Author Topic: 529 Plan Account as a Tax Shelter  (Read 9102 times)

• Bristles
• Posts: 279
• Age: 39
• Location: SoCal
529 Plan Account as a Tax Shelter
« on: February 25, 2015, 09:57:12 PM »
In a case study thread, the idea came up of using a 529 Plan account (normally a college savings vehicle) as a vehicle to tax shelter investment growth. At CanuckExpat's suggestion, I started a thread here to explore the idea a little further. (See here: http://forum.mrmoneymustache.com/ask-a-mustachian/reader-case-study-evaluate-our-five-year-plan-to-fire/msg569293/#msg569293)

I put together a simple spreadsheet (attached below, if you are interested) to make a comparison of 529 Plan vs. Taxable investment account over a long time horizon. Here is the scenario built into the spreadsheet:

Investor is currently working and has a marginal tax rate (cell A26 = 28%). He could make a one-time contribution of \$1000 to a 529 (cell C5) or \$1000 to a taxable investment account (cell C18). (If there are state income tax breaks, you could model the 529 contribution as accordingly higher.) Annual growth of the investment value is constant (cell A11 & A24 = 5%) and annual dividends are also constant (cell A12 & A25 = 2%). At the end of the year, taxes are assessed on the taxable account only, and dividends are reinvested for both accounts.

After X years (row 1), if the investor liquidates the 529 for non-qualified expenses, income tax + 10% penalty (cell A7 = 10%) is assessed on all the earnings. The resulting total gain (after tax) after X years is shown in row 8. An effective annual growth rate is calculated in row 9.

When the investor liquidates the taxable investment account after X years a capital gains rate (cell A20 = 0%) is assessed against the capital gains portion of the investment, and the total gain (after tax) after X years is shown in row 21. An effective annual growth rate is calculated in row 22.

Plotting the effective annual growth rate for both scenarios, the crossover point is where the 529 account breaks even with the taxable investment account. For the numbers above, it turns out the 529 account breaks even in a little less than 9 years.

Playing around with the spreadsheet, it seems to me that this idea might hold water for long time horizons, or perhaps if there are state income tax breaks for contributing to the 529. Keeping withdrawals under the taxable income threshold seems to be key to keeping the time horizon "reasonable" (you still get hit with the 10% withdrawal penalty.) Investments weighted more toward dividend returns rather than value growth break even faster.

Thoughts? Questions?

MDM

• Senior Mustachian
• Posts: 10767
Re: 529 Plan Account as a Tax Shelter
« Reply #1 on: February 25, 2015, 10:31:25 PM »

At the cost of piling conjecture upon supposition upon...there is also the question of what fraction of taxable dividends will be "qualified" and thus have the same tax rate as the long term capital gains.

Oh - check formulas in row 21.  Do you want to refer to \$C\$4 there?  Noticed that when I tried entering differing starting amounts to account for state tax benefit.

• Bristles
• Posts: 279
• Age: 39
• Location: SoCal
Re: 529 Plan Account as a Tax Shelter
« Reply #2 on: February 26, 2015, 12:22:41 AM »

At the cost of piling conjecture upon supposition upon...there is also the question of what fraction of taxable dividends will be "qualified" and thus have the same tax rate as the long term capital gains.

Oh - check formulas in row 21.  Do you want to refer to \$C\$4 there?  Noticed that when I tried entering differing starting amounts to account for state tax benefit.

Thanks for catching the formula error. I hadn't thought about the state tax benefit of contributing to a 529 until after I finished the spreadsheet and started writing up my post, so I didn't really test out that part of the spreadsheet thoroughly.

Given the potential for the tax benefit, it occurs to me that the spreadsheet required a few modifications to really adequately represent the value of the income tax break. Gains for the 529 should actually be pegged to the same basis as the taxable account in this comparison. Let's say you get a 3% tax break on \$1000. Now you have (roughly) \$1030 to invest in the 529. That automatically boosts your return over the \$1000 you would have had for a taxable account by 3% in the first year. Is this the right way to think about it? Anyway, I updated the spreadsheet with this in mind (attached.) I had to add a few rows at the top so the specific cell references from my first post are not valid on this version.

Note: I don't live in a state that offers tax breaks for 529 contributions, but I DO think spreadsheets are fun :-) I don't know what the typical rules are for a state tax break but I'm going to assume you can't withdraw the money the same year you put it into the 529. Is there a waiting period?

I'll think about the question of qualified dividends when I have more brain cells available. (It's getting late, I'm under the fog of baby sleep deprivation).

CanuckExpat

• Magnum Stache
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Re: 529 Plan Account as a Tax Shelter
« Reply #3 on: February 26, 2015, 12:56:20 AM »
Thanks for posting this and taking the initiative. I've always been a bit lazy about learning about optimizing taxes, but that needs to change.
One thing I wanted to ask, you need to account for state tax rates as well right? For example in California, a federal tax bracket of 28% means State tax 9.3% for an effective 37.3% marginal tax rate right? When I enter that into the spreadsheet, the 529 + penalty comes out ahead in every year..
Am I doing something wrong, or is that juts California taxes?

• Bristles
• Posts: 279
• Age: 39
• Location: SoCal
Re: 529 Plan Account as a Tax Shelter
« Reply #4 on: February 26, 2015, 08:14:16 AM »
Thanks for posting this and taking the initiative. I've always been a bit lazy about learning about optimizing taxes, but that needs to change.
One thing I wanted to ask, you need to account for state tax rates as well right? For example in California, a federal tax bracket of 28% means State tax 9.3% for an effective 37.3% marginal tax rate right? When I enter that into the spreadsheet, the 529 + penalty comes out ahead in every year..
Am I doing something wrong, or is that juts California taxes?
Yes, that is how I would do it.

I am in California too, and my tax brackets for 2014 were 25% + 9.3%. In 2015 they will be 15% + 8% due to maxing out 403(b) account, so a 529 is not as much of a slam dunk. But it still breaks even in ~16 years which is compatible with my savings horizon for college. It was kind of an eye opener to look at my (Mustachian-level) projected expenses in retirement. I was surprised to find that with the 5 personal exemptions I get from having 3 kids, I actually would come in under the federal taxable income threshold. I had kind of assumed I wouldn't. (California is pretty stingy with the personal exemptions but I would possibly move out of California in retirement.) So it seems for now I don't really have to worry about over-saving in my 529 account.

How reasonable are my assumptions of 5% growth and 2% dividends? I might think about the effect of volatility of the market over the weekend if I have time.

• Bristles
• Posts: 279
• Age: 39
• Location: SoCal
Re: 529 Plan Account as a Tax Shelter
« Reply #5 on: February 26, 2015, 08:39:14 AM »
It was kind of an eye opener to look at my (Mustachian-level) projected expenses in retirement. I was surprised to find that with the 5 personal exemptions I get from having 3 kids, I actually would come in under the federal taxable income threshold. I had kind of assumed I wouldn't. (California is pretty stingy with the personal exemptions but I would possibly move out of California in retirement.) So it seems for now I don't really have to worry about over-saving in my 529 account.
Although it occurs to me that I wouldn't want to raid the 529 until after the kids are done with college. I probably won't get those juicy personal exemptions at the time I want to redeem the 529 with non qualified withdrawals. Again, not a slam dunk for me.

johnny847

• Magnum Stache
• Posts: 3188
Re: 529 Plan Account as a Tax Shelter
« Reply #6 on: February 26, 2015, 09:18:15 AM »
I'm a little bit confused as to why you say effective income tax rate as opposed to marginal income tax rate in the spreadsheet. I'm assuming that you're not just using 529 money as your sole source of income. So you've already got another source of income filling in the lower tax brackets.

Also, if you want to consider the state tax break, you must look at the possibly higher expense ratio of funds in your state's 529. There are some states, such as NY, NV, UT, that offer funds that are very close to expense ratios you could get at Vanguard in a taxable account. If you're not fortunate enough to live in a state with a competitive 529 plan, you may need to take this into account (obviously if the expense ratio difference is not very high, then to first order approximation you can just ignore it).

If you meant to have 28% tax on dividends as a "default value," that's a pretty terrible default value, because tax efficient funds like VTSAX have 100% qualified dividends (aside from 94% in 2013). Meaning they qualify for long term capital gains rates, which are going to be either 0% or 15% for almost all Americans. And for people in the 0% or 15% long term capital gains brackets, they are incredibly unlikely to be in a 13% state marginal tax rate (I don't even know if such a state even exists).

• Bristles
• Posts: 279
• Age: 39
• Location: SoCal
Re: 529 Plan Account as a Tax Shelter
« Reply #7 on: February 26, 2015, 09:54:07 AM »
I'm a little bit confused as to why you say effective income tax rate as opposed to marginal income tax rate in the spreadsheet. I'm assuming that you're not just using 529 money as your sole source of income. So you've already got another source of income filling in the lower tax brackets.

Also, if you want to consider the state tax break, you must look at the possibly higher expense ratio of funds in your state's 529. There are some states, such as NY, NV, UT, that offer funds that are very close to expense ratios you could get at Vanguard in a taxable account. If you're not fortunate enough to live in a state with a competitive 529 plan, you may need to take this into account (obviously if the expense ratio difference is not very high, then to first order approximation you can just ignore it).

If you meant to have 28% tax on dividends as a "default value," that's a pretty terrible default value, because tax efficient funds like VTSAX have 100% qualified dividends (aside from 94% in 2013). Meaning they qualify for long term capital gains rates, which are going to be either 0% or 15% for almost all Americans. And for people in the 0% or 15% long term capital gains brackets, they are incredibly unlikely to be in a 13% state marginal tax rate (I don't even know if such a state even exists).

Thanks for the feedback. These are all good points. I came from a skeptical viewpoint assuming the 529 plan is not a very good alternative to a general taxable investment account. The current values in the spreadsheet are not meant to be a "default" value but rather an illustrative example of a case in which 529 might be a viable alternative. Update with values that might apply to you.

I hadn't previously considered the possibility of qualified dividends reducing the tax load on a taxable account until it was brought up above. This certainly could make a 529 account less desirable. I am relatively new to investing beyond the scope of tax advantaged retirement accounts; do investments with qualified dividends typically have a lower overall return? (I can only assume so, otherwise why wouldn't everybody invest solely in those types of investments?) If so, this can be modeled in the spreadsheet.

Good point on the possible higher expense ratio on your own state's 529. Again, I haven't put too much thought into the state tax break scenario since I don't live in one of the applicable states.

Yes, under "effective" tax rate you really need to input the "applicable" tax rate for your withdrawal strategy. Why not take 529 money as your sole source of income for a year or two if that's what makes sense to reduce the overall tax load on the 529? (As opposed to spreading it out over a number of years at the marginal rate.) Unless I am missing something?

MDM

• Senior Mustachian
• Posts: 10767
Re: 529 Plan Account as a Tax Shelter
« Reply #8 on: February 26, 2015, 10:25:30 AM »
do investments with qualified dividends typically have a lower overall return? (I can only assume so, otherwise why wouldn't everybody invest solely in those types of investments?)
Most of the dividends you get from US-based companies are likely to be qualified dividends.  See http://en.wikipedia.org/wiki/Qualified_dividend for more details.

• Bristles
• Posts: 279
• Age: 39
• Location: SoCal
Re: 529 Plan Account as a Tax Shelter
« Reply #9 on: February 26, 2015, 10:58:48 AM »
I do plan to think about the question of qualified dividends in more detail. But at first blush a 100% qualified dividend portfolio could be modeled by putting the applicable capital gains rate in place of the marginal income tax rate (and updating gains/dividend percentages as applicable). A blended portfolio could be something between the capital gains rate and income tax rate.

Putting aside the question of qualified dividends for now - another issue with the scenario in the spreadsheet is that it models dividends in the taxable account as being taxed at the same high marginal income tax rate (or capital gains rate) across all years until you pull the money out. If you plan to retire and sit at a lower marginal income tax / capital gains rate for awhile before withdrawing the money, the comparison will look different. In some cases it might end up making sense to keep the money in the 529 only as long as you are at the higher income tax bracket. When I get a chance, I ought to add input options for how many years until retirement and income tax before/after.

Note to self: Other things to think about are robustness to potential future changes in U.S. tax code (e.g. capital gains rates, marginal tax rates, personal exemptions/standard deductions), unknowns in future personal finance needs (e.g. income level needed in retirement), and effect of variable/uncertain returns.

Thanks to all for the comments so far, keep 'em coming!

CanuckExpat

• Magnum Stache
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Re: 529 Plan Account as a Tax Shelter
« Reply #10 on: February 26, 2015, 11:37:41 AM »
do investments with qualified dividends typically have a lower overall return? (I can only assume so, otherwise why wouldn't everybody invest solely in those types of investments?)
Most of the dividends you get from US-based companies are likely to be qualified dividends.  See http://en.wikipedia.org/wiki/Qualified_dividend for more details.

My asset allocation calls for a bit of bond funds and REITs. Being out of tax advantaged space, I don't have a good place to put them, so in my case I don't mind modelling to find out if the 529 + penalty is a good place for those excess funds

johnny847

• Magnum Stache
• Posts: 3188
Re: 529 Plan Account as a Tax Shelter
« Reply #11 on: February 26, 2015, 11:42:12 AM »
Thanks for the feedback. These are all good points. I came from a skeptical viewpoint assuming the 529 plan is not a very good alternative to a general taxable investment account.
And I agree. I'm pretty sure as more people chime in, we will come to realize that using a 529 for non educational purposes is pretty bad. For example, I also just remembered another correction you need to make - I'll mention at the end of this comment.

The current values in the spreadsheet are not meant to be a "default" value but rather an illustrative example of a case in which 529 might be a viable alternative. Update with values that might apply to you.
Gotcha.

I hadn't previously considered the possibility of qualified dividends reducing the tax load on a taxable account until it was brought up above. This certainly could make a 529 account less desirable.

I am relatively new to investing beyond the scope of tax advantaged retirement accounts; do investments with qualified dividends typically have a lower overall return? (I can only assume so, otherwise why wouldn't everybody invest solely in those types of investments?) If so, this can be modeled in the spreadsheet.
Nope. VTSAX, total (US) stock market index, a very popular and widely recommended index fund (a part of the lazy 3 fund portfolio), issues qualified dividends. And as I said before, aside from 94% qualified dividends in 2013, all other dividends in the past ten years have been qualified dividends.

Why not take 529 money as your sole source of income for a year or two if that's what makes sense to reduce the overall tax load on the 529? (As opposed to spreading it out over a number of years at the marginal rate.) Unless I am missing something?
Sorry, I'm not used to thinking this way - I'm only used to thinking of a 529 as for educational expenses.

Putting aside the question of qualified dividends for now - another issue with the scenario in the spreadsheet is that it models dividends in the taxable account as being taxed at the same high marginal income tax rate (or capital gains rate) across all years until you pull the money out. If you plan to retire and sit at a lower marginal income tax / capital gains rate for awhile before withdrawing the money, the comparison will look different. In some cases it might end up making sense to keep the money in the 529 only as long as you are at the higher income tax bracket. When I get a chance, I ought to add input options for how many years until retirement and income tax before/after.
This is a significant issue. Tax efficient funds with qualified dividends let you defer almost all of the taxes on your gains until you sell.

Another issue with the state tax break. Most states have a recapture provision in their tax code - if you claim the tax deduction for a 529 contribution but then later have a nonqualified withdrawal (ie, don't use 529 money for educational expenses) then this tax deduction is clawed back. I've quoted the information for the GA 529 (my state)
Quote

In addition to the taxation of the earnings portion of withdrawals other than Qualified Withdrawals discussed above, any portion of a rollover to another state’s qualified tuition program, a Taxable  Withdrawal, or an Unqualified Withdrawal that is attributable to contributions previously deducted for Georgia income tax purposes will be taxed to the Account Owner in the year of the withdrawal or rollover. The amount to be added to the Account Owner’s Georgia taxable net income will be determined by multiplying the non-earnings portion of the total funds withdrawn or rolled over by the proportion of contributions in the Account at the time of such withdrawal or rollover that have previously been deducted for Georgia income tax purposes. Georgia law does not specifically address the state tax consequences to the Account Owner if someone other than the Account Owner makes a contribution to the Account, and the Account Owner subsequently makes a withdrawal or rollover that would trigger a recapture of prior contribution deductions

Because of that provision, if you have no intention of using a 529 for educational expenses, then you will most probably not be able to claim the 529 tax deduction for your state, even if it is offered (I say most probably because perhaps a state won't recapture the deduction...but I doubt this because the point of 529s is to use the money for educational expenses.)

• Bristles
• Posts: 279
• Age: 39
• Location: SoCal
Re: 529 Plan Account as a Tax Shelter
« Reply #12 on: February 26, 2015, 11:49:32 AM »
Another issue with the state tax break. Most states have a recapture provision in their tax code - if you claim the tax deduction for a 529 contribution but then later have a nonqualified withdrawal (ie, don't use 529 money for educational expenses) then this tax deduction is clawed back. I've quoted the information for the GA 529 (my state)
...
Because of that provision, if you have no intention of using a 529 for educational expenses, then you will most probably not be able to claim the 529 tax deduction for your state, even if it is offered (I say most probably because perhaps a state won't recapture the deduction...but I doubt this because the point of 529s is to use the money for educational expenses.)
Interesting. Very important to be aware of!

Something else: I hadn't taken into consideration state taxes on capital gains. I just learned that California taxes capital gains at ordinary income tax rates (learn something new every day!) Perhaps another reason to move away in retirement.

johnny847

• Magnum Stache
• Posts: 3188
Re: 529 Plan Account as a Tax Shelter
« Reply #13 on: February 26, 2015, 12:16:48 PM »
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.

• Bristles
• Posts: 279
• Age: 39
• Location: SoCal
Re: 529 Plan Account as a Tax Shelter
« Reply #14 on: March 07, 2015, 09:04:04 PM »
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.

I was going to say, some 529 funds have pretty competitive expense ratios. My target-date funds with California's Scholarshare are 0.18% (compared to the 0.19% in my Vanguard target date retirement funds). But then I looked up VTSAX. I guess 0.05% is hard to compete with!

But the 529 plan needs to overcome at least a 20% tax disadvantage!

You left out one case, which is if your income in retirement falls below the taxable threshold. Then the 529 plan only has to overcome a 10% disadvantage. As I mentioned in my original post, this seems to be key.

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.

I came to the same conclusion long ago (maybe for the wrong reasons), but started the thread as a challenge to myself to explore the idea. I guess now I've come full circle and have a better understanding of WHY it doesn't really work for the average Joe.

Maybe one of the few who can use a 529 as a tax shelter will find this thread!

johnny847

• Magnum Stache
• Posts: 3188
Re: 529 Plan Account as a Tax Shelter
« Reply #15 on: March 07, 2015, 10:16:20 PM »
I was going to say, some 529 funds have pretty competitive expense ratios. My target-date funds with California's Scholarshare are 0.18% (compared to the 0.19% in my Vanguard target date retirement funds). But then I looked up VTSAX. I guess 0.05% is hard to compete with!

Haha yea. The only ways that I know of to beat that are the institutional and institutional plus shares, which you can generally only find at 401k's with a large number of employees (because of the multiple millions of dollars in minimum investment thresholds), and I believe in the federal Thrift Savings Plan.
Or, if you have enough in assets that you can just buy the individual stocks that make up the index yourself, and you are able to do this without incurring too much in commisions.

You left out one case, which is if your income in retirement falls below the taxable threshold. Then the 529 plan only has to overcome a 10% disadvantage. As I mentioned in my original post, this seems to be key.

Ah true I did. But for a married couple without itemized deductions, that's only \$20,600 to work with. And I would assume that most early retirees would want to use the Roth pipeline, so if you are already going to use the Roth pipeline, then it doesn't leave much room for the 529 withdrawals to fit in the de facto 0% tax bracket.
If you're not using the Roth pipeline, then you can use the Roth to supplement up to \$20,600 in withdrawals if need be. But you would still have to do the math comparing the particular 529 funds in question to your tax drag in a taxable account (including state taxes if applicable).