues:

• If you did receive a tax benefit from your 529 contribution and subsequently make a non-qualified withdrawal, that prior tax benefit could in some circumstances be subject to recapture. That's not applicable to CA, as you note.

• Not every state considers K-12 tuition a qualified 529 withdrawal. CA does not. As such, it will treat the pro-rated gains portion of your withdrawal as CA income, and it will be subject to state income tax. As toddthebod notes, CA also imposes a 2.5% penalty on non-qualified withdrawals (which I was not aware of).

[KlangFool]

Total net worth is ~2.8M. Roughly 700K of NW is in pre-tax 401k, Mega backdoor Roth IRA, and Roth IRA. Yearly expenses are 120K (for now).

FireToBiz,

Net worth is pointless.

A) What is the size of your portfolio? 700K?

B) How much of your net worth is in the home equity?

KlangFool

[toddthebod]

California does not consider K-12 withdrawals as qualified expenses. You will still owe tax on the earnings in addition to a penalty (2.5% of earnings I believe).

Given your level of wealth and age, consider whether a 529 is worthwhile in the first place. Tuition checks are exempt from gift tax and reporting. You can get more money out of your estate by paying tuition out of pocket and making separate annual exclusion gifts to a trust for the child's benefit.

Interesting, K-12 tuition withdrawals are not state-tax-exempt? How about other education related purchases such as laptop, textbooks during K-12?

When you say "You will still owe tax on the earnings in addition to a penalty (2.5% of earnings I believe)." Do you mean state tax only, and is the withdrawal still federal-tax-exempt? And why am I paying a 2.5% penalty on withdrawals for K-12 tuition? This is still education related withdrawal. (This 2.5% penalty is I assume different from the 10% penalty applied for unqualified withdrawals from 529 accounts).

By "You can get more money out of your estate by paying tuition out of pocket and making separate annual exclusion gifts to a trust for the child's benefit.":
- "Paying tuition out of pocket": I'm already taxed 40%-45% in CA, despite maxing out all tax-advantages accounts. Paying tuition out of pocket: I can just as well tap into my taxable brokerage account to pay it, or pay it from my paycheck.
- "Making separate annual exclusion gifts to a trust for the child's benefit": This is the 18k / year gift exclusion, right? Are you suggesting transferring some of my "highly appreciated stocks" to a trust account for my child only, so that I can use it for education on his behalf? That way, the 18k appreciated stock is not taxed?

California never updated their 529 law when the federal government added K-12. The 2.5% penalty is California's version of the federal 10% penalty for non qualified withdrawals. Other education expenses during K-12 are non qualified for federal or state. Only tuition for those years.

The rest has to do with estate taxes. If you foresee a future where you are concerned with estate taxes, you will want to consider whether you are better off gifting money to your kids up to the annual exclusion on top of writing a check to the university.

[majiaknight]

As a California resident, you may treat the 529 account solely for college education expenses. To my knowledge, ScholarShare 529 offers the lowest expense ratio for individual U.S. stock and bond index funds, which I appreciate for their simplicity.
If you’re concerned about overfunding the 529, you could also split contributions between a UTMA account (e.g., at Vanguard) and the 529, and perform annual tax gain harvesting in UTMA to fully utilize the kiddie tax rule.