And I have my doubts on whether most people can actually devise an applicable scenario where the 529 plan makes sense over a taxable account for general purpose investing. I mean, you can, but it's hard.
529 plan withdrawals are subject to a 10% penalty + normal income tax rates on the gains. Whereas selling funds from a taxable account are subject to the long term capital gains tax rates (which requires you hold the fund for at least a year, but that's pretty easy), and these rates are strictly lower than normal income tax rates.
Assume that your state either doesn't have a tax break for 529s or recaptures it if you use 529 money for non educational expenses. This means
you start out with the same amount of money in either scenario.
Assume you use Vanguard's total stock market index in both the 529 and the taxable brokerage account.
You make a contribution to a 529.
If you
- live in a no tax state (as you mentioned madamwitty, most states tax short and long term capital gains at normal income tax rates)
- invest only in funds like VTSAX that give 100% qualified dividends (because really, tax inefficient funds belong in a proper retirement account anyway)
- are in the 15% marginal income bracket or lower
then there is no tax drag on the growth of VTSAX. Hence, the final balance of your 529 and your taxable account are exactly the same.
Otherwise, your taxable account will have a lower final balance than your 529. But, for the vast majority of people, the tax drag on qualified dividends should not be all that large (I know you're trying to quantify how large this is). But by the conclusion you'll see that for most people you won't even need to quantify this.
But, if you want to consider tax drag, you should also consider the drag incurred by a higher expense ratio of the VTSAX fund in the 529.
Now many years down the line, you go to withdraw. Remember, we incur the favorable long term capital gains tax in the taxable account, and normal income tax on the 529 account.
Marginal income tax rate | Tax on LTCG | Tax on 529 gains | Penalty on 529 gains | 529 tax Disadvantage |
10% | 0% | 10% | 10% | 20% |
15% | 0% | 15% | 10% | 25% |
25% | 15% | 25% | 10% | 20% |
28% | 15% | 28% | 10% | 23% |
33% | 15% | 33% | 10% | 28% |
35% | 15% | 35% | 10% | 30% |
39.6% | 20% | 39.6% | 10% | 29.6% |
(I've left out the 3.8% Obamacare tax that kicks in after $200k income for singles and $250k for MFJ, but it doesn't change the conclusion)
Now remember, it is very unlikely that you will end up with the same final balance (and hence, same gains, because we assumed you start with the same amounts). Because a significant number of people will experience tax drag on their returns in their taxable account, the 529 balance will be higher.
But the 529 plan needs to overcome at least a 20% tax disadvantage! For this to make sense, you need significant tax drag on your taxable account, and a competitive (in terms of expense ratio) fund in a 529.