Author Topic: 529s: are the penalties worse than the benefits?  (Read 10936 times)

Manguy888

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529s: are the penalties worse than the benefits?
« on: August 20, 2014, 08:52:32 AM »
Hey all-

I have one 10 month old daughter and another on the way in December. I started a 529 and have been dutifully contributing to it. When I read about saving for college, the 529 is basically the only advice people give. But the more I look at this thing and apply common sense to it, the more I start to see some serious problems:

- The money HAS to be used for education or you pay taxes PLUS a 10% penalty. I don't see any kinds of loopholes to avoid this penalty the way you
- The 18 year timeline of college savings is too short to guarantee the kinds of returns we read about when we consider retirement planning.
- If I were to FIRE before my kids went to college, I'd likely be at an income where I didn't have to pay capital gains anyways, essentially making all investments a 529 without the restrictions

I can see a situation where my daughters either don't go to college or get a scholarship and I have 100k in money sitting there that I'll be taxed and penalized on.

The only true benefits I can see are A) 529 money is not counted toward FAFSA (financial aid) and B) the accounts make it easy for family and friends to give money to children and know that it will be used for college. There are also some state by state benefits, but none of them really affect us.

My conclusion based on this is that I should keep the account for friends and family, but diversify with a regular taxable fund with some vanguard funds.

What do all you smart people think? Am I wrong here?

matchewed

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Re: 529s: are the penalties worse than the benefits?
« Reply #1 on: August 20, 2014, 09:02:30 AM »
I'll address these one at a time.
- The money HAS to be used for education or you pay taxes PLUS a 10% penalty. I don't see any kinds of loopholes to avoid this penalty the way you

Yep. It's meant for education expenses. That is what it is designed for so...
- The 18 year timeline of college savings is too short to guarantee the kinds of returns we read about when we consider retirement planning.

Yes retirement planning and education expense planning will be two different creatures. I'm not sure what you're getting at with this "problem". 18 year timelines are still rather long so historical returns aren't a bad model for them.
- If I were to FIRE before my kids went to college, I'd likely be at an income where I didn't have to pay capital gains anyways, essentially making all investments a 529 without the restrictions

Sure then a 529 just may not be for you. You aren't wrong. The 529 is designed for people to put money away specifically for education expenses for someone in their family. If that doesn't fit your needs then you just don't use it. That doesn't make the "problems" worse than the "benefits", it just makes it unsuitable for your particular circumstances.

Manguy888

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Re: 529s: are the penalties worse than the benefits?
« Reply #2 on: August 20, 2014, 09:11:20 AM »
I guess what I'm pushing back against here is the idea that the 529 is the be all end all of college planning, which is what I've heard and read said in many places.

It seems dangerous to pump money into an account that can only be used for education when your childrens' future is so uncertain. What will college look like in 18 years? Will my specific children go? There are no rules to allow you to skirt the penalties if, say, your child gets a full scholarship.

I'm curious what other people's strategies are. My initial plan to put all my eggs in the 529 basket seems wrong to me now.

Lkxe

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Re: 529s: are the penalties worse than the benefits?
« Reply #3 on: August 20, 2014, 09:24:13 AM »
I was going to write this information but I found an article to help you make your own decision. http://www.freemoneyfinance.com/2007/06/what_to_do_with.html My older son got a full tuition scholarship and a stipend ( the stipend is not tied to expenses) and we could have taken money out of his 529 but he may wish for graduate school and he has a little brother or we may have grandchildren. I did stop adding to the boys 529's recently because while I was saving the new GI Bill became transferable. Hopefully, all future Lkxes (at least 2 generations) will have college funds.

matchewed

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Re: 529s: are the penalties worse than the benefits?
« Reply #4 on: August 20, 2014, 09:31:49 AM »
Sure lots of places encourage it. Much like lots of places encourage 401k's and IRA's. It is a tool for a specific goal. If you're not planning on that goal or have other methods then it may not apply to you. All the concerns you've brought up are valid for you. But if you're a parent saying my child will go to college and I will pay for it, then it's not such a bad thing.

Different tools for different problems doesn't make something bad or good. A screwdriver isn't a bad tool because you can't hammer with it.

Manguy888

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Re: 529s: are the penalties worse than the benefits?
« Reply #5 on: August 20, 2014, 09:34:02 AM »
Now we're getting somewhere! Thanks for the info - I didn't realize you could withdraw the amount of a scholarship. That's a big deal

ketchup

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Re: 529s: are the penalties worse than the benefits?
« Reply #6 on: August 20, 2014, 09:40:13 AM »
My grandma started a 529 for me and contributed to it from 1996~2012.  It didn't even keep up with inflation mostly because of the obscene (2%+) expense ratios on the funds.  My dad was incredibly frustrated with that and she didn't seem to get it.  So if you do contribute, make sure the funds you have as options are actually worthwhile.  A taxable account with sensible funds (Vanguard) would have come out far ahead of my grandma's tax-advantaged 529.

rmendpara

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Re: 529s: are the penalties worse than the benefits?
« Reply #7 on: August 20, 2014, 09:43:32 AM »
Now we're getting somewhere! Thanks for the info - I didn't realize you could withdraw the amount of a scholarship. That's a big deal

Absolutely great news.

The one thing to avoid (assuming you don't add new beneficiaries for future generations), is to overfund the 529 significantly.

If you want to split your bet, perhaps consider a 529 for half of the planned college expenses, and fund the remainder through current income (at the future time) and general investments?

I don't mind leaving a bit over to grandchildren, niece/nephew, etc, but if anything I'd prefer a general trust rather than a 529 to transfer some, if any, inter-generational wealth.

Up to you, of course, but I'd suggest avoiding over-contributing to a 529.

Manguy888

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Re: 529s: are the penalties worse than the benefits?
« Reply #8 on: August 20, 2014, 09:45:59 AM »
good point ketchup. My 529 is through vanguard so I'm in good hands.

We're all savvy here in MMM-land, but I do feel for non-savvy people when they look at these funds. Every state has a 529. Okay, that makes sense. But then you find out that you can use Any state's 529. Okay, understand that. But ALSO, the state specific benefits to 529s only happen if you use YOUR state's 529. But for a lot of people these benefits aren't worth the expense ratios of a bad plan. Are we surprised that people are confused?

My father in law (a retired VP of a re-insurance company) spent many hours pouring over paperwork before figuring out that using vanguard (who operates nevada's plan) is the best choice. It should have been easier.

Mrs. Healthywealth

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Re: 529s: are the penalties worse than the benefits?
« Reply #9 on: August 20, 2014, 09:58:37 AM »
We also had the same concerns about a 529 with setting up an acct for our twins. Since there is a chance they receive scholarships, or choose not to go to school. The other reason for not funding it that came up was that the state we are planning to move to is looking to possibly change how you pay for state colleges--don't pay for college up front but later they take a percentage from your income after you graduate. (we are not necessarily banking on this to happen)

I called Vanguard and discussed how they set up their 529 (I believe it's the Nevada plan) and set up a taxable account similarly. We started with 100% in VTSMX. You can see this information on Vanguard's website. We are also in the process of purchasing a house in the next couple years so were uncertain if we may need that money, but we would not use it if did not have to. We decided we wanted them to have a little bit more freedom with what they could do with the funds ie down payment on a house or continue to invest it. We will also be FIRE'd by then :)

Im not really concerned about the 18 year timeline in terms of returns, but I also always calculate the most puny rate of return.

My wife paid for her undergrad and she thought it helped her in becoming more financially responsible since she had to work and go to school. Just thought that was a valid perspective to share too.

FrugalSpendthrift

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Re: 529s: are the penalties worse than the benefits?
« Reply #10 on: August 20, 2014, 10:44:47 AM »
Now we're getting somewhere! Thanks for the info - I didn't realize you could withdraw the amount of a scholarship. That's a big deal
He didn't say that avoids the penalty.  He said they decided to leave the funds in there for some unknown future college expense, either his childs grad school or some other relative that has college expenses.  The beneficiary can be re-assigned, so it could become your grandchild's college fund.

Scandium

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Re: 529s: are the penalties worse than the benefits?
« Reply #11 on: August 20, 2014, 10:54:23 AM »
Sure it has limits, but 18 years of tax-free gains sounds like  a pretty good deal to me, at least for part of the college costs. But it can also be used for any education expenses. Like trade school, or if you or your spouse wants to get more schooling (not sure what the restrictions on this are).

As you say; when you FIRE your income will likely drop. If you're in the 10% bracket you would then only pay 20% on the gains in the account if you took it out to spend on whatever. Perhaps not ideal, but I don't think that's a terrible outcome either.

And I wouldn't mind just leaving it to grow for 30+ years and giving a massive college fund to my grand kids, if my child doesn't need it.

msilenus

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Re: 529s: are the penalties worse than the benefits?
« Reply #12 on: August 20, 2014, 11:14:24 AM »
The penalty is not good, but it's better worse than the alternative for lots of people.  What's your marginal tax rate on investment income?  What do you expect it to be when kids go off to college?  I pay AMT in California, so my marginal rate is about 45%.  That's half my dividends every year.  When I last ran the numbers, it turned out that undercontributing to a 529 by $1 was worse than overcontributing by $4 and paying a penalty on earnings on those $4.

The benefit goes beyond taxes, too.  When you liquidate your 529 to pay for college, you don't realize income for FAFSA purposes.  For the mustache crowd, that's a pretty big deal, as you're likely to be retired and earning not a whole lot at that point.  Hide the rest of your assets in your home equity and ERISA-qualified retirement accounts, and you can look positively destitute.  Go run some numbers over at Havard's financial aid office using their calculator, and see what falls out for you.

But perhaps most important is having contingency plans to avoid the penalty.  Mine shift around, but they might look like this some of the time:

Plan A: Use the money to pay for my kids' college, and/or take money out when they get scholarships and/or financial aid (with no penalty.)

Plan B: Point the account at a nephew or niece.  I don't have any nephews, yet.  But let's say I eventually do, and let's say that my siblings don't use a 529 to save for their college, and that they go.  Kid goes to school, incurs education expenses.  Now I'm eligible to withdraw money from the account penalty free.  Maybe I pay for the tuition and then they pay me back, you're thinking?  Unnecessary, actually.  If you check the IRS rules, all that matters to avoid the penalty is that there existed eligible education expenses.  It's just really important to make sure that your 529 is the only one being used for those expenses.

Plan C: Point the account at me and my wife.  Use the money to pay qualified education expenses, including room and board.  Attending a community college 50% time doesn't cost a lot, but room and board allowances are something like $10k/yr around where I am now.  We can keep doing this in good faith for as long as we want to learn.  I expect that will be a long time.

Plan D: Point a diminished balance at grandkids, with an epic compounding horizon.  How great would it be to relieve my kids of the burden of paying for their kids' college?  Maybe we can get a dynastic wealth thing going on, esp. if my other investments have done well and the 'stache has grown.  Doing that for education expenses isn't socially toxic and affluenza-breeding like it is with cash.

Plan E: Pay a penalty if the balance is still looking too high, or I need the money, and still come out ahead.  By the time we get to Plan E, how old am I, do you think, given Plans A-D?  Probably pretty old.  According to my spreadsheet, after about 30 years a 529 is better than a taxable account even with the penalty.  So if I can put off withdrawals into my seventies, I can't lose.

Plan F: Okay, I guess I apparently come out behind.  But see my first paragraph again.  Overshooting a bit is perfectly rational for me.

Plan G: I wildly overshot.  Oops?  How terrible this is basically boils down to how much you like or hate your job.  It means you could have quit a bit earlier, but now you have more money than you planned on, less 10% on the earnings.  How bad is that, really?
« Last Edit: August 20, 2014, 11:29:44 AM by msilenus »

MooseOutFront

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Re: 529s: are the penalties worse than the benefits?
« Reply #13 on: August 20, 2014, 11:56:12 AM »
Dividends and capital gains are currently tax free for me and I expect they will be when I retire before my kids go to college as well.  Also my state has no deduction on 529 contributions.  I don't see much use for them vs taxable and would feel the same even if I expected to have to pay some tax on dividends and capital gains. 

gimp

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Re: 529s: are the penalties worse than the benefits?
« Reply #14 on: August 20, 2014, 12:10:10 PM »
There's another cool thing about 529s - they can transfer from person to person. For example, I know a family who saved enough in a 529 for their three kids to go to school, and they still have a bunch left over - so when their kids start having kids, the 529s will be used for the grandchildren.

If you need to draw on the money for yourself, or if you don't believe in funding education that way, then maybe not the best bet. If you'll never miss the money, there's nothing wrong with sticking it into a 529 to create a bit of a short-term dynasty, you know?

johnny847

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Re: 529s: are the penalties worse than the benefits?
« Reply #15 on: November 20, 2014, 10:20:23 AM »
The penalty is not good, but it's better worse than the alternative for lots of people.  What's your marginal tax rate on investment income?  What do you expect it to be when kids go off to college?  I pay AMT in California, so my marginal rate is about 45%.  That's half my dividends every year.  When I last ran the numbers, it turned out that undercontributing to a 529 by $1 was worse than overcontributing by $4 and paying a penalty on earnings on those $4.

The benefit goes beyond taxes, too.  When you liquidate your 529 to pay for college, you don't realize income for FAFSA purposes.  For the mustache crowd, that's a pretty big deal, as you're likely to be retired and earning not a whole lot at that point.  Hide the rest of your assets in your home equity and ERISA-qualified retirement accounts, and you can look positively destitute.  Go run some numbers over at Havard's financial aid office using their calculator, and see what falls out for you.

But perhaps most important is having contingency plans to avoid the penalty.  Mine shift around, but they might look like this some of the time:

Plan A: Use the money to pay for my kids' college, and/or take money out when they get scholarships and/or financial aid (with no penalty.)

Plan B: Point the account at a nephew or niece.  I don't have any nephews, yet.  But let's say I eventually do, and let's say that my siblings don't use a 529 to save for their college, and that they go.  Kid goes to school, incurs education expenses.  Now I'm eligible to withdraw money from the account penalty free.  Maybe I pay for the tuition and then they pay me back, you're thinking?  Unnecessary, actually.  If you check the IRS rules, all that matters to avoid the penalty is that there existed eligible education expenses.  It's just really important to make sure that your 529 is the only one being used for those expenses.

Plan C: Point the account at me and my wife.  Use the money to pay qualified education expenses, including room and board.  Attending a community college 50% time doesn't cost a lot, but room and board allowances are something like $10k/yr around where I am now.  We can keep doing this in good faith for as long as we want to learn.  I expect that will be a long time.

Plan D: Point a diminished balance at grandkids, with an epic compounding horizon.  How great would it be to relieve my kids of the burden of paying for their kids' college?  Maybe we can get a dynastic wealth thing going on, esp. if my other investments have done well and the 'stache has grown.  Doing that for education expenses isn't socially toxic and affluenza-breeding like it is with cash.

Plan E: Pay a penalty if the balance is still looking too high, or I need the money, and still come out ahead.  By the time we get to Plan E, how old am I, do you think, given Plans A-D?  Probably pretty old.  According to my spreadsheet, after about 30 years a 529 is better than a taxable account even with the penalty.  So if I can put off withdrawals into my seventies, I can't lose.

Plan F: Okay, I guess I apparently come out behind.  But see my first paragraph again.  Overshooting a bit is perfectly rational for me.

Plan G: I wildly overshot.  Oops?  How terrible this is basically boils down to how much you like or hate your job.  It means you could have quit a bit earlier, but now you have more money than you planned on, less 10% on the earnings.  How bad is that, really?

I was referred to this thread by somebody else, and I was thinking about some of the drawbacks to some of your contingencies...thoughts?

The math on the penalty doesn't quite max sense to me. Maybe you can shed some light on it, but when you make a nonqualified withdrawal from a 529, you have to pay both penalties and taxes on the gains. And you don't get to deduct the penalty amount when calculating the taxes either/

Contingency plan B and D may rely on hypothetical family members coming into being. If you already have a nephew or niece though, this could be a viable option. Of course, in order to get that money back, your brother or sister would have to pay you back for the money you're spending on their kid. Which may not be worth the hassle, or they may not agree to such a maneuver.

Contingency C is interesting. But, room and board use of a 529 requires that a student be enrolled at least half time. So the math on this situation may work out, if your local community college is that cheap even to be a half time student. But it's something everybody would have to evaluate for themselves. Also, again, this relies on the assumption that you would be living near a cheap community college sometime in the future.

Contingency E - Huh? I'm still confused. Expense ratios in a taxable account at Vanguard are lower than in any 529, so that's a compounding loss right there. And then you pay a tax and penalty on gains for money pulled out of a 529 not used for educational expenses.

Contingency F - I agree, overshooting a bit is perfectly rational. But you can overshoot in a taxable account instead and not have to deal with this headache. And I'm not quite convinced about the math of still coming out ahead.

msilenus

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Re: 529s: are the penalties worse than the benefits?
« Reply #16 on: November 20, 2014, 10:54:55 AM »
I'm running from memory here, but here goes:

If you put your money in a 529 and then pay a penalty, it doesn't become "like a taxable account, but with a 10% penalty on earnings."  It becomes "like an after-tax 401(k) with a penalty" or "like a traditional IRA with no deduction and a penalty."  You have a 10% penalty, but you also get the benefit of deferring taxes on interest and dividends, which yields a stronger compounding benefit than the difference in expense ratios.  (TBH, I'm certain I assumed equal expense ratios, but that's close enough to correct with a good 529 that I'm not going to sweat it.)  Leave the money in an account like that for long enough, with a high enough tax rate dragging back the taxable baseline scenario, and it can become better than taxable eventually.  IIRC, it was something like 30-40 years in my model.  But by 20, the penalty had been defanged considerably.

Note also that the core claim isn't about winning by paying a penalty.  (Though that's possible far enough out, see E.)  I said that if I had $10k too little in my 529, then that would cost me 4x as much (in taxes) over the long haul as having $10k too little (in penalties).  It's ideal to save exactly the right amount in your 529, but the odds of that happening are tiny.  Our intuition is to aim for the true target as best we can, but I think that's wrong: an asymmetry in costs means you should lead your target a bit, and be content with the understanding that that means you intend to oversave most of the time as a hedge against the times when you would otherwise have undersaved.  So having a quantitative view of the relative costs of the two options is really helpful.  Note also that for someone in a lower low tax bracket, the ratio would be very different.  This is all very individual.

I think that might speak a bit to your concerns about the general math, and Contingency E.  Of course, if you can't reproduce the numbers in a spread sheet, then it's certainly possible I did something wrong.  I get the sense that you haven't gone that far yet, so I'm just trying to explain how they came out that way for me.

You're right that people need to have their own contingency plan that makes sense for them.  If you know you aren't going to have nephews or nieces who will be game for playing some tax games with you, then you discount the value of that option a bit.  I think it might still be relatively high on the list, because I think it makes sense to rank the list by order of efficiency and flexibility. 
« Last Edit: November 20, 2014, 10:59:25 AM by msilenus »

Pigeon

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Re: 529s: are the penalties worse than the benefits?
« Reply #17 on: November 20, 2014, 10:56:47 AM »
Money from 529s can also be used for post-secondary vocational schools, not just colleges.  They are very much YMMV.

For us, it made a lot of sense.  We get a significant deduction on our state taxes, which are pretty high.  We plan on providing our kids with enough money for four years tuition, room and board at one of our state's numerous and excellent public colleges, so saving that much in a 529 was a pretty easy decision.  Should they decide to live at home and go to the local public university, they can apply what's left to grad school.  Both kids are teens now and college is definitely in their future.

We have numerous nieces and nephews, so if for some reason our kids didn't use the money, it wouldn't go to waste.

rmendpara

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Re: 529s: are the penalties worse than the benefits?
« Reply #18 on: November 20, 2014, 11:07:38 AM »
I guess what I'm pushing back against here is the idea that the 529 is the be all end all of college planning, which is what I've heard and read said in many places.

It seems dangerous to pump money into an account that can only be used for education when your childrens' future is so uncertain. What will college look like in 18 years? Will my specific children go? There are no rules to allow you to skirt the penalties if, say, your child gets a full scholarship.

I'm curious what other people's strategies are. My initial plan to put all my eggs in the 529 basket seems wrong to me now.

Shoot for a much lower goal. Say, half of planned college funding (whatever amount you choose) to be funded through a 529, and the other half through general investments.

You could also just have some mutual fund/ETFs invested and set aside mentally for children's college expenses, and that would also be fairly tax efficient as well since there would only be taxes if you sell often or have tax-inefficient holdings.

Personally, I'm unmarried and childless, but funded a 529 when I started working because of exactly what you mentioned... 18 years doesn't seem like a very long time for compounding to be very magical. To date, I've got a balance around $7k, and will likely contribute until it hits $10k, but for now am planning to stop contributing to the 529 plan at that point and fund the rest through general investments and future earnings. I don't want to overcomplicate my life by having to track a 529 plan in too much detail.

Perhaps you could try the same? Choose a low amount, maybe 20-40% of college expenses to fund through 529 plan and the rest through taxable investment accounts?


msilenus

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Re: 529s: are the penalties worse than the benefits?
« Reply #19 on: November 20, 2014, 11:11:15 AM »
This is something I don't usually emphasize when talking up 529s with friends, because it's highly particular to our little cult here, but it's so important that I think it needs emphasizing: if you're already retired when your kids are in college, the benefit of your 529 expands from just tax savings, to income sheltering on financial aid forms.   (!!)

It's hard to plan things out this far in the future with certainty, but if you look at how the current system is structured, this is potentially huge.  If you wind up under-contributing, and having to liquidate appreciated securities to pay for a kid's college, then it doesn't just cost you on taxes --it undermines their financial aid eligibility in subsequent years and costs you there as well.  This was a huge factor (alongside the ratio above, and the long list of contingencies) in shifting my perspective on this from being afraid to contribute too much, to being absolutely terrified of contributing too little.

sol

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Re: 529s: are the penalties worse than the benefits?
« Reply #20 on: November 20, 2014, 11:13:51 AM »
For us, the primary benefit of a 529 plan like Vanguard's isn't the tax-free withdrawals in retirement, because like others here we expect to have no tax liability in retirement anyway.  No, the benefit is in the tax free growth NOW, while we're still working.  It's a valuable tax shelter for working folks with high incomes.

We also invest in Washington State's GET program, which is like a 529 but you're prepaying the cost of college credits instead of just investing the money.  That has it's own set of problems, but at least it's a guaranteed margin of return.

We have three kids, and expect to fund half of their educations through accounts like these.  The other half may come from the kids themselves, or from debt, or from our taxable investments if we have surplus money when the time comes. 

brooklynguy

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Re: 529s: are the penalties worse than the benefits?
« Reply #21 on: November 20, 2014, 11:26:38 AM »
For us, the primary benefit of a 529 plan like Vanguard's isn't the tax-free withdrawals in retirement, because like others here we expect to have no tax liability in retirement anyway.  No, the benefit is in the tax free growth NOW, while we're still working.  It's a valuable tax shelter for working folks with high incomes.

We also invest in Washington State's GET program, which is like a 529 but you're prepaying the cost of college credits instead of just investing the money.  That has it's own set of problems, but at least it's a guaranteed margin of return.

We have three kids, and expect to fund half of their educations through accounts like these.  The other half may come from the kids themselves, or from debt, or from our taxable investments if we have surplus money when the time comes.

Even better than the deferral of taxes on earnings (especially if using tax-efficient investments anyway), for those of us in states with high tax rates, is the upfront state tax deduction (if there is one).  For anyone performing a contingency analysis like msilenus' above, though, keep in mind that in some states the upfront state tax deduction may be subject to clawback if the funds are not used for qualified educational expenses.

johnny847

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Re: 529s: are the penalties worse than the benefits?
« Reply #22 on: November 20, 2014, 12:01:09 PM »
I think that might speak a bit to your concerns about the general math, and Contingency E.  Of course, if you can't reproduce the numbers in a spread sheet, then it's certainly possible I did something wrong.  I get the sense that you haven't gone that far yet, so I'm just trying to explain how they came out that way for me.

Did you factor in the LTCG rates for redemption in a taxable account? I ran some numbers, with some help of Bogleheads formulas http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140669
Assumptions:
Start with $10k, only looking at using VTSAX in a taxable account vs a 529 (I'm assuming you're putting your tax inefficient funds elsewhere).
2.1% dividend yield for VTSAX
For the sake of the argument for tax deferral, assume federal 43.4% marginal income tax rate and 23.8% LTCG rate (the extra 3.8% because of ACA).
I will assume GA state tax rates, because I am familiar with those. 6% marginal rate on income over $7k after deductions.
Use a NY 529. I only checked Vanguard (I think that's NV), Utah, and NY 529s because they are the ones highest regarded on Bogleheads forum. There may exist a 529 with a US domestic stock fund with a better ER, but honestly, the ER effect isn't that big.

In the taxable account, the tax drag is equivalent to an extra 0.650% ER. VTSAX has a ER of .05%, so for comparison to a 529, it's got an ER of 0.7%.
In the NY 529, the ER of the total US stock fund is 0.16%.

After 20 years, the balances are 40925 in the taxable, and 45247 in the 529.
At redemption, in the taxable account, assume that all of the capital gains are long term capital gains. Capital gains tax is assessed on $30925
The penalty on the 529 is $3524. But state taxes do not have a long term capital gains rate.

Various redemption scenarios:

1) Assume that all of the money at 15% marginal / 0% capital gains rate + 6% state. This assumes that the retiree has other sources of taxable income that pushes him or her up to the 15%/0% bracket.

Tax + penalty on 529 gains: .21*(35247)+3524 = 10925.
Leftover after redemption: 34322

Tax on taxable account gains: .06(35247) = 2114
Leftover after redemption: 38811

2) Assume that all the money is redeemed at 10% marginal / 0% capital gains rate. Again, assume the retiree has other sources of taxable income that pushes him up to the 10%/0% bracket + 6% state

Tax + penalty on 529 gains: .16*(35247)+3524 = 9163
Leftover after redemption: 36084

Tax on taxable account gains: .06(35247) = 2114
Leftover after redemption: 38811

Those two scenarios above have the maximum tax deferral effect - highest tax bracket during investment, and low tax brackets at redemption.

If I rerun the numbers over 40 years:
529 balance: 204736. Penalty: 19474
Leftover at 15% + 6% state = 144367.
Leftover at 10% + 6% state = 154104.

Taxable balance: 167489.
Leftover at 0% LTCG + 6% state = 158040


Perhaps I made a math error, but I can't seem to find a scenario where you can come out ahead with a penalty.
EDIT: I assumed that AMT doesn't come into play, because I have no understanding of how it works, other than it sucks.

Note also that the core claim isn't about winning by paying a penalty.  (Though that's possible far enough out, see E.)  I said that if I had $10k too little in my 529, then that would cost me 4x as much (in taxes) over the long haul as having $10k too little (in penalties).  It's ideal to save exactly the right amount in your 529, but the odds of that happening are tiny.  Our intuition is to aim for the true target as best we can, but I think that's wrong: an asymmetry in costs means you should lead your target a bit, and be content with the understanding that that means you intend to oversave most of the time as a hedge against the times when you would otherwise have undersaved.  So having a quantitative view of the relative costs of the two options is really helpful.  Note also that for someone in a lower low tax bracket, the ratio would be very different.  This is all very individual.
Could you explain more by your distinction between winning despite a penalty vs "I said that if I had $10k too little in my 529, then that would cost me 4x as much (in taxes) over the long haul as having $10k too little (in penalties)"
« Last Edit: November 20, 2014, 12:17:54 PM by johnny847 »

johnny847

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Re: 529s: are the penalties worse than the benefits?
« Reply #23 on: November 20, 2014, 12:03:34 PM »
This is something I don't usually emphasize when talking up 529s with friends, because it's highly particular to our little cult here, but it's so important that I think it needs emphasizing: if you're already retired when your kids are in college, the benefit of your 529 expands from just tax savings, to income sheltering on financial aid forms.   (!!)

It's hard to plan things out this far in the future with certainty, but if you look at how the current system is structured, this is potentially huge.  If you wind up under-contributing, and having to liquidate appreciated securities to pay for a kid's college, then it doesn't just cost you on taxes --it undermines their financial aid eligibility in subsequent years and costs you there as well.  This was a huge factor (alongside the ratio above, and the long list of contingencies) in shifting my perspective on this from being afraid to contribute too much, to being absolutely terrified of contributing too little.

Wait isn't a 529 plan owned by the parent with the kid as the beneficiary counted as a parental asset, the same way that a taxable investment portfolio is? I know 401k balances are not counted as assets by financial aid, but I thought 529s were....

I know this can work if the 529 is not owned by the parent, but by an uncle or some other relative.

catccc

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Re: 529s: are the penalties worse than the benefits?
« Reply #24 on: November 20, 2014, 12:17:35 PM »
As others have stated, you can withdraw the amount of scholarships received w/o getting hit with the penalty, but you do need to pay income taxes on it.

Also, if your college student attends school at least half time, but lives off campus, you can withdraw up to the cost of on-campus housing tax and penalty free.

And it isn't just for tuition- books and supplies count, too.

For residents of certain states, there are other tax benefits.  I'm in PA, where we are lucky to be able to reduce our taxable income by the amount that is contributed to any state's 529 plan.  We use New York's 529 plan, which is a very low expense plan and invests in Vanguard.

I'm not putting a ton in it; I'm not worried about over saving for this.  Right now the kids are 3 & 6 and there's $40K in it right now.  But chances are my kids will go to college.  Most 17/18 year olds don't have much better to do than keep on schoolin'.  Unless they have some really brilliant alternative, I'm "making" them go.  They have shown no signs of being, say musical geniuses or anything.  And if they were they could go to Julliard, that probably isn't cheap...

msilenus

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Re: 529s: are the penalties worse than the benefits?
« Reply #25 on: November 20, 2014, 12:25:13 PM »

Wait isn't a 529 plan owned by the parent with the kid as the beneficiary counted as a parental asset, the same way that a taxable investment portfolio is? I know 401k balances are not counted as assets by financial aid, but I thought 529s were....

I know this can work if the 529 is not owned by the parent, but by an uncle or some other relative.

The comparison isn't between 401(k) and 529.  It's between taxable and 529.  Both taxable and 529 balances are counted, so there's no advantage for either on that score.

Balance is bad for financial aid calculations, but not extremely bad.  Esp. if you're diligent about hiding your assets in retirement accounts and primary home equity.  Income, OTOH, is completely toxic to financial aid calculations.  Parental income included.
« Last Edit: November 20, 2014, 12:41:49 PM by msilenus »

msilenus

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Re: 529s: are the penalties worse than the benefits?
« Reply #26 on: November 20, 2014, 12:40:46 PM »
Could you explain more by your distinction between winning despite a penalty vs "I said that if I had $10k too little in my 529, then that would cost me 4x as much (in taxes) over the long haul as having $10k too little (in penalties)"

It's a subtle distinction, and I didn't explain it very well.  Consider two thought experiments: 

Let's say you put a billion dollars in your 529.  (We're pretending that this is allowed.)  Exotic family structures notwithstanding, approximately 0% of that will be eligible for withdrawal based on college expenses.  My model suggested that for me, this would still be a breakeven move after 3-4 decades.  This is what I mean by coming out ahead despite a penalty.  You don't need to be spending anything on college to win in this sort of scenario, so the 529 is functioning as a sort of general-purpose tax shelter.

Let's say you visited an Oracle, and the Oracle said "Your investments will return exactly 7%.  Bobby's college will either cost exactly $100k, or exactly $90k.  The probability of each is exactly .5."  Some things would jump out at you: 1) that's a mighty nerdy Oracle.  2) you can now save for the future with perfect information about your ending balance in the 529, something that is regretfully impossible for most people.  3) you're going to want to target some amount between 90k and 100k, inclusive. 

In my situation, I would want to save 100k for Bobby, because the opportunity cost on a $10k shortfall is so much higher than the penalty on a $10k overcontribution that any degree of hedging is silly, and I've got backup plans to dodge penalties if I go $10k over.  (Someone in a much lower tax bracket might find $90k ideal.)  However, I would not want to put a billion dollars in my 529, because the time horizon for breaking even on that play is absurd.  Does that illustrate the distinction a bit better?

- -

To your other examples, this is all very individual.  You need a high tax rate for compounding on tax savings to add up to a lot.  AMT + California is how I got there.  AMT hits your LTCG redemption.  I think I got the tax rates right.

« Last Edit: November 20, 2014, 12:47:21 PM by msilenus »

Pigeon

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Re: 529s: are the penalties worse than the benefits?
« Reply #27 on: November 20, 2014, 02:43:48 PM »

I'm not putting a ton in it; I'm not worried about over saving for this.  Right now the kids are 3 & 6 and there's $40K in it right now.  But chances are my kids will go to college.  Most 17/18 year olds don't have much better to do than keep on schoolin'.  Unless they have some really brilliant alternative, I'm "making" them go.  They have shown no signs of being, say musical geniuses or anything.  And if they were they could go to Julliard, that probably isn't cheap...

Julliard is $56K/year, but on the bright side, you could use your 529 to pay for it.  ;)

johnny847

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Re: 529s: are the penalties worse than the benefits?
« Reply #28 on: November 20, 2014, 03:22:09 PM »
Could you explain more by your distinction between winning despite a penalty vs "I said that if I had $10k too little in my 529, then that would cost me 4x as much (in taxes) over the long haul as having $10k too little (in penalties)"

It's a subtle distinction, and I didn't explain it very well.  Consider two thought experiments: 

Let's say you put a billion dollars in your 529.  (We're pretending that this is allowed.)  Exotic family structures notwithstanding, approximately 0% of that will be eligible for withdrawal based on college expenses.  My model suggested that for me, this would still be a breakeven move after 3-4 decades.  This is what I mean by coming out ahead despite a penalty.  You don't need to be spending anything on college to win in this sort of scenario, so the 529 is functioning as a sort of general-purpose tax shelter.

Let's say you visited an Oracle, and the Oracle said "Your investments will return exactly 7%.  Bobby's college will either cost exactly $100k, or exactly $90k.  The probability of each is exactly .5."  Some things would jump out at you: 1) that's a mighty nerdy Oracle.  2) you can now save for the future with perfect information about your ending balance in the 529, something that is regretfully impossible for most people.  3) you're going to want to target some amount between 90k and 100k, inclusive. 

In my situation, I would want to save 100k for Bobby, because the opportunity cost on a $10k shortfall is so much higher than the penalty on a $10k overcontribution that any degree of hedging is silly, and I've got backup plans to dodge penalties if I go $10k over.  (Someone in a much lower tax bracket might find $90k ideal.)  However, I would not want to put a billion dollars in my 529, because the time horizon for breaking even on that play is absurd.  Does that illustrate the distinction a bit better?
I get what you're saying about better to save more than less. Sorry, some of my thoughts are coming off a discussion where somebody suggested speculatively saving for a kid, even before they were married and/or had a kid. So I'm jumbling up some of my thoughts here.


AMT hits your LTCG redemption.
Wait are you saying you're expecting to be hit by AMT when your kid goes to college?


Sorry if I come off as thinking 529s are terrible - I think they can be great. It just depends on the tax situation. I used them as a free $2000 state tax deduction as a grad student.

johnny847

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Re: 529s: are the penalties worse than the benefits?
« Reply #29 on: November 20, 2014, 03:24:31 PM »

Wait isn't a 529 plan owned by the parent with the kid as the beneficiary counted as a parental asset, the same way that a taxable investment portfolio is? I know 401k balances are not counted as assets by financial aid, but I thought 529s were....

I know this can work if the 529 is not owned by the parent, but by an uncle or some other relative.

The comparison isn't between 401(k) and 529.  It's between taxable and 529.  Both taxable and 529 balances are counted, so there's no advantage for either on that score.

Balance is bad for financial aid calculations, but not extremely bad.  Esp. if you're diligent about hiding your assets in retirement accounts and primary home equity.  Income, OTOH, is completely toxic to financial aid calculations.  Parental income included.
But isn't that what you were saying when you said your 529 benefit expands to income sheltering on 529 forms?

msilenus

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Re: 529s: are the penalties worse than the benefits?
« Reply #30 on: November 20, 2014, 03:27:07 PM »
Wait are you saying you're expecting to be hit by AMT when your kid goes to college?

No.  Sorry, that wasn't a terribly relevant thing to mention.  But AMT does, as I think Sol notes, have a big impact on your after-tax investment returns before redemption.

msilenus

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Re: 529s: are the penalties worse than the benefits?
« Reply #31 on: November 20, 2014, 03:38:51 PM »
But isn't that what you were saying when you said your 529 benefit expands to income sheltering on 529 forms?

Read literally, what you seem to be asking here is "aren't you saying the same thing as you said before?"  I think the answer is 'yes', but I don't think that's what you're trying to ask.  (Note: there's no such thing as a 529 form.  I was speaking about financial aid forms.)  I'll try to clarify:

Several things reduce your eligibility for financial aid:
* Student assets
* Student income
* Parental assets  (both taxable account and 529 account balances impact this)
* Parental income (taxable account liquidations impact this, but 529 withdrawals *do not*.)

Student money (assets and income) hits aid eligibility much harder than parent money.   Income hits much harder than assets (for both parents and children.)  So parental assets (what 529s impact) are literally the least of your worries.  What 529s do, aside from tax savings --which is downright magical-- is keep the income from your 529 investments off your financial aid declarations, even though you're liquidating appreciated securities to pay for college.  (!)  If you were paying for college out of taxable, in contrast, you'd generate all this damned income from those liquidations, and it would hit your financial aid eligibility.  If you were withdrawing basis from a Roth, you'd get a 1099-R (I think) and the same thing would happen, even though it was principal.  But 529s are special.

Note: you still have to worry about parental assets.  If you've got millions in taxable, your kids won't get financial aid.  But if it's in retirement accounts and home equity instead --they might.
« Last Edit: November 20, 2014, 03:47:07 PM by msilenus »

seattlecyclone

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Re: 529s: are the penalties worse than the benefits?
« Reply #32 on: November 20, 2014, 03:53:57 PM »

Wait isn't a 529 plan owned by the parent with the kid as the beneficiary counted as a parental asset, the same way that a taxable investment portfolio is? I know 401k balances are not counted as assets by financial aid, but I thought 529s were....

I know this can work if the 529 is not owned by the parent, but by an uncle or some other relative.

The comparison isn't between 401(k) and 529.  It's between taxable and 529.  Both taxable and 529 balances are counted, so there's no advantage for either on that score.

Balance is bad for financial aid calculations, but not extremely bad.  Esp. if you're diligent about hiding your assets in retirement accounts and primary home equity.  Income, OTOH, is completely toxic to financial aid calculations.  Parental income included.
But isn't that what you were saying when you said your 529 benefit expands to income sheltering on 529 forms?

Yes, 529 balances are counted as assets just like taxable brokerage accounts are. Having $100k in a 529 plan will have the same effect on financial aid eligibility as if you had $100k in a taxable account.

The difference is on the income side. Your $100k taxable account might get $2-3k of dividend income throughout the year. That has to be reported on the FAFSA and will serve to increase your EFC and decrease your financial aid. What's worse, if you sell $20k of appreciated stock to pay for college and realize a $10k gain in the process, that's another $10k of income you will need to report on the FAFSA.

By contrast, if you have the same balance in a 529 plan, the dividends don't need to be reported on the FAFSA, nor do capital gains on distributions to pay for education expenses. This can make a big difference in the income you report on the FAFSA.

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Re: 529s: are the penalties worse than the benefits?
« Reply #33 on: November 20, 2014, 07:46:01 PM »
Best is to contribute enough for one or two years of in state tuition, max. Let junior work for the rest and compete for scholarships - I.e. Begin to solve for key needs (a life skill, no?)

kenmoremmm

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Re: 529s: are the penalties worse than the benefits?
« Reply #34 on: January 19, 2018, 01:10:21 AM »
But isn't that what you were saying when you said your 529 benefit expands to income sheltering on 529 forms?

Read literally, what you seem to be asking here is "aren't you saying the same thing as you said before?"  I think the answer is 'yes', but I don't think that's what you're trying to ask.  (Note: there's no such thing as a 529 form.  I was speaking about financial aid forms.)  I'll try to clarify:

Several things reduce your eligibility for financial aid:
* Student assets
* Student income
* Parental assets  (both taxable account and 529 account balances impact this)
* Parental income (taxable account liquidations impact this, but 529 withdrawals *do not*.)

sorry, old thread.

when you say "both taxable account and 529 account", does that include traditional 401k accounts?

matchewed

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Re: 529s: are the penalties worse than the benefits?
« Reply #35 on: January 19, 2018, 05:01:26 AM »
But isn't that what you were saying when you said your 529 benefit expands to income sheltering on 529 forms?

Read literally, what you seem to be asking here is "aren't you saying the same thing as you said before?"  I think the answer is 'yes', but I don't think that's what you're trying to ask.  (Note: there's no such thing as a 529 form.  I was speaking about financial aid forms.)  I'll try to clarify:

Several things reduce your eligibility for financial aid:
* Student assets
* Student income
* Parental assets  (both taxable account and 529 account balances impact this)
* Parental income (taxable account liquidations impact this, but 529 withdrawals *do not*.)

sorry, old thread.

when you say "both taxable account and 529 account", does that include traditional 401k accounts?

No

https://fafsa.ed.gov/fotw1718/help/fotw33c.htm

catccc

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Re: 529s: are the penalties worse than the benefits?
« Reply #36 on: January 19, 2018, 12:30:12 PM »
This is an old thread, but recent tax legislation has added some flexibility to 529s.  They can now be used for K-12 tuition (for those opting for private school) and your can all transfer them to an ABLE account (tax advantaged savings for disabled individuals).

I also read someplace on these boards that if your kid doesn't use them, a nice FIRE strategy is to transfer it to your name, take some college classes, and if enrolled half time, qualified expenses can include off-campus room and board.

brooklynguy

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Re: 529s: are the penalties worse than the benefits?
« Reply #37 on: January 19, 2018, 12:40:10 PM »
I also read someplace on these boards

Probably in this very thread!  See msilenus' "Plan C" above.