I occasionally hear this suggestion, mostly from super-savers who have already maxed out their retirement accounts and need and want to save more for their retirement. Occasionally I get some version of it from those who have saved a great deal in 529s and wonder if perhaps they have oversaved for college and can just use the leftovers for retirement.
First, let’s consider the benefits of using a 529 for retirement savings. The first benefit is that your state may give you a tax deduction or credit for some portion of your 529 contribution. In my state, they give a 5% credit up to the first $3,720 per “qualified beneficiary” (i.e. child, but may include friends, relatives, and even yourself (although the credit in my state is only available if the beneficiary is 18 or younger when the account is opened.) The second benefit is that the money grows in a tax-protected manner. The underlying funds kick out dividends and capital gains distributions each year which in a taxable account would cost you some money that you don’t have to pay thanks to the 529 structure. The third benefit is that if the money is spend on qualified educational expenses, the earnings are never taxed. Obviously, if you’re using this for retirement purposes, that one isn’t going to apply.
An additional benefit that you might not have considered is the asset protection issue. 28 states offer some amount of asset protection for their 529 accounts. The maximum protection occurs when the child owns the account, of course, since it is no longer your asset, but you obviously lose control when you do that. Many states have statutes that specifically protect the account from the creditors of the owner, and/or beneficiary, and/or other contributors to the account. Maximal protection is available in Colorado, Florida, Illinois, South Dakota, and Virginia. Remember that asset protection law is always state-specific.
Obviously, the government doesn’t really want you to use a 529 for retirement savings. Therefore it has put some rules and penalties in place for those who do so. The main rule is that if you spend the money on something other than education, you will have to pay regular income tax plus a 10% penalty, but only on the earnings, not the basis.
As an example, let’s assume you have a $50K 529 distribution. The basis (what you contributed) is $10K. You pull it out and spend it all on a boat. You are in the 28% bracket. You will owe in taxes:
$40K*0.28 + $40K*0.10 = $15,200.
If you state gave you an upfront deduction or credit for contributions, you may also owe “recapture tax” for that if you don’t use the money for education. You might be able to move the money to another 529 before withdrawing it and avoid it, but most states with recapture tax also charge it when money is removed from that state’s 529 program. Look up your state’s recapture tax rules here..
If the money had been in a taxable account, you may have only owed capital gains taxes at 0%, 15%, 20%, or 23.8%, depending on your bracket. Of course, it would not have grown as quickly (so there would be less money) given the drag caused by the tax on annual dividends and capital gains distributions.
Solutions for “I Saved Too Much”
Many people are worried about overcontributing to 529s accidentally. There are lots of solutions to this problem. For example, you can redesignate the beneficiary to the beneficiary’s sibling or child. You can even change it to yourself. You can also withdraw money penalty-free (but not tax-free-the earnings are still taxed at your regular tax rate) in the amount of a scholarship, VA benefits, employer-provided educational assistance, and Pell grants (like you’re going to get any of those.) If your beneficiary dies, is disabled, or attends a service academy, you can take the money out without the additional 10% tax penalty, but do have to pay regular income taxes on the earnings, just like with scholarship money. Keep in mind, in some 529s this income can assigned to the kid and taxed at his (hopefully lower) bracket. If your 529 doesn’t allow that, you could first transfer it to another 529 that did.
The Calculation – 529 vs Taxable account
So now let’s do a little calculating to see how and when it might be smart to use a 529 instead of a taxable account. Let’s make some assumptions. Let’s say you want to contribute $10K you know you won’t use for education into a 529 and leave the money in the account for 40 years, then withdraw it all in one year (for simplicity’s sake.) The investment grows at a pre-expense and pre-tax rate of 8%. You did not get a state tax credit or deduction so there will be no recapture tax (again, for the sake of simplicity.) Let’s also assume a 15% dividends and capital gains tax rate throughout the entire period, although that could possibly be as low as 0% at withdrawal, and as high as 23.8% during peak earnings years. We’ll also assume a 28% regular tax bracket at withdrawal.
A Very Tax Efficient Investment
Let’s say you invest in Vanguard’s Total Stock Market Fund in both accounts. In the 529, we’ll use an expense ratio of 0.16% (the current overall expense in the Utah 529 for this fund.) In the taxable account, we’ll use Vanguard’s Admiral Fund ER of 0.05%. The fund distributes a yield of about 2% a year, so the 15% tax rate on that will reduce returns by about 0.3% per year in the taxable account (although the reinvested dividends DO increase the basis each year, so we’ll need to account for that at withdrawal.)
The tax due on the taxable account will be 15% of the gains. However, we first will need to update our basis, the original $10K + all the reinvested dividends that weren’t used to pay the ongoing taxes. I calculate that basis at $53,250. So the tax due will be ($190,793 – $53,250) * 0.15 = $20,623.
The tax due on the 529 account will be 28% plus 10%, or 38% of the gains.
($204,736 – $10,000) * 38% = $74,000
After expenses and tax, the taxable investor is left with $170,170 and the 529 investor is left with $130,736. Obviously, using the 529 wasn’t very smart, especially if the investor died before taking this distribution when the taxable investment would have gotten the step-up in basis. Of course, is the investor felt he got $40,000 or more of value from the asset protection the 529 provided, he might consider that $40,000 just an expensive insurance premium. But I think the typical investor will look at this calculation and say that under these assumptions, it would have been best to use a taxable account.
Lower Tax Brackets
What if somehow you’re able to get very favorable tax brackets in retirement due to low income or a large percentage of tax-free (Roth) income in retirement (same brackets during peak earnings years). What if you’re in the 15% regular tax bracket and thus the 0% capital gains bracket? What does the final total look like?
Less Tax-efficient Investment
Let’s assume now that you’re going to use the 529 for a relatively high return, but very tax-inefficient investment such as REITs. We’ll assume that same 8% pre-tax and pre-expense return and the same investment expenses (yes, I know they’re slightly different, but not enough to affect the calculation), but let’s assume the entire return is distributed each year and taxed at your marginal tax rate of 28% before reinvestment. There will be no capital gains taxes due at the end, of course, but the growth rate will be much lower in the taxable account. You will end up with the same $130,736 in the 529 account. But the taxable account will only grow to $93,942.
Thus, we can see that for tax-inefficient assets, much like a variable annuity, a 529 will work out better, and for tax-efficient assets, the taxable account will work better. However, if you’re just going to use a 529 as a variable annuity, why not just skip the 529 and use a variable annuity and save the 10% penalty? Or better yet, put your tax-inefficient assets into your 401(k) and Roth IRA and just use a taxable account?
While I’m sure someone can come up with some extreme example where using a 529 for retirement savings would be a good idea, for the most part 529s should be used exactly as intended- as a college savings tool. They’re far better than a taxable account, retirement accounts, and the myriad of insurance schemes proposed for this purpose. But 529s are not a “Stealth IRA” by any means. Plan on spending yours on someone’s education.
What do you think? Do you agree with my assumptions and calculations? Are you using a 529 as a retirement account? Why or why not? Comment below!