How much money do you really save by using a 529?
You get the benefits of tax-free growth, tax-free rebalancing if needed (probably not since you can usually rebalance simply with new contributions), and tax-free withdrawals when used for education. You may get a break on your state taxes for some or all of your contributions. You also get some minor asset protection and estate planning benefits. In return for these tax benefits, you pay some fees. How much money are you really saving versus just using a taxable account? A lot of it depends on how much you're paying in fees and what kind of returns you see in the account. For example, if your investment return in the 529 is actually negative, you would have been better off using a taxable account. That way you could at least harvest the tax losses and have Uncle Sam share your pain, plus you saved all the fees!
Showdown: 529 vs Taxable Account
Let's use an example from my own state of Utah, which happens to have a particularly excellent 529 plan with very low costs and excellent investments including Vanguard and DFA funds. I also get a state tax credit of 5% of my annual contribution, up to $3680 per kid ($184.) Let's assume 18 years of contributions, 8% pre-tax, pre-expense, annual returns (remember I invest my 529s very aggressively), 15% taxes on dividends and capital gains in the taxable account, 0.10% average ERs in the taxable accounts, 0.06% average ERs in the UESP, and an additional 0.2% UESP fee. We'll assume, just for ease of calculation, that I take out the entire investment and spend it on educational expenses after year 18. We'll also assume the UESP tax credit is invested in a taxable account at the same rate.
UESP: $151,340
Taxable Account: 131,184
So using the 529 instead of a taxable account under these assumptions is worth $20,156. This is the equivalent of a 1.35% higher annualized return.
Take Away The Tax Credit
If you eliminate the benefit of the tax credit, the advantage of the 529 drops to only $13,597 ($144,781 vs $131,184.)
The Effect Of A Lower Return
If you reduce the pre-tax, pre-expense return to 6% instead of 8%, the 529 advantage shrinks to just $14,514 ($122,753 vs $108,238).
The Effect Of Higher Fees
If you increase the 529 fees from 0.26% (.06% ER + 0.20% administrative fee) to 0.76%, then the advantage shrinks to $12,684 ($143,868 vs $131,184.) Inferior investments in the 529 would have a similar effect.
Losing The Tax Credit, Getting Lower Returns, and Paying Higher Fees
If you combine all 3 of these effects, the impact can be dramatic. The benefit of the 529 in that scenario after 18 years is just $3,186 ($111,424 vs $108,238). This is less than 16% of the benefit under the more favorable assumptions. It is only the equivalent of achieving a 0.28% higher annualized return. It isn't difficult to come up with some assumptions that can make investing in a 529 even worse than investing in a simple taxable account.
What do you think? Do you use a 529 to save for college expenses? What do you do to limit fees and maximize tax benefits? Comment below!
I think there is a tradeoff between flexibility (that a taxable account provides) and discipline (that a 529 account provides). With a 529 account, it is very easy to determine how much I have in the pot for my childrens education at any given point in time. I started out saving aggressively in an aggressive plan and have made my number for covering a fair portion of their undergraduate education (I used the saving for college calculator). With still a few more years to go before they head off to college, I’ve switched to contributing to my taxable account. I now have the flexibility to use these funds for other things.
If the money is really for them, might want to consider an UGMA.
A Coverdell Education Savings Account has far greater benefits than state 529 plans, in my opinion and experience. You can use for legitimate education costs from kindergarten through secondary, college and up to age 30 with the ability to pass it on to related family members. The ability to truly self-direct is what makes it especially attractive (can invest in real estate and through leverage, maximize growth).
I had a coverdell. I converted them to 529s and kept the same investments PLUS got a tax credit on the conversion. Can’t beat that. Their other downside is the $2K per year limit. It’s just not high enough to save a lot for college. I mean, I’m not saving that much, but it’s more than $2K per kid.
Agree that Coverdells are more flexible, but they have a lower contribution limit.
The other benefit of a 529 is the catch up contribution you can make as college approaches.
I also invest extremely aggressively in the 529, because the worst case is I have to cough up some person funds + have the kid get loans.
Like the other factors mentioned It seems that your capital gains tax rate may also alter the outcome, for those who are in the higher tax brackets…or those in the highest bracket when you need to use the money.
I decided to front-load my 529 contributions to maximize tax benefits, rather than contributing smaller amounts over many years. In fact, I did that before having kids! What I might lose in annual deductions from my state taxes I should more than make up in dividend and capital gains taxes avoided (although, incidentally, VA residents enjoy unlimited carry forwards for the 529 deduction). I named myself as beneficiary and will transfer the accounts to my kid(s) over time subject to gift tax thresholds. If the accounts grow faster than expected, I can to some extent “manage to” my goal by dialing back the investment mix. When using the lump-sum approach, I think it’s better to slightly over-fund the accounts than to under-fund them, since the penalty for any non-qualified withdrawals is mostly (and under some assumptions completely) neutralized by the benefits of many years of tax-free compounding. Of course, this assumes that the 529 plan is very low cost.
I’ve been thinking about front loading my 529s as well with extra money that would otherwise go to my taxable account. WCI, what are your thoughts on this idea?
I think it’s a great idea. Better tax protection, better asset protection, better estate planning. Perhaps slightly more expensive investments, but if you’re going to spend the money on education anyway, then yeah, use a 529.
I used the New York State program, which is managed by Vanguard, so fees are well below average. I rebalance annually. My daughter is completing her junior year, and will have just enough to fund her last year of college without touching her Coverdell, which has grown to six figures. I have been very happy with the returns Vanguard has provided, and although I haven’t run the figures through a spreadsheet, I am sure the large capital gains would have incurred a decent tax bite if the same investments were held outside of a 529 or a Coverdell.
If your state provides an incentive as well as a reasonably low-cost plan, the state plans are a no-brainer, yet I still see people getting sold load fund plans from brokers all of the time. Louisiana is fortunate to have a good plan in place here, with a state tax incentive, earnings enhancement, and low-cost Vanguard funds.
It’s a good place to put your money if you have maxed out 401K’s and Roth/backdoor Roth contributions. I look at it as an “educational Roth IRA”. It’s a no brainer for me, living in Illinois with a 5% tax credit (up to $500 per parent) and Vanguard index funds as choices.
Anyone in Indiana that doesn’t use a 529 is just plain ignorant. Guess what the tax credit is???
GO ahead, guess. You know you want to. !!
(using a search engine is not guessing)
Currently, the tax credit offered is 20% of the amount contributed to qualifying plans. (Up to $1000 credit)
Now if only the fund choices were less expensive !!!
That’s nice. Much better than Utah’s 5% credit.
i just use my own state up to the tax benefit limit and then use utah on top of that. Easy enough to have 2 accounts per child.
This was a super useful post. I’ve always wondered what the incremental benefits added up to be for a 529 as my family and I are moving from VA (where the tax advantages to the state 529 are excellent) to TX (no state income tax, no tax advantage). Though we will lose that benefit, with high contribution limits and a gaggle of children, we will continue aggressively funding their 529’s when we leave VA. Good work and thanks WCI.
I will be moving to Virginia to start my post-residency job. From what I see, though, the VA options are either a) through a financial planner, or b) in a program with shoddy fund selections.
Which did you choose and why (also how has your experience been)? I’m stoked that the tax breaks in VA are great, especially if each kid has a 2 529’s, one through myself and one by my wife.
The VA 529 is really pretty nice. Virginia529 account owners can deduct their contributions up to $4,000 per account (and you can have multiple accounts per child), per year, with unlimited carry forward to future tax years which is helpful come tax time. Especially as VA has pretty high (5.75%) state income tax, which when coupled with a couple of kids will almost guarantee you will be subject to AMT for the rest of your VA living lives. 🙂 So I usually end up using my state refund to pay off my Fed AMT overtax.
The investing options are two fold. You can use their preset “evolving” options which become less risky as the child nears college age, or “non-evolving” investments which are basically all Vanguard indexes which are my favorite investing vehicle. It’s worked out pretty well for us. Make sure when you sign up that you google a promo code to avoid the $25 registration fee.
Good luck!
Interesting that in Virginia state tax deductions are unlimited if you’re over 70.
Multiple $4000 accounts per child with the same owner being deductible is a little screwy. I doubt that’s actually true. I tried to look it up on the site but couldn’t find it.
On the tax deductions for multiple accounts per child, see http://www.bogleheads.org/forum/viewtopic.php?f=2&t=87220. I agree it’s screwy, but it’s true.
Good for you. Must not be very many people abusing it!
The non-evolving investment options are low-cost Vanguard funds with super-low expenses. They’re the opposite of shoddy.
My mistake, there are Vanguard funds in the inVEST program, but they are fixed portfolios. Only a few of the funds in each portfolio are Vanguard.
Something to add — a 529 is nice for grandparents/relatives to contribute. This is another advantage over a taxable account.
Remember 529s must be used for tuition/room/board or be penalized. If you have over-funded your child’s 529 this could be a problem. If a parent takes the proceeds (and pays student expenses), the IRS could mistake this for a non-allowed distribution and assess penalties.
529s are nice for asset protection purposes.
What does this mean, “asset protection?” Everyone seems to through this around. Does this mean that if somebody wins a lawsuit against you, that this is protected?
That’s exactly what it means.
Each of us approaches this from a different time span. I live in FLorida so no state income tax. I got married older and started have my two children in my 50’s. That puts a lot of spin on a lot of different things. Had a conversation with my bank (BOA) a couple of years ago and they introduced a young broker to me that they wanted to see if I would use him. Gave him a softball pitch and asked about a 529. He was really gungho and was willing to set one up immediately, when I asked him about fees he straightforward said of course there would be upfront fees up to 5% percent for the load on the mutual funds. I let the conversation drift and didn’t go back to the subject, and I’ve never spoken with him again. He should have been straight up front and told me to look at a state 529 since it would be the cheapest. Very obvious he did not have my financial well being in mind. After looking around the country I opened the accounts for my sons in Utah. I belive they have great plans at rock bottom prices. Being an older parent and in better financial shape my wife and I opened each plan with the max investment you can do and then not place anymore in for five years. Watching the growth of those accounts has been really nice. Now seeing that those accounts will grow taxfree for them for more than fourteen years my worries about their college and possible grad school expenses under any reasonable economy going forward is done. When you look at the financial aid forms for college students the amount required from the student is also less than if it came from your pocket which is also a consideration. And lastly for the last couple of years their godfather has contributed to their accounts each year which is also allowable. The tax benefit to any high earning physician for a 529 is manna from heaven.
I live in Pennsylvania. There are some good asset protections built in to staying with the state plan but no penalty and I still get tax benefits if I get a 529 outside my state. Which would you recommend? Stick with PA or go with best overall plan, and which would that be?
You’ll find this post useful.
https://www.whitecoatinvestor.com/the-best-529-in-the-country-gets-even-better/
thank you, that post was helpful and looks like Utah is the plan to go with.
However, in your rankings do you take into account the benefits with staying with PA (i.e. Assets held in a PA 529 plan are not counted when determining state financial aid for college. Assets in any other state 529 plan are counted. PA 529 assets are also protected from creditors in Pennsylvania. Assets in out-of-state plans are not protected.)?
Does UT still beat PA in your opinion with this info?
Personally, I think asset protection should be WAAAAY down the list in considerations. If you’re that worried about it, how about having grandpa own the 529? How much financial aid do you really expect a doctor’s kids to qualify for?
My wife and I just turned 39 and 42 respectively. We have 2 kids, ages 1 and 4. Both of us work full time. Currently, I have maxed out: 403b (50% match), 457b (unmatched), and my Backdoor Roth. She has maxed out 401k (50% match) and her Backdoor Roth IRA. I recently became eligible for corporate VUL underwritten thru John Hancock that will be matched 50% annually (for me, up to $20,000 in matching $, and still get the max $7,750 avail through my 403b match). VUL cliff vests only after 7 years. I can contribute up to $40,000 after-tax annually to VUL and they will contribute up to $20,000 (presumptively pre-tax). Assuming I already have $2.5 million in term insurance, how should we best allocate any additional funds after maxing out my 403b, her 401K, and both of our back door Roth IRAs. I am considering not contributing to 403b or any 529’s in favor of putting all our additional funds in VUL given its match and that I feel I will remain in my current practice position for a long time.
Military specific considerations to 529?
I have read a lot about 529’s, and I am not quite sure that they are worthwhile for everyone. The only universal advantage seems to be tax-free investment gains, but I think that this should be balanced against the flexibility of having your money in a taxable low-cost index fund (vanguard). The actual tax liability of the gains will obviously depend a lot on the amount invested, market conditions, and the investors marginal tax rate. As a military physician, my tax rate is not particularly high given that housing allowances are tax-free and we are maximizing TSP contributions. Add to that, I don’t pay a state income tax. So I am not sure that it is really worthwhile to lock up funds in a 529. I think that it might make more sense to fund a 529 after military separation, when income is higher. Am I missing something here? Any military docs have experience with 529s?
Sure. I used an ESA while in the military, then moved the money to a 529 upon separation, taking the state tax break then.
If you’re going to be spending the money on education, you might as well have it in an ESA or 529.
Which ESA did you use while in the military? Vanguard and Fidelity currently do not offer new ESA’s (Vanguard does service ESA’s if opened previously). Any other military docs currently using ESA’s?
I used a Vanguard one. I closed it the year the contribution limit went to $500 and obviously can’t reopen it. Better for me to use the Utah 529 anyway.
If I do not want to overfund a 529, can I withdraw contributions which have been converted from an after-tax IRA to Roth IRA without penalty if I am under 59 1/2 and some of the contributions were rolled-over less than 5 years prior to withdrawal?
i.e., contribute $5,500 now and then take out in 4 years for college expenses, while leaving earnings in the account for retirement? Penalty?
The 5 year rule applies to Roth IRA contributions. They can be withdrawn tax and penalty free at any time after 5 years.
http://www.rothira.com/blog/the-five-year-rule-with-roth-ira-withdrawals
However, converted traditional IRA funds have different rules. Michael Kitces has a nice article on the subject here:
https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/
But, all of that doesn’t matter when it comes to spending it on education. That’s penalty-free. http://www.irs.gov/publications/p970/ch09.html
So my understanding is that you could tap not principle, but earnings to to pay for college without paying a penalty.
After maxing out 403bs and backdoor roths, should we add to 529s or contribute to a 457 hospital plan? State is New York. Thanks!
Do you want to save for retirement or college? If you’ve already saved enough for retirement (at least 20% of gross) and want to save for college, then do the 529s. If not, then do the 457 (but read this first: https://www.whitecoatinvestor.com/non-governmental-457-plans-friday-qa-series/)
We have not saved enough for retirement at all, but I would like to do whatever makes financial sense. Personally, the idea that a hospital bankruptcy might wipe out a 457 is concerning, but I’m looking for the rational decision.
Thanks for the quick reply.
Sounds like you need more for retirement. So if you don’t trust the 457, use a taxable account to save for retirement rather than 529s for college. Basically, you need two plans- one for retirement and one for college. Don’t mix the two. And retirement is the priority. 529 tax breaks are nice, but it’s a lousy account for retirement saving.
I consider it one pot because I know I’ll end up helping the kids with tuition anyway, though I do understand what you’re saying.
It looks like you’re comfortable with the 457s based upon your link?
As a general rule, yes, but it would be the first money I spent in retirement.
What I’m saying is that if you aren’t on track for a reasonable retirement, you shouldn’t help the kids with tuition. You can’t get loans for retirement or choose a cheaper retirement university.
I’d encourage you to put college savings in the 529, retirement savings in retirement accounts, and use the taxable account as needed for either one.
Thank you.
any thoughts on the Vanguard offered 529 plans?
That’s the Nevada plan. It’s fine. Make sure you get any benefit from your own state plan first, if there is any.
Dear WCI,
Thanks for the great advice on 529 plans. As you suggested I have a plan with UESP for my almost 1 year old now. I have a question about using the 529 when he goes off to college. Specifically, when my son enters college, can I purchase a town home or condo near the campus for him to live in and charge him rent from his 529 plan as the “living expenses” portion? What are your thoughts? Is this an approved or legal use of a 529 plan? Thanks for all the excellent advice!
Yes. Legitimate housing expenses up to the published cost by the University can be paid for with a 529.
Expenses for room and board must be incurred by
students who are enrolled at least half-time.
The expense for room and board qualifies only to
the extent that it isn’t more than the greater of the following
two amounts.
a. The allowance for room and board, as determined
by the eligible educational institution, that was included
in the cost of attendance (for federal financial
aid purposes) for a particular academic period
and living arrangement of the student.
b. The actual amount charged if the student is residing
in housing owned or operated by the eligible
educational institution.
You may need to contact the eligible educational institution
for qualified room and board costs.
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