Overfunding a 529 - weighing risk / reward

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we1
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Overfunding a 529 - weighing risk / reward

Post by we1 » Mon Oct 07, 2019 9:15 pm

Depending on state schools vs private schools, and potentially grad school, my kids’ college could cost anywhere from $125k to $400k+ in today’s dollars. I have to make some kind of assumptions on how much they’ll need. I’m thinking the following - considering the penalty for unused funds is 10% and the benefit in taxes for using the money is 20%, it seems like there is a 2:1 payoff. Therefore, it’s ok to slightly overfund, up to the point where I think there is at least a 1 in 3 chance of using the incremental funds being added.

Any other ideas in trying to figure out the right amount to fund a 529?
Last edited by we1 on Mon Oct 07, 2019 10:27 pm, edited 2 times in total.

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Brianmcg321
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Re: Overfunding a 529 - weighing risk / reward

Post by Brianmcg321 » Mon Oct 07, 2019 9:26 pm

There's not a penalty for unused funds, unless you take it out and use if for something else.

You could always just keep the money in there and change the beneficiary to someone else, a grandchild perhaps.

Are you already maxing out Roth IRAs?

Roth IRAs can also be used for higher education expenses. The extra could go into that and if its not used you could use it for retirement.
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miamivice
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Re: Overfunding a 529 - weighing risk / reward

Post by miamivice » Mon Oct 07, 2019 9:29 pm

The penalty for non-qualified withdrawals is two fold: First you pay a 10% penalty and you also have to pay income tax at your marginal tax rate. For most Bogleheads, your marginal tax rate is much, much higher than long term capital gains tax.

Most parents do not fund kids grad school. In many cases, one's employer will fund grad school.

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goodenyou
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Re: Overfunding a 529 - weighing risk / reward

Post by goodenyou » Mon Oct 07, 2019 9:33 pm

miamivice wrote:
Mon Oct 07, 2019 9:29 pm
The penalty for non-qualified withdrawals is two fold: First you pay a 10% penalty and you also have to pay income tax at your marginal tax rate. For most Bogleheads, your marginal tax rate is much, much higher than long term capital gains tax.

Most parents do not fund kids grad school. In many cases, one's employer will fund grad school.
Except medical, dental and law school.
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mottooscillator
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Re: Overfunding a 529 - weighing risk / reward

Post by mottooscillator » Mon Oct 07, 2019 9:46 pm

I'm in the same boat. Some ideas I've considered to offset a possible overfunding scenario:

1. Naming nieces/nephews as beneficiaries. We have just one kid.
2. Leaving our kid the beneficiary and getting a head start on grad school.
3. Taking the money back over for continuing education for me/wife in retirement.

forkhorn
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Re: Overfunding a 529 - weighing risk / reward

Post by forkhorn » Mon Oct 07, 2019 10:05 pm

I'm not sure I agree with your 2:1 payoff logic, but I struggled with the same overall question and decided to fund my kids' 529s to the cost of an in-state 4 year flagship. It is unlikely that they won't go to at least a second-tier 4-year school, and if they go to something more expensive I'll just cash-flow the difference (or have "the talk" with them and let them take out loans). I came up with the same $125k as your low end.

They aren't quite that well funded yet, but getting close. I decided that the only way I'll fund beyond that level is if I decide that I just don't have anything else to do with the money and intend to use the 529s as education trust funds for possible future grandkids (presumably waaay in the future, since my kids are preschoolers).

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we1
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Re: Overfunding a 529 - weighing risk / reward

Post by we1 » Mon Oct 07, 2019 10:24 pm

Thanks for all the replies.

I knew about the 10% penalty but didn’t know you had to pay the marginal income tax rate on the gains. That is higher than my cap gains rate so the penalty is more than I thought.

I am currently maxing out on all the other tax-advantaged space that I have.

I don’t really have close younger nieces/nephews who could you use excess funds and planning for grandkids just feels too far out right now. We might be fine letting unused funds sit around but my base case is that we’d take the penalty and use excess money for ourselves.

I could likely pay some costs from existing after-tax accounts but I’m also ok with my kids having some loans. If they did take loans, ideally the amount would be well under 1x their starting income. Enough to keep them motivated, but not enough to feel like a burden.

inbox788
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Re: Overfunding a 529 - weighing risk / reward

Post by inbox788 » Tue Oct 08, 2019 1:46 am

I’ll probably overfund he 529 a bit. You can wait till you’re in a lower tax bracket to take out if necessary. Or you can wait till a crash to rebalance out. I’m 100% stock in the 529 and use other funds to meet my overall AA. I’m still working out the glide path, but plan to stay aggressive in the 529 and use other funds if the market crashes during those use years. Any left over can be used for graduate programs, other relatives, grandkids, or maybe even use them myself.

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Re: Overfunding a 529 - weighing risk / reward

Post by shess » Tue Oct 08, 2019 3:04 am

miamivice wrote:
Mon Oct 07, 2019 9:29 pm
The penalty for non-qualified withdrawals is two fold: First you pay a 10% penalty and you also have to pay income tax at your marginal tax rate. For most Bogleheads, your marginal tax rate is much, much higher than long term capital gains tax.
You generally pay taxes on the portion not already taxed (you don't pay taxes on return of your original contributions). Which has me wondering ... how do contributions versus earnings get allocated? Since I see basically nothing specific on the web, other than that you pay taxes on earnings, I'm guessing that it's pro-rata all the way, both for qualified distributions and for non-qualified withdrawals. I sure hope our provider tracks these things, because 529 plans seem somewhat opaque to me compared to regular brokerage or mutual fund accounts.

Though if they took qualified distributions out of earnings first, that would make for a tidy solution to overfunding, because your original contributions would end up in the leftover section.

ivk5
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Re: Overfunding a 529 - weighing risk / reward

Post by ivk5 » Tue Oct 08, 2019 3:22 am

shess wrote:
Tue Oct 08, 2019 3:04 am
how do contributions versus earnings get allocated? Since I see basically nothing specific on the web, other than that you pay taxes on earnings, I'm guessing that it's pro-rata all the way, both for qualified distributions and for non-qualified withdrawals.
See IRS Pub 970, Chapter 8 - Qualified Tuition Program (QTP), Section "Are Distributions Taxable?", second paragraph (PDF HTML):
Publication 970 wrote: Earnings and return of investment. You will receive a Form 1099-Q from each of the programs from which you received a QTP distribution in 2018. The amount of your gross distribution (box 1) shown on each form will be divided between your earnings (box 2) and your basis, or return of investment (box 3). Form 1099-Q should be sent to you by January 31, 2019.

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RickBoglehead
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Re: Overfunding a 529 - weighing risk / reward

Post by RickBoglehead » Tue Oct 08, 2019 3:30 am

shess wrote:
Tue Oct 08, 2019 3:04 am
miamivice wrote:
Mon Oct 07, 2019 9:29 pm
The penalty for non-qualified withdrawals is two fold: First you pay a 10% penalty and you also have to pay income tax at your marginal tax rate. For most Bogleheads, your marginal tax rate is much, much higher than long term capital gains tax.
You generally pay taxes on the portion not already taxed (you don't pay taxes on return of your original contributions). Which has me wondering ... how do contributions versus earnings get allocated? Since I see basically nothing specific on the web, other than that you pay taxes on earnings, I'm guessing that it's pro-rata all the way, both for qualified distributions and for non-qualified withdrawals. I sure hope our provider tracks these things, because 529 plans seem somewhat opaque to me compared to regular brokerage or mutual fund accounts.

Though if they took qualified distributions out of earnings first, that would make for a tidy solution to overfunding, because your original contributions would end up in the leftover section.
All withdrawals are prorated.
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shess
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Re: Overfunding a 529 - weighing risk / reward

Post by shess » Tue Oct 08, 2019 3:41 am

ivk5 wrote:
Tue Oct 08, 2019 3:22 am
shess wrote:
Tue Oct 08, 2019 3:04 am
how do contributions versus earnings get allocated? Since I see basically nothing specific on the web, other than that you pay taxes on earnings, I'm guessing that it's pro-rata all the way, both for qualified distributions and for non-qualified withdrawals.
See IRS Pub 970, Chapter 8 - Qualified Tuition Program (QTP), Section "Are Distributions Taxable?", second paragraph (PDF HTML):
Publication 970 wrote: Earnings and return of investment. You will receive a Form 1099-Q from each of the programs from which you received a QTP distribution in 2018. The amount of your gross distribution (box 1) shown on each form will be divided between your earnings (box 2) and your basis, or return of investment (box 3). Form 1099-Q should be sent to you by January 31, 2019.
Thanks for the info! This is my first year on the distribution end of a 529, so I guess I'd have eventually gotten this 1099-Q and figured it out.

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dogagility
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Re: Overfunding a 529 - weighing risk / reward

Post by dogagility » Tue Oct 08, 2019 4:43 am

we1 wrote:
Mon Oct 07, 2019 9:15 pm
Any other ideas in trying to figure out the right amount to fund a 529?
If your state provides an income tax deduction or better yet an income tax credit for contributions, this needs to be considered in the equation.

We expected to fund our two daughters 529 at the full cost of attendance for a flagship university. Due to moving to a lower cost state and the investment performing better than projected, the 529 was over-funded for undergraduate school by about 50K. But... after a year of working, one daughter decided to get a medical degree... over-funding problem solved!

My suggestion would be to know your expectations for your kids education and plan accordingly. If you are like most Bogleheads, you are unlikely to receive any significant need-based grant aid from the college or the government. The plan when your kids are young may be to fund a flagship university education. Adjust contributions as your kids grow older, the investment performance becomes realized, and your kids' aspirations come into better focus.
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Prettyfrtnt
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Re: Overfunding a 529 - weighing risk / reward

Post by Prettyfrtnt » Tue Oct 08, 2019 3:04 pm

miamivice wrote:
Mon Oct 07, 2019 9:29 pm
The penalty for non-qualified withdrawals is two fold: First you pay a 10% penalty and you also have to pay income tax at your marginal tax rate. For most Bogleheads, your marginal tax rate is much, much higher than long term capital gains tax.

Most parents do not fund kids grad school. In many cases, one's employer will fund grad school.
See here is where I completely disagree with the overfunded 529 logic...

If you goal is to fund your child. Which clearly it is...

If you have an extra say 100k in the account once your child is 18. Your child can remove this money at their incredibly low tax rate with a 10% penalty (much like retired folks do Roth conversions).

Your child can pay 15% up to 37000 on only the prorated earnings!! Plus the 10% penalty. Total 25% on the earnings. That is almost the exact same as my own long term cap gain rate(23.8). Your kids can do this during their college years when they earn next to nothing if you project to be overfunded.

And now you have a house down payment.
Last edited by Prettyfrtnt on Tue Oct 08, 2019 3:08 pm, edited 1 time in total.

miamivice
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Re: Overfunding a 529 - weighing risk / reward

Post by miamivice » Tue Oct 08, 2019 3:07 pm

Prettyfrtnt wrote:
Tue Oct 08, 2019 3:04 pm
miamivice wrote:
Mon Oct 07, 2019 9:29 pm
The penalty for non-qualified withdrawals is two fold: First you pay a 10% penalty and you also have to pay income tax at your marginal tax rate. For most Bogleheads, your marginal tax rate is much, much higher than long term capital gains tax.

Most parents do not fund kids grad school. In many cases, one's employer will fund grad school.
See here is where I completely disagree with the overfunded 529 logic...

If you goal is to fund your child. Which clearly it is...

If you have an extra say 100k in the account once your child is 18. Your child can remove this money at their incredibly low tax rate with a 10% penalty (much like retired folks do Roth conversions).

Your child can pay 15% up to 37000 on only the prorated earnings!! Plus the 10% penalty. Total 25% on the earnings. That is almost the exact same as my own long term cap gain rate(23.8). Your kids can do this during their college years when they earn next to nothing if you project to be overfunded.
I have heard that the kiddie tax will apply until the kid is 25 or something. I haven't looked into it though so I don't know for sure.

Agree that at some point in the future, someone will be at a low tax bracket and can withdraw the money with little tax consequences.

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Wiggums
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Re: Overfunding a 529 - weighing risk / reward

Post by Wiggums » Tue Oct 08, 2019 3:27 pm

the kiddie tax applies to unearned income. Unearned income typically means investment income like dividends, capital gains and interest; those amounts are subject to the kiddie tax.

The general rule is this: If your child is under the age of 19 (or under the age of 24 and a full-time student), the kiddie tax applies once unearned income hits $2,200 in 2019. If that’s the case, your child has unearned income subject to the kiddie tax, and must file a federal form 8615, Tax for Certain Children Who Have Unearned Income (downloads as a PDF).

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Wiggums
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Re: Overfunding a 529 - weighing risk / reward

Post by Wiggums » Tue Oct 08, 2019 3:29 pm

I don’t think this was mentioned here. You could fully fund the 529 and then switch to UGMA/UTMA for the rest.

ThisTimeItsDifferent
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Re: Overfunding a 529 - weighing risk / reward

Post by ThisTimeItsDifferent » Tue Oct 08, 2019 3:53 pm

RickBoglehead wrote:
Tue Oct 08, 2019 3:30 am
shess wrote:
Tue Oct 08, 2019 3:04 am
miamivice wrote:
Mon Oct 07, 2019 9:29 pm
The penalty for non-qualified withdrawals is two fold: First you pay a 10% penalty and you also have to pay income tax at your marginal tax rate. For most Bogleheads, your marginal tax rate is much, much higher than long term capital gains tax.
You generally pay taxes on the portion not already taxed (you don't pay taxes on return of your original contributions). Which has me wondering ... how do contributions versus earnings get allocated? Since I see basically nothing specific on the web, other than that you pay taxes on earnings, I'm guessing that it's pro-rata all the way, both for qualified distributions and for non-qualified withdrawals. I sure hope our provider tracks these things, because 529 plans seem somewhat opaque to me compared to regular brokerage or mutual fund accounts.

Though if they took qualified distributions out of earnings first, that would make for a tidy solution to overfunding, because your original contributions would end up in the leftover section.
All withdrawals are prorated.
I thought that withdrawals are prorated within an account or provider so that one should withdtaw from the most appreciated accounts first.

inbox788
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Re: Overfunding a 529 - weighing risk / reward

Post by inbox788 » Tue Oct 15, 2019 2:35 pm

Wiggums wrote:
Tue Oct 08, 2019 3:27 pm
the kiddie tax applies to unearned income. Unearned income typically means investment income like dividends, capital gains and interest; those amounts are subject to the kiddie tax.

The general rule is this: If your child is under the age of 19 (or under the age of 24 and a full-time student), the kiddie tax applies once unearned income hits $2,200 in 2019. If that’s the case, your child has unearned income subject to the kiddie tax, and must file a federal form 8615, Tax for Certain Children Who Have Unearned Income (downloads as a PDF).
Trying to wrap my head around this kiddie tax business. Not easy. Goal is to fund an additional year of private college expenses, with extra funds going to buying a car and/or savings for down payment on first home (with understanding that any funds child controls can be misspent, and that's an acceptable risk).

Weighing the complexity/benefit of UTMA with some appreciated stock vs simply overfunding 529. Is the total tax benefit capped at $700-1100 as described in the wiki, or is there additional benefit being overlooked? This does appear to be potentially an annual benefit and may extend beyond age 18 (while attending college and after).

To achieve this maximum requires calculating optimal transfers and realizing capital gains, a bunch of accounting and record keeping, and depending on thresholds extra forms on the tax return and in some cases, the child having to do his own return. This is more likely if child works and adds earned income.

https://www.bogleheads.org/wiki/Kiddie_ ... in_general

Let's say 5 years before/during/after college, you had $50k extra and you opened a new 529 that gained/earned $10k or $20k during that period (meanwhile the student spends the other 529 entirely on qualified college expenses). You can take out the initial contribution tax/penalty free and you want to spend the earnings on a car, so it's subject to the 10% penalty and up to 37% income tax. If instead you left it in a taxable account, you'd simply pay the long term capital gains rate of 15 or 20% on the earnings. If instead, you transferred to UTMA and tax gain harvested $1000/year, you may only have about $5k or $15k in long term gain liability under student rate which might be 0%. Subject to kiddie tax rates while student, so it seems to be beneficial to wait till student graduates and/or turns 25 to realize gains.

So it seems to be more beneficial the larger the amounts and transfers, correct? Any errors in these options and outcomes?

I loathe the complexity of the kiddie tax and UTMA, but I'm starting to believe there is a worthwhile benefit, especially if you set out to max out the 529. Still trying to figure out the thresholds for Form 8814 vs full child tax return and tradeoffs.

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