Author Topic: Are 529 Plans Worth it When You Live in a State Without State Income Tax?  (Read 4216 times)

Platypuses

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My initial plan to help pay for college was to use the funds stashed in my Vanguard investment account, especially since I live in TX where we have no state income tax. The benefit of not paying capital gains taxes on the 529 account is appealing, but is it worth the loss of flexibility?

I currently max out my retirement accounts, and put anything extra into VTSAX. Kids are currently 6,4 and 1.

sirdoug007

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This is a great question.

Without a state income tax to side-step, 529 plans become a lot less compelling.

For one, you can only use them for education expenses.  Anything else and you will pay income tax + 10% on any earnings. 

But I think the biggest drawback is fees.  You could start a taxable account and pay a 0.04%/year fee on VTSAX.  In contrast, 529 plans could have fees over 1%/year.  The crazy thing is 529 plans aren't required to disclose their fees in their marketing materials!  They bury this info.

Here are the fees for the Texas College Savings Plan.  They are between 0.6% and 1.0% depending on what you choose:
https://geminifund.com/RegulatoryDocumentCenter/PublicDocuments/Current.aspx?FundFamily=Texas529Plan&DocType=TCSP-012&DisplayCommon=False&Fund=TCSP%20529%20Literature

Another consideration is that, if you are in the 10-15% marginal tax bracket, you pay ZERO long term capital gains!  For a married couple that is up to a taxable income of $75,900 in 2017 or $108,850 in gross income for a family of 5 (factoring in 5 exemptions and the standard deduction). 

All in all, I would lean towards the flexibility of a taxable account given the restrictions and high costs of 529 plans.

sirdoug007

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Oh apparently there is another Texas 529 called "Lone Star 529." 

That one has an average of 1.8% annual fees!  Yikes!

http://money.usnews.com/529s/texas

omachi

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You can shift funds from one beneficiary to another tax free. So if the first kid doesn't use up all the funds in their 529, you can shuffle those over to the second. This provides some flexibility in that if you're over the needed amount by a little you can stop saving for the next kid a bit early. If you manage to overshoot all three kids, you'd end up paying a 10% penalty and federal tax on the excess earnings. But, the excess is proportioned to be principal and earnings based on what was added and earned, so the penalty and tax doesn't apply to the whole excess. Also, if a beneficiary gets a scholarship, the 10% penalty doesn't apply to excess funds in that amount, though taxes still do, which will be higher than capital gains.

So a 529 isn't completely inflexible as long as you don't dump way too much into the account. If that can be done, no capital gains should outweigh any small amount of federal tax at your marginal rate on the excess. Since you have three kids, the beneficiary shift should mean no overages except on the third kid. By that point you should have a good idea about costs, and you might try to undershoot a little and pull the necessary remainder from after tax investments for the best of both worlds.

You can open a Vanguard 529 if you aren't avoiding state taxes, which means you'll get low fee investment choices. You aren't limited to your own state's plans.

dcozad999

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He also doesn't have to use Texas plans.

Kansas allows us a tax break on any state qualified plan. I use Utah's. It's fees are only .16 - .22

http://money.usnews.com/529s/utah/utah-educational-savings-plan/5pusa00019

v8rx7guy

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I too chose Utah's UESP 529 plan, I live in WA where our 529 plan is falling apart and we don't have state taxes.

sirdoug007

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Good points on the out of state 529s.

However if you fall within the 0% long term capital gains income I mentioned I still think taxable may be a better choice due to lower fees and more flexibility.

You would only be paying tax on non-qualifying dividends which is not much for a heavy equity approach.


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« Last Edit: June 12, 2017, 06:48:19 PM by sirdoug007 »

Laserjet3051

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I too chose Utah's UESP 529 plan, I live in WA where our 529 plan is falling apart and we don't have state taxes.
Why/how is the WA 529 plan falling apart?

Paul der Krake

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I too chose Utah's UESP 529 plan, I live in WA where our 529 plan is falling apart and we don't have state taxes.
Why/how is the WA 529 plan falling apart?
Basically WA only had a prepaid-tuition 529, and made promises that assumed tuition inflation numbers. The assumptions didn't hold up and the fund had to be closed and people were offered buyouts. It is set to reopen soon, along with the other, more common type of 529.

I think 529s are valuable even if you don't get a state tax deduction. Heck, I have own as myself as the beneficiary. The beneficiary rules are incredibly lax.

Continuing education is Mustachian af.


Paul der Krake

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Another advantage of 529s is that they are usually protected from creditors. Check your state's laws for verification, but from a cursory look it looks like Texas protects qualified education savings plans from all states.

Laserjet3051

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Another advantage of 529s is that they are usually protected from creditors. Check your state's laws for verification, but from a cursory look it looks like Texas protects qualified education savings plans from all states.

I have no plans for a bankruptcy, but 529 protection from creditors is a HUUUGE factor to consider in how to save for education that I never see discussed in the pros and cons of various strategies. While few of us really plan for catastrophe, life has a way of kicking us upside the head sometimes and peace of mind knowing my kids education dollars are protected, even w/o any state tax benefit is a "sleep well at night" consideration for me.

merula

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I live in a state with an income tax, but no tax credit on 529 contributions, and I still contribute to them for my kids. I do not plan on having 100% of my children's college expenses saved in the plan, since I'm also planning on using my IRA savings; it'll probably be something more like 30-40%.

One major advantage I've seen so far with the 529s is in family members' gifts. People seem more likely to give to a 529 in my child's name than to give to a random account in my name. (This is probably a continuation of how people would gift me savings bonds for college instead of cash.) I use the NY plan (nysaves.org), so each of my children is assigned a unique code. I send that to people who ask, and they can go to a website, enter the code and contribute via online bank transfer.

The NY plan is administered by Vanguard, so the ER is 0.16% and there are no out-of-state fees.

Platypuses

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Thanks everyone for all the feedback and suggestions. I didn't think about the advantage of the funds being protected from creditors in the case of a catastrophe. Gifting directly to the 529 plan by family members would be nice, although I don't see this happening.

It looks like Vanguard uses the college savings plan sponsored by the state of Nevada. I just opened one for my oldest. Thanks.

smallstache

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I live in a state with an income tax, but no tax credit on 529 contributions, and I still contribute to them for my kids. I do not plan on having 100% of my children's college expenses saved in the plan, since I'm also planning on using my IRA savings; it'll probably be something more like 30-40%.

One major advantage I've seen so far with the 529s is in family members' gifts. People seem more likely to give to a 529 in my child's name than to give to a random account in my name. (This is probably a continuation of how people would gift me savings bonds for college instead of cash.) I use the NY plan (nysaves.org), so each of my children is assigned a unique code. I send that to people who ask, and they can go to a website, enter the code and contribute via online bank transfer.

The NY plan is administered by Vanguard, so the ER is 0.16% and there are no out-of-state fees.

After about 10 years in a "moderate allocation" 529 plan, I have earned about a 50% return on invested capital.  I will withdraw the earnings, tax-free, for me kids' qualified college expenses.  I will withdraw the contributions, tax-free, for my own personal expenses or reinvest it. 

The fee in Georgia was about .28%.  I switched to an identical plan in California for a .17% fee.  The Georgia plan option has apparently been discontinued.

One can park a ton of money in a 529 plan, which is why Obama wanted to kill the program.  Sounds like a good program to me.

omachi

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I live in a state with an income tax, but no tax credit on 529 contributions, and I still contribute to them for my kids. I do not plan on having 100% of my children's college expenses saved in the plan, since I'm also planning on using my IRA savings; it'll probably be something more like 30-40%.

One major advantage I've seen so far with the 529s is in family members' gifts. People seem more likely to give to a 529 in my child's name than to give to a random account in my name. (This is probably a continuation of how people would gift me savings bonds for college instead of cash.) I use the NY plan (nysaves.org), so each of my children is assigned a unique code. I send that to people who ask, and they can go to a website, enter the code and contribute via online bank transfer.

The NY plan is administered by Vanguard, so the ER is 0.16% and there are no out-of-state fees.

After about 10 years in a "moderate allocation" 529 plan, I have earned about a 50% return on invested capital.  I will withdraw the earnings, tax-free, for me kids' qualified college expenses.  I will withdraw the contributions, tax-free, for my own personal expenses or reinvest it. 

I'm pretty sure that's not how it works. You'll make a distribution to the kid's expenses and should receive a 1099Q that tells you what portion of the distribution was earnings and what portion was basis.

merula

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I'm pretty sure that's not how it works. You'll make a distribution to the kid's expenses and should receive a 1099Q that tells you what portion of the distribution was earnings and what portion was basis.

I'd be interested in learning more about this as well. I looked into what options my plan allows, and I can have a withdrawal sent to my bank account, it doesn't need to go directly to the school. So, theoretically it'd work, but Google is turning up non-IRS sites saying that the earnings are assigned proportionally to the withdrawn basis and can't be separated like this.

Paul der Krake

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I'm pretty sure that's not how it works. You'll make a distribution to the kid's expenses and should receive a 1099Q that tells you what portion of the distribution was earnings and what portion was basis.

I'd be interested in learning more about this as well. I looked into what options my plan allows, and I can have a withdrawal sent to my bank account, it doesn't need to go directly to the school. So, theoretically it'd work, but Google is turning up non-IRS sites saying that the earnings are assigned proportionally to the withdrawn basis and can't be separated like this.
Yep, that's the gotcha part, all distributions are pro-rated between earnings and principal. An astute parent with the means to play games would stick 500k in the 529 when Timmy enters high school, let it grow for 4 years to 600k, spend the 100k on Timmy's college and withdraw the original 500k back. Voila, 100k of completely tax-free unearned income to pay for college with no strings attached.

That would be the mother of all tax giveaways to the wealthy, and the pro-rata rule prevents that.

smallstache

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I live in a state with an income tax, but no tax credit on 529 contributions, and I still contribute to them for my kids. I do not plan on having 100% of my children's college expenses saved in the plan, since I'm also planning on using my IRA savings; it'll probably be something more like 30-40%.

One major advantage I've seen so far with the 529s is in family members' gifts. People seem more likely to give to a 529 in my child's name than to give to a random account in my name. (This is probably a continuation of how people would gift me savings bonds for college instead of cash.) I use the NY plan (nysaves.org), so each of my children is assigned a unique code. I send that to people who ask, and they can go to a website, enter the code and contribute via online bank transfer.

The NY plan is administered by Vanguard, so the ER is 0.16% and there are no out-of-state fees.

After about 10 years in a "moderate allocation" 529 plan, I have earned about a 50% return on invested capital.  I will withdraw the earnings, tax-free, for me kids' qualified college expenses.  I will withdraw the contributions, tax-free, for my own personal expenses or reinvest it. 

I'm pretty sure that's not how it works. You'll make a distribution to the kid's expenses and should receive a 1099Q that tells you what portion of the distribution was earnings and what portion was basis.

The principal portion is not subject to tax or penalty, just the earnings. That is one reason I went with multiple accounts. Liquidate the entire account, use the earnings towards qualified education expenses, and use the contributions for whatever I want.

omachi

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The principal portion is not subject to tax or penalty, just the earnings. That is one reason I went with multiple accounts. Liquidate the entire account, use the earnings towards qualified education expenses, and use the contributions for whatever I want.
Principal not being subject to tax or penalty is correct, but I am pretty sure your notion of assigning earnings is not. If you liquidate the whole account, it either all must be used for qualified expenses or the IRS will assign principal and earnings proportionally to the qualified expenses you report. You will then pay tax and penalties on the earnings that were not used to cover qualified expenses.

Paul der Krake

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Yeah, not going to work:
https://www.irs.gov/publications/p970/ch08.html#en_US_2016_publink1000178534

Quote
Taxable earnings.   Use the following steps to figure the taxable part.

1. Multiply the total distributed earnings shown on Form 1099-Q, box 2, by a fraction. The numerator (top part) is the adjusted qualified education expenses paid during the year and the denominator (bottom part) is the total amount distributed during the year.

2. Subtract the amount figured in (1) from the total distributed earnings. The result is the amount the beneficiary must include in income. Report it on Form 1040 or Form 1040NR, line 21.

Example:
Liquidating an account with a $50,000 balance, out of which $20,000 are earnings
Tuition bill for the year is $25,000

1) 20,000 * (25,000 / 50,000) = $10,000
2) $20,000 - 10,000 = $10,000 counted as income

And then in the instructions of line 21 on form 1040, you are warned that you are required to calculate the additional tax on Form 5329.

Smallstache may want to rethink his plans.


seattlecyclone

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A few thoughts:

1) The 0% capital gains tax has not even existed for 10 years. Who knows if it will last through your kid's college education? At best we keep the 0% rate and a taxable account is no worse than a 529, but in no case where you actually need the money for college is the 529 worse. Just don't invest more than you know you'll want to spend.
2) Even if you do plan to be in the 15% bracket or lower when your kid is in college, any years between now and then where you are above that bracket will see you paying taxes on dividends.
3) Reallocating the money between family members is pretty easy if your kid doesn't end up needing the money. You could even use the money on your own food and housing expenses while taking some language classes or something at a community college post-FIRE (must be a half-time student).
4) Capital gains income, even if untaxed, will increase your family contribution under the FAFSA. 529 withdrawals won't.

So far our son is young enough that we don't know for sure what his college spending needs will be, or how much we even want to help him with. But we did open a 529 through the Vanguard/Nevada plan as a place to store occasional monetary gifts from grandparents. It works pretty well for that purpose.

smallstache

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Yeah, not going to work:
https://www.irs.gov/publications/p970/ch08.html#en_US_2016_publink1000178534

Quote
Taxable earnings.   Use the following steps to figure the taxable part.

1. Multiply the total distributed earnings shown on Form 1099-Q, box 2, by a fraction. The numerator (top part) is the adjusted qualified education expenses paid during the year and the denominator (bottom part) is the total amount distributed during the year.

2. Subtract the amount figured in (1) from the total distributed earnings. The result is the amount the beneficiary must include in income. Report it on Form 1040 or Form 1040NR, line 21.

Example:
Liquidating an account with a $50,000 balance, out of which $20,000 are earnings
Tuition bill for the year is $25,000

1) 20,000 * (25,000 / 50,000) = $10,000
2) $20,000 - 10,000 = $10,000 counted as income

And then in the instructions of line 21 on form 1040, you are warned that you are required to calculate the additional tax on Form 5329.

Smallstache may want to rethink his plans.

Smallstache will be fine.  His kids are nearing college age.  The key is his kids need to find a place to live that charges the maximum allowed as a qualified education expense.  In order words, maximize the denominator in the calculation.  As it so happens, Smallstache controls entities that can readily purchase condos that will charge Smallstache's kids such an amount.  The entities will benefit from depreciation and other write-offs before making regular periodic distributions to Smallstache.

Paul der Krake

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Smallstache will be fine.  His kids are nearing college age.  The key is his kids need to find a place to live that charges the maximum allowed as a qualified education expense.  In order words, maximize the denominator in the calculation.  As it so happens, Smallstache controls entities that can readily purchase condos that will charge Smallstache's kids such an amount.  The entities will benefit from depreciation and other write-offs before making regular periodic distributions to Smallstache.
Ha! That's very cool. I take it that the rental income is mostly or entirely offset by depreciation and other deductions?

My only concerns would be the opportunity cost of having the entities purchase condos that don't make much financial sense unless they are used as part of this scheme, and potentially running afoul of the arm's length doctrine (can't charge rent that's grossly inflated). I'd be curious to hear more about your setup, maybe in another thread? It sounds like you've put a lot of thought into this.

sirdoug007

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A few thoughts:

1) The 0% capital gains tax has not even existed for 10 years. Who knows if it will last through your kid's college education? At best we keep the 0% rate and a taxable account is no worse than a 529, but in no case where you actually need the money for college is the 529 worse. Just don't invest more than you know you'll want to spend.
2) Even if you do plan to be in the 15% bracket or lower when your kid is in college, any years between now and then where you are above that bracket will see you paying taxes on dividends.
3) Reallocating the money between family members is pretty easy if your kid doesn't end up needing the money. You could even use the money on your own food and housing expenses while taking some language classes or something at a community college post-FIRE (must be a half-time student).
4) Capital gains income, even if untaxed, will increase your family contribution under the FAFSA. 529 withdrawals won't.

So far our son is young enough that we don't know for sure what his college spending needs will be, or how much we even want to help him with. But we did open a 529 through the Vanguard/Nevada plan as a place to store occasional monetary gifts from grandparents. It works pretty well for that purpose.

All good points.

So it basically boils down to

1. Don't accumulate more than you will spend on education.
2. Use a low cost plan in whatever state has the best deal.