Author Topic: Do I need a 529? Please help me understand. This stuff is confusing.  (Read 861 times)

jamesbond007

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DD is 6-year-old. So far, my plan has been to save in my Roth IRA and DWs Roth IRA to potentially pay for DDs college. But is putting money in 529 a better option? I live in CA and my income level doesn't qualify for tIRA deduction of Roth IRA contribution. So, we do Backdoor Roth every year. My rationale is that there is no tax benefit in contributing to 529 in CA and I don't think I can get any benefit from other states' 529 as I don't have earned income in another state anyway. Instead I can use my Roth IRA and I will have a huge chunk of money to take out from it tax free/penalty free by the time DD goes to college. I still can leave my gains in there.


Is this the right approach? My thinking is that parent's retirement funds are not counted towards any potential aid/scholarship. So, this method would be advantageous to us, right? Is there anything I am missing in terms of 529?

Laura33

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Re: Do I need a 529? Please help me understand. This stuff is confusing.
« Reply #1 on: August 31, 2020, 11:28:35 AM »
I understand CA doesn't offer a 529 tax deduction, so you're right that one of the primary benefits doesn't exist.  Me, I view all tax shelters as useful; I currently do not have enough of them to save everything I want to save for retirement, so I would rather not divert some of that retirement savings to some other use.

A Roth and a 529 have pretty much the same tax consequences:  no deduction (in your state) for the contributions; both grow tax-free; and then you can use the money (within the rules) without tax.  So from the financial contribution-and-growth perspective, they operate similarly.  A couple of distinctions to consider:

1.  Obviously, 529s are limited to eduational expenses, but if you're looking to save for college, that's not an issue.
2.  For a Roth, you can withdraw your contributions, and if you are withdrawing before 59.5 for educational expenses, you can withdraw the growth without paying the 10% penalty.  However, you will still pay taxes on the growth if you take the money out before 59.5.  Also keep in mind that if you're looking to save for 15 years or so, most of what you're counting on to pay for college is the growth on that original investment.  So you lose the tax-free growth unless you will be above that 59.5 age threshold by the time you need to draw on the growth.
3.  Roths are limited to IIRC $6500/yr.  529s are not -- they often have limits, but it's on the order of six-figure account values.
4.  I am not an expert in this, so I may stand corrected by someone who is, but this is how I understand it:  most colleges do not consider amounts in retirement accounts in determining financial aid, but they would consider withdrawals as income in the year it's withdrawn (check me on that).  529 plans, OTOH, are generally counted as parental assets and so assessed at a little over 5% (i.e., the college will assume you can pay 5-6% from the account every year as part of your share), and withdrawals are also counted as income in the year it's withdrawn (the common advice I've heard is to wait until junior year to make withdrawals if you can to avoid hurting financial aid).  However, some private colleges do consider retirement plans, home value, and other sorts of things in assessing financial need.   

It seems to me that if you have the ability to save both for college and for retirement (i.e., maxing out the Roth and saving for college), then you should do the math on both options.  Two options below; both assume you are maxing your 401(k) and have another $10K to save for college and/or retirement.

Option 1:  Put $6500 in your Roth and $3500/yr in a standard brokerage account.  Result:  your Roth will not be considered in financial aid equations, but the $3500 you put in the standard brokerage account will be assessed at that 5-6% rate.  Start by cashing in your Roth to pay for college.  Your contributions are free, but the share that represents your gains is taxed as income that year, and then counted as income the following year in your financial aid calculations.  The $3500/yr in the brokerage account, meanwhile, grows more slowly, because you are paying capital gains every year, and you then pay capital gains whenever you sell (whether for college or retirement).  If you use some of this money for college, I assume the growth would count as income, but because you've already paid capital gains on your basis, that part of the withdrawal shouldn't affect aid calculations.

Option 2:  Put $6500 in your Roth and $3500/yr in 529 (or the other way around, depending on whether you need more for retirement or college).  The amount in the Roth is not considered in financial aid equations, but the $3500 in the 529 is counted at that 5-6% rate -- (so the result is the same as above if you are putting the same amount in the 529 vs. the individual brokerage account; if you put $6500 or all $10K in the 529, then that provides more to be assessed at that 5-6% rate).  You then cash out the 529 to use for college.  There is no tax on these withdrawals, and if you can wait until Junior year, there is also no impact on financial aid; however, if you need to withdraw for freshman/sophomore year, that withdrawal is counted as income (so, again, same result as taking it from the Roth).  If you can maintain the Roth until 59.5, when you need to take those withdrawals, the whole thing is tax-free.

I suspect if you put everything in a spreadsheet and made some assumptions about tax rates, you'd probably find you're better off using the 529, because in either case you're maxing the Roth, so it's just a question of whether the rest of the money goes to a taxable account or gets some tax protection in the 529.  But run the numbers yourself for your own situation.

jamesbond007

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Re: Do I need a 529? Please help me understand. This stuff is confusing.
« Reply #2 on: August 31, 2020, 12:06:27 PM »
I understand CA doesn't offer a 529 tax deduction, so you're right that one of the primary benefits doesn't exist.  Me, I view all tax shelters as useful; I currently do not have enough of them to save everything I want to save for retirement, so I would rather not divert some of that retirement savings to some other use.

A Roth and a 529 have pretty much the same tax consequences:  no deduction (in your state) for the contributions; both grow tax-free; and then you can use the money (within the rules) without tax.  So from the financial contribution-and-growth perspective, they operate similarly.  A couple of distinctions to consider:

1.  Obviously, 529s are limited to eduational expenses, but if you're looking to save for college, that's not an issue.
2.  For a Roth, you can withdraw your contributions, and if you are withdrawing before 59.5 for educational expenses, you can withdraw the growth without paying the 10% penalty.  However, you will still pay taxes on the growth if you take the money out before 59.5.  Also keep in mind that if you're looking to save for 15 years or so, most of what you're counting on to pay for college is the growth on that original investment.  So you lose the tax-free growth unless you will be above that 59.5 age threshold by the time you need to draw on the growth.
3.  Roths are limited to IIRC $6500/yr.  529s are not -- they often have limits, but it's on the order of six-figure account values.
4.  I am not an expert in this, so I may stand corrected by someone who is, but this is how I understand it:  most colleges do not consider amounts in retirement accounts in determining financial aid, but they would consider withdrawals as income in the year it's withdrawn (check me on that).  529 plans, OTOH, are generally counted as parental assets and so assessed at a little over 5% (i.e., the college will assume you can pay 5-6% from the account every year as part of your share), and withdrawals are also counted as income in the year it's withdrawn (the common advice I've heard is to wait until junior year to make withdrawals if you can to avoid hurting financial aid).  However, some private colleges do consider retirement plans, home value, and other sorts of things in assessing financial need.   

It seems to me that if you have the ability to save both for college and for retirement (i.e., maxing out the Roth and saving for college), then you should do the math on both options.  Two options below; both assume you are maxing your 401(k) and have another $10K to save for college and/or retirement.

Option 1:  Put $6500 in your Roth and $3500/yr in a standard brokerage account.  Result:  your Roth will not be considered in financial aid equations, but the $3500 you put in the standard brokerage account will be assessed at that 5-6% rate.  Start by cashing in your Roth to pay for college.  Your contributions are free, but the share that represents your gains is taxed as income that year, and then counted as income the following year in your financial aid calculations.  The $3500/yr in the brokerage account, meanwhile, grows more slowly, because you are paying capital gains every year, and you then pay capital gains whenever you sell (whether for college or retirement).  If you use some of this money for college, I assume the growth would count as income, but because you've already paid capital gains on your basis, that part of the withdrawal shouldn't affect aid calculations.

Option 2:  Put $6500 in your Roth and $3500/yr in 529 (or the other way around, depending on whether you need more for retirement or college).  The amount in the Roth is not considered in financial aid equations, but the $3500 in the 529 is counted at that 5-6% rate -- (so the result is the same as above if you are putting the same amount in the 529 vs. the individual brokerage account; if you put $6500 or all $10K in the 529, then that provides more to be assessed at that 5-6% rate).  You then cash out the 529 to use for college.  There is no tax on these withdrawals, and if you can wait until Junior year, there is also no impact on financial aid; however, if you need to withdraw for freshman/sophomore year, that withdrawal is counted as income (so, again, same result as taking it from the Roth).  If you can maintain the Roth until 59.5, when you need to take those withdrawals, the whole thing is tax-free.

I suspect if you put everything in a spreadsheet and made some assumptions about tax rates, you'd probably find you're better off using the 529, because in either case you're maxing the Roth, so it's just a question of whether the rest of the money goes to a taxable account or gets some tax protection in the 529.  But run the numbers yourself for your own situation.

Thanks for a very detailed respose. It turns out there it is not as simplistic as I had thought. I have do some analysis.

seemsright

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Re: Do I need a 529? Please help me understand. This stuff is confusing.
« Reply #3 on: August 31, 2020, 03:40:10 PM »
Laura is spot on. The other thing I think you must consider is your risk tolerance. If you save money in a 529 it must be used for education (or have a hefty tax bill) and that is great if your kid goes to college, or if you are loaded enough so it can be saved for future generations.

I do not like the 529. I think it is way two many eggs in one basket. The tax savings is just not worth the risk to me. Hubby and I did a mix. We did the 529 for about 5 years and we just transitioned into the Roth. We did this to be able to be more diverse and we found out that the grandfather was saving for our kid in a 529. It turns out that grandparent 529s are a bit tricky to use. I just do not want 'two much' money saved for college.

Understanding the bigger picture of your entire portfolio will help you understand the 529 and how YOU want to use it.   

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Re: Do I need a 529? Please help me understand. This stuff is confusing.
« Reply #4 on: August 31, 2020, 04:22:40 PM »
We only do the 529 up to the amount the state allows us to deduct from our income taxes.  Beyond that, we see nearly no benefit vs. other means of savings.

jamesbond007

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Re: Do I need a 529? Please help me understand. This stuff is confusing.
« Reply #5 on: August 31, 2020, 04:23:56 PM »
Laura is spot on. The other thing I think you must consider is your risk tolerance. If you save money in a 529 it must be used for education (or have a hefty tax bill) and that is great if your kid goes to college, or if you are loaded enough so it can be saved for future generations.

I do not like the 529. I think it is way two many eggs in one basket. The tax savings is just not worth the risk to me. Hubby and I did a mix. We did the 529 for about 5 years and we just transitioned into the Roth. We did this to be able to be more diverse and we found out that the grandfather was saving for our kid in a 529. It turns out that grandparent 529s are a bit tricky to use. I just do not want 'two much' money saved for college.

Understanding the bigger picture of your entire portfolio will help you understand the 529 and how YOU want to use it.   

I am in the same boat. My investments are simple. Besides 401K and Roth IRA (via backdoor), everything else is in a taxable account and all 100% VTSAX. I live in CA so no tax benefit from a 529. That's why I went with this Roth approach. The principal I am contributing to Roth is earmarked for DDs college expenses if needed. If not, I can keep it. I cannot take the gains before 59.5 without a tax penalty anyway and I don't plan to touch it.

moof

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Re: Do I need a 529? Please help me understand. This stuff is confusing.
« Reply #6 on: August 31, 2020, 04:27:51 PM »
Laura is spot on. The other thing I think you must consider is your risk tolerance. If you save money in a 529 it must be used for education (or have a hefty tax bill) and that is great if your kid goes to college, or if you are loaded enough so it can be saved for future generations.

I do not like the 529. I think it is way two many eggs in one basket. The tax savings is just not worth the risk to me. Hubby and I did a mix. We did the 529 for about 5 years and we just transitioned into the Roth. We did this to be able to be more diverse and we found out that the grandfather was saving for our kid in a 529. It turns out that grandparent 529s are a bit tricky to use. I just do not want 'two much' money saved for college.

Understanding the bigger picture of your entire portfolio will help you understand the 529 and how YOU want to use it.
Here in Oregon I avoid the 9% state tax up to almost $5k a year (we max this out), and will also avoid capital gains compared to a taxable account.  Basically if the kiddo bails on college and retire to a lower state tax location it ends up close to a draw after penalties compared to a taxable account.  We already max out Roth IRA's, so I don't compare it to that.  If I had more Roth headroom I'd shove it there in a heartbeat.

If the kiddo bails on college my wife will flip her lid and I'll likely have more to deal with on that front than worrying about minor tax issue with the gains.

Another aspect that truly hurts my head is financial aid.  Money sitting in your bank account, a 529, house equity, etc all go into a magic formula that spits out how much you as a parent are supposed to pony up for your adult child to go to college.  There are optimizations there to make yourself as poor-on-paper as possible, and I don't have the stomach to figure all that out.

Our 7 (almost 8) year old has $43.6k in his 529, and our goal is to get him to ~100k by time he hits college between 4 more years of savings and growth.  That is 100% more than either of our parents saved for us, so even if it ends up not being enough to cover everything it will be plenty from my point of view.

pdxvandal

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Re: Do I need a 529? Please help me understand. This stuff is confusing.
« Reply #7 on: August 31, 2020, 06:06:14 PM »
I live in Oregon as well but they've changed the 529 rules for this tax year so it's a credit, not a deduction ... not sure how you can avoid "almost $5k" of income tax now.

With my family earning less than $100k AGI, we gain no tax benefits by contributing more than $1,200, which I'm doing this year and for the foreseeable future.

But if there are no benefits or deductions in your state, I'd definitely forgo as most are not managed as well and have more fees than a traditional brokerage.

seemsright

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Re: Do I need a 529? Please help me understand. This stuff is confusing.
« Reply #8 on: August 31, 2020, 08:19:41 PM »
I live in Oregon as well but they've changed the 529 rules for this tax year so it's a credit, not a deduction ... not sure how you can avoid "almost $5k" of income tax now.

With my family earning less than $100k AGI, we gain no tax benefits by contributing more than $1,200, which I'm doing this year and for the foreseeable future.

But if there are no benefits or deductions in your state, I'd definitely forgo as most are not managed as well and have more fees than a traditional brokerage.

I am in OR also. With the 529 now being a credit and how this state is being ran and history says they wont change the tax forms to compensate for the tax change. Doing taxes in this state takes us months to get it 'right' but that is a whole different issue.

Sometimes it is worth keeping investments simple. When we do have college expenses we plan on using the 529 as a middle man and get the tax benefit. Just having the account available can be useful. It does not mean you need to save a dollar amount per month. 

 

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