Author Topic: Worthwhile to contribute to a 529 if you don't expect to use it for education?  (Read 3353 times)

not_a_trex

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Worthwhile to contribute to a 529 if you don't expect to use it for education?
« on: September 01, 2015, 11:18:10 PM »
Hey guys,

I'm curious if you guys know if it's worthwhile to contribute to a 529 even if the intent to use the funds are not for education. I know that there is a 10% penalty on top of capital gains taxes on withdrawal, but is there perhaps a break even point where if the money stays in the account for long enough it's worthwhile to invest in it anyways due to the tax deferred nature of the 529 account?

I haven't seen it often discussed so I'm guessing it's not. But I wanted to see the math behind it to see why it is or isn't worthwhile.

Let's for example look at the 529 program offered by NY. It offers a vanguard portfolio with an expense ratio of .16% using a mix of VTSAX and VTIAX funds.

Some assumptions:
Incremental annual additions of \$5000/yr for 30 years. Draw down is uniform annually over 10 years starting immediately after 30 years of investing.
Withdrawing from the account incurs a 10% penalty on gains within the account.
Withdrawals are made while in the 15% capital gains tax bracket.
Performance averages ~7% growth/year, 2% of the 7% will be from dividends (to make the math easy assume dividends are distributed once a year)
Contributions are made while in the 25% income tax bracket.

I imagine calculating how much money will be in the tax deferred account after 30 years is fairly straight forward. You could use use a compound interest calculator with P0=5000, i=.0684 (.07 - .0016 for management fees), t=30, and r=1.

Would calculating the compound interest of the same amount in a taxable account be almost as easy? I would guess everything would remain the same, except for i. Would i be .0634 (.07 - .0016 - .02 * .25) with the last bit tacked on for taxes on dividends?

The part I have trouble on is calculating the value of payments uniformly distributed from the account over ten years. In addition to the fees and taxes of making the withdrawal, you still have to incorporate the gains that could be growing while the money is still in the account. Does anyone know how to calculate the distribution amount?

msilenus

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Re: Worthwhile to contribute to a 529 if you don't expect to use it for education?
« Reply #1 on: September 01, 2015, 11:43:06 PM »
When I ran the numbers for myself, it looked like breakeven was around 30 years.  Way too far out.  That's with a high tax rate (California + AMT) so circumstances were fairly favorable to shenanigans.  However, it was also with largely equities.  If the account were in 100% bonds, it's certainly better than 30 years, but I'm not sure how much better.

I've read that the IRS has been signaling that they're going to crack down on abuse of 529s.  I would not expect just paying the penalty to be a viable strategy over a long time horizon.

Consider whether there's really no way you'd use one for education.  In my area community colleges are very reasonable, and 1/2 time qualifies you for around 10k/yr in education-related living expenses.
« Last Edit: September 01, 2015, 11:46:42 PM by msilenus »

CanuckExpat

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Re: Worthwhile to contribute to a 529 if you don't expect to use it for education?
« Reply #2 on: September 16, 2015, 09:43:32 PM »
We discussed this a bit previously in this thead: http://forum.mrmoneymustache.com/investor-alley/529-plan-account-as-a-tax-shelter/

I have to revisit the topic and crunch the numbers myself, but my take away was: Probably not worth it for equities, possibly worth it for investments that throw off a lot of interest / ordinary income.

In our case, we are somewhat using it as a tax shelter for the REIT portion of our asset allocation. We are out of tax advantaged space, and the 529 happens to have a better/cheaper REIT fund anyways.

So the 529 is nominally in our son's name, but it's managed as part of our overall asset allocation and used to hold REITs and international bonds as much as possible. If it so happens that we don't use it for educational purposes, the money will revert back to us, and there may have been a slight tax advantage.

johnny847

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Re: Worthwhile to contribute to a 529 if you don't expect to use it for education?
« Reply #3 on: September 16, 2015, 10:13:50 PM »
We discussed this a bit previously in this thead: http://forum.mrmoneymustache.com/investor-alley/529-plan-account-as-a-tax-shelter/

I have to revisit the topic and crunch the numbers myself, but my take away was: Probably not worth it for equities, possibly worth it for investments that throw off a lot of interest / ordinary income.

In our case, we are somewhat using it as a tax shelter for the REIT portion of our asset allocation. We are out of tax advantaged space, and the 529 happens to have a better/cheaper REIT fund anyways.

So the 529 is nominally in our son's name, but it's managed as part of our overall asset allocation and used to hold REITs and international bonds as much as possible. If it so happens that we don't use it for educational purposes, the money will revert back to us, and there may have been a slight tax advantage.

Ah thank you, I was trying to find the thread I had posted in previously on this topic.

The counterargument to possibly worth it for investments that throw off a lot of interest/ordinary income:
For bonds, you can hold tax free munis in a taxable account as opposed to a bond fund in a 529. Obviously, munis do not have the same risk/return profile as say Vanguard's total bond fund. It is an imperfect substitute. But it is an option that doesn't involve you in this 529 business.
For REITs, I don't have a counterargument. There is no tax advantaged version of them.

I've read that the IRS has been signaling that they're going to crack down on abuse of 529s.  I would not expect just paying the penalty to be a viable strategy over a long time horizon.

You bring up a good point. There is certainly more risk because of a possible policy change in the future.
(To be fair, it is within the realm of possibility that Congress could change the rules and tax Roth IRA withdrawals. However, that is a far less likely scenario than Congress changing the rules of 529 penalties)

Threshkin

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Re: Worthwhile to contribute to a 529 if you don't expect to use it for education?
« Reply #4 on: September 22, 2015, 10:40:38 AM »
I set up a 529 account for my kids when they were little.  Fast forward about 20 years and aside for some comparatively minor deductions, the account is still there, growing at market rates, currently mid-five figures.  My kids are old enough that I feel no strong obligation to fund their education.  The account will be available for me and my wife's use if we want post-FIRE.  The remainder will be a legacy for my grand children.

One thing to watch out for is that a 529 account is set up with a single beneficiary.  If you have more than one child you need to have individual accounts for each child (or so I have been told).  If you use funds from a 529 for someone who is not the designated beneficiary you can get in trouble with the IRS if you are audited.  It is easy to change the beneficiary but it is also easy to miss this if you have multiple children in school at the same time.

msilenus

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Re: Worthwhile to contribute to a 529 if you don't expect to use it for education?
« Reply #5 on: September 22, 2015, 12:05:50 PM »
I set up a 529 account for my kids when they were little.  Fast forward about 20 years and aside for some comparatively minor deductions, the account is still there, growing at market rates, currently mid-five figures.  My kids are old enough that I feel no strong obligation to fund their education.  The account will be available for me and my wife's use if we want post-FIRE.  The remainder will be a legacy for my grand children.

One thing to watch out for is that a 529 account is set up with a single beneficiary.  If you have more than one child you need to have individual accounts for each child (or so I have been told).  If you use funds from a 529 for someone who is not the designated beneficiary you can get in trouble with the IRS if you are audited.  It is easy to change the beneficiary but it is also easy to miss this if you have multiple children in school at the same time.

Do your own research and/or seek professional advice, but based on what I've read this isn't quite right.

The IRS requires you to prove that the beneficiary incurred \$X in eligible expenses.  If they did, then you can withdraw \$X without tax or penalty.

So the identity of the beneficiary is important.  (As you say.)  But you go a bit further and say that how the money is spent is also important, which is not my current understanding.

Note that if I were personally contemplating keeping money that I withdraw this way, I would do much more research than I have.  I'd worry particularly about gift tax interactions, in addition to double-checking IRS requirements, and also checking the wording of the supporting law.  Sane people would ask a pro to research it.

(And it's also probably awkward to ask a kid for a tuition receipt if you're not actually helping them pay for college.)

Threshkin

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Re: Worthwhile to contribute to a 529 if you don't expect to use it for education?
« Reply #6 on: September 22, 2015, 12:19:19 PM »
I set up a 529 account for my kids when they were little.  Fast forward about 20 years and aside for some comparatively minor deductions, the account is still there, growing at market rates, currently mid-five figures.  My kids are old enough that I feel no strong obligation to fund their education.  The account will be available for me and my wife's use if we want post-FIRE.  The remainder will be a legacy for my grand children.

One thing to watch out for is that a 529 account is set up with a single beneficiary.  If you have more than one child you need to have individual accounts for each child (or so I have been told).  If you use funds from a 529 for someone who is not the designated beneficiary you can get in trouble with the IRS if you are audited.  It is easy to change the beneficiary but it is also easy to miss this if you have multiple children in school at the same time.

Do your own research and/or seek professional advice, but based on what I've read this isn't quite right.

The IRS requires you to prove that the beneficiary incurred \$X in eligible expenses.  If they did, then you can withdraw \$X without tax or penalty.

So the identity of the beneficiary is important.  (As you say.)  But you go a bit further and say that how the money is spent is also important, which is not my current understanding.

Note that if I were personally contemplating keeping money that I withdraw this way, I would do much more research than I have.  I'd worry particularly about gift tax interactions, in addition to double-checking IRS requirements, and also checking the wording of the supporting law.  Sane people would ask a pro to research it.

(And it's also probably awkward to ask a kid for a tuition receipt if you're not actually helping them pay for college.)

I was focusing on the beneficiary aspect.  Proper disbursement is also very important.  In no way was I advocating gaming the system by claiming a disbursement was for education expenses when it was for other use.

All of my disbursements from the 529 have been to directly pay for my children's qualified education expenses.  In fact i was even more conservative in that I only used the account for tuition or books, items that are clearly education-related.  Per the statute you can also use the account for living expenses but I considered that to be a grey area where the IRS might decide to disallow the expense.

My or my wife's future use of this fund would be for life-enriching education expenses.  If we don't spend it all on our own education (unlikely) we will set our grandchildren up as the beneficiaries when they reach college age.

msilenus

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Re: Worthwhile to contribute to a 529 if you don't expect to use it for education?
« Reply #7 on: September 22, 2015, 01:06:18 PM »
Why wouldn't you advocate gaming the system?

To not game it is to overpay.

It is important to game it correctly.

 To validate that I'm not hallucinating I just grabbed pub 970 and started scanning through how the IRS tells you to figure out the taxable part of your distribution.  I could be missing something, but it seems to be as I recall: take earnings, subtract off qualified tuition payments (QTPs) for beneficiary.  No check (that I see) requiring that the withdrawal was actually used for those payments, or to defray those payments.  Of course, tax court has recently ruled that IRS pubs aren't an ironclad defense if the law says something different, so it's not the last word on the matter even if I'm not missing anything.

http://www.irs.gov/pub/irs-pdf/p970.pdf
« Last Edit: September 22, 2015, 01:26:29 PM by msilenus »