By Dr. James M. Dahle, WCI Founder
Using a 529 account for additional savings is a suggestion I hear from time to time, mostly from super-savers who have already maxed out their retirement accounts 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 over saved for college and can just use the leftovers for retirement.
The Benefits of a 529 for Retirement Savings
If you’re a super-saver and looking for an additional retirement account, a 529 plan does have a few benefits to consider.
#1 Tax Deduction/Credit
Your state may give you a tax deduction or credit for some portion of your 529 contributions. 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).
#2 Tax-Protected Growth
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. Additionally, if the money is spent 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.
#3 Asset Protection
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.
Disadvantages of a 529 Plan for Retirement Savings
Obviously, the government doesn't really want you to use a 529 plan for retirement savings. Therefore, there are 529 account rules and penalties in place that you should be aware of. The main 529 account 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 your state gave you an upfront deduction or credit for 529 plan 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.
What to Do If You Over Contribute to a 529 Plan
Many people are worried about overcontributing to 529s accidentally. There are a lot 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 be 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.

Matt Hylton, 200 feet up Dark Shadows outside Las Vegas. There aren't a lot of climbing shots where you can hide the rope without Photoshop
Taxable Account vs 529 Plan
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.
Scenario 1 – Funds Placed in 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, if 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.
Scenario 2 – 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?
Taxable $190,763
529 $156.052
Scenario 3 – 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?
A 529 Plan Is a Great Education Savings Tool
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!
Typo in the last section. Should be that reits are INEFFICIENT.
Sorry, on a tablet before. Looks like u fixed it. Quoted for preservation from email:
“Let’s assume now that you’re going to use the 529 for a relatively high return, but very tax efficient 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. “
Yes, I fixed it. REITs are NOT tax-efficient.
As always Jim…you are killin’ it with your timely and pragmatic posts.
I’ve pondered a 529 plan since I will max out a 401k, Roth, HSA and dump the extra into a taxable account and hard assets.
I was contemplating the legal ramifications of a 529 without having children(don’t want any).
Now, I know my options. I still have to run the numbers though. Doesn’t appear advisable in my current/future financial situation.
Thanks again!
Has anybody used 529 money for CME? How about using it to pay for CME while also deducting this as a business expense?
Or, if you need to ditch the money, I wonder if you could donate a 529 plan to your alma mater to create an endowed scholarship and then deduct this?
As I understand the rules, you can’t do any of those things.
To be honest, I expect in retirement I’ll want to help my grandchildren with education. I’d shuffle beneficiaries around and have it as a scholarship fund for them. I don’t really see any problems with this (in Utah, at least). But then, I’m still a long ways from doing that and laws can change. Or I could just be unaware of something.
We aggressively funded 529’s for our three kids. The older two opted for public universities with big scholarships with the intention to save 529’s for post graduate education. One has opted to enter the work force. One is headed to med school. One is still in 8th grade. We will hold the 50K of overfunding for the 1st child in case she needs it in the future. If not, we can easily transfer it to the other two or save for (hopefully) grandkids someday. We looked at the idea of saving it for our retirement but the math was not favorable in our case.
It took us awhile to grasp the concept that efficient taxable investing is a great tool. Unfortunately it seems like many people get so lured by the tax breaks that they forget they give up the flexibility to get to the money whenever they want. In fact, we had some taxable investing for the kids’ college in addition to 529’s as they have many expenses that are not “qualified” so the benefits of the 529 do not apply. We had kept it mainly in cash and it allowed us the flexibility to not use the 529’s when the market tanked. Just like different accounts in retirement give the owner flexibility, the same can be said for college savings. The withdrawal tactics from the 529’s are good practice for similar concepts in retirement withdrawals.
Via email:
Can 529 money be used to purchase a condo for a student?
From the IRS:
Qualified education expenses. These are expenses related to enrollment or attendance at an Eligible educational institution (defined later). As shown in the following list, to be qualified, some of the expenses must be required by the institution and some must be incurred by students who are enrolled at least half-time. See Half-time student , later.
The following expenses must be required for enrollment or attendance of a Designated beneficiary (defined later) at an eligible educational institution.
Tuition and fees.
Books, supplies, and equipment.
Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible educational institution.
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 is not more than the greater of the following two amounts.
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.
The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.
You will need to contact the eligible educational institution for qualified room and board costs.
According to that, the student must be enrolled at least half-time and you can only use upt othe amount the school includes in the cost of attendance. I don’t see that it says anything about not being able to use it to actually buy a house, but I’m not sure you can even get much of a down payment, must less any of the mortgage payments, out of just a few thousand a year. But if you used non-529 money for the down payment and closing costs, a decent chunk of the mortgage payments could probably come out of the 529. I’m not saying it’s a wise thing to do, but I don’t see that it is specifically disallowed.
When our kids lived on campus, the room and board qualified expense was easy. We just took what we were charged from the 529. Now that they live off campus, the documentation of living expenses is in what seems like a grey area. The school allows for $12,178 for fall and spring semester room and board. So that is the amount considered qualified to use for housing and food. Anything over that amount comes from non-529 savings. The university does not provide a documented housing expense for summer semester so we extrapolated for those summers. We decided purchasing a condo in our situation only worked if both kids lived in it together from the beginning. We did not want to force that living situation upon them even though they get along great. Allowing them to grow and find their own paths individually took precedence over what was a small financial benefit of buying a condo.
What about a 529 as an estate planning tool? Does a “child” have to be below a certain age to contribute to her 529? Our state takes a its cut starting at estates >$1M. I’m hoping to use my rather small Roth IRA in this way-50 years from now it may be worth something even without adding contributions.
A typical 529 can be funded for a beneficiary of any age. Read your state program’s specific rules, of course. I’m not sure I understand your scheme for estate planning. If you give money away, it’s out of your estate and estate taxes won’t be assessed on it. Money put in a 529 is considered out of your estate, even if you still control it. Kind of cool that way. Watch the gift tax limit each year, of course. But I think there is some potential estate planning benefit there.
Excellent discussion, Jim. There are much better options for retirement planning. There may be a role for using the 529 plan to siphon money from the grandparents to grandchildren–I know one wealthy (non-physician) family that is using the tool for that purpose.
I have personally used a multi-tier approach for my children (13 and 16). Each child should have about $160k in their respective 529 accounts prior to starting college, barring a job loss or complete market meltdown. I will plan to use $40k/year from the account for each. Additional funding, if required, will come from personal cash flow. If cash flow is not available (myself or wife or both have change in job status), each child has an additional UMTA account, which should be close to $100k/child, to make up the difference.
I will incentivize the kids, as much as possible, to choose the lower cost/higher value college option. Any money left over will be given outright to the child, at an appropriate time–to help buy a home, get additional educational or training, start a business, maybe even travel or study in Europe for a year after college.
Great article – I’m looking at the possibility of having some extra 529 $$… Our oldest who just started her 1st year managed to get an academic full ride, and I’m able to cover her room and board + allowance out of current earnings – and try to leave her $45K or so growing… The middle child has even better test scores so I’m hoping he’ll score a similar or better scholarship deal. Our youngest and most social 8th grader may not do so well on the tests, but she could benefit by roll over from the other kids’ accounts, thereby allowing me an earlier (semi-)retirement! Alternatively, still debating whether I’d give the kids the money in some fashion (grad school or Europe education etc) vs roll down to any grandkids (the accounts could be quite substantial by that time) …
Finally, if life-long learning is something one would do in retirement anyway, then having some 529 dollars is a great idea – basically a tax-diversification strategy. My wife and I would love to retire in a college town – I wouldn’t mind paying tuition for “geography of wine 301” or similar course!! Or how about Semester at Sea? I would expect there’ll be plenty of interesting and qualified options to accept 529 dollars
Apologies for commenting on an article from October, but I am catching up on my WCI reading. This post provides some excellent information for those who have over-contributed to 529s. Would you expect identical outcomes if using a Coverdell instead of a 529? My particular situation is a vastly overfunded Coverdell coupled with a 529 that is nearly depleted as my only daughter completes college. She will have enough funds in the 529 to fund her final semester and she doesn’t plan on going to grad school at this point. If she has no educational expenses to use the Coverdell assets on before she turns 30 in eight years, can she instead use it for a down payment on a house, or her wedding? Would her tax penalty be less than mine, assuming her salary would be much lower than my earnings during her early employment years? Thanks in advance.
Rather than pulling the money out, have you considered keeping it in there and using it for the next generation? But yes, if you really feel like you need to/should pull it out, far better for her to pay the taxes/penalties (and as soon as possible) than for you.
Thanks for confirming my intuition. She could definitely use the funds for her children, if she has any before she turns 30. Thanks again for your fast response!
I am curious what WCI (and other readers with young children) are saving in 529’s? If you use college savings calculators, saving enough to cover full cost 18 years from now for a private school is enormous. I have heard some suggest saving just enough for a state university. Others have suggested saving just 1/3 of the expected amount, and planning the other 1/3 from student loans (skin in the game for kid) and the other 1/3 from earned income/cash flow while student is enrolled. Thoughts?
I have an entire post on the topic:
https://www.whitecoatinvestor.com/how-my-children-will-pay-for-their-college/
I live in CT which offers a Tax Deduction for 529 Contributions and also No recapture tax on rollovers to another states plan.
In this case I am curious to know if I Rollover the CT 529 plan to another state (no recapture tax) and then I take a unqualified withdrawal while still being a CT resident, will I still not have to pay any state income tax on that withdrawal since it’s coming from another state? Ignoring any earnings and just the principal.
I would guess not, but that’s probably a good question for an accountant in CT if it is a sizable amount of money. I suspect you’d be flying under the radar right through a little loophole.
I saw in the post and in the comments that you can re-designate the beneficiary to the original beneficiary’s child in the event of excess 529 funds. Doesn’t this incur tax penalties and the 10% penalty because it’s seen as a generational transfer?
My understanding, after discussing this with my CPA, is that penalties are imposed only if funds are withdrawn for unqualified expenses. Additionally, many relatives, not just the beneficiary’s child/children, are able to be named as the new beneficiary. These include cousins, nieces, nephews, etc.
The definition of “family member” is fairly well documented by the IRS. But while a child is listed as a qualified family member I’m pretty sure there’s a generational gifting issue. This post has some good information. I’ve seen so many different things online, but a consistent thing is that there is some potential tax liability with skipping generations with beneficiary designations. What this guy says is that say you’ve got $100K still left in the 529 and your child is the beneficiary who just finished college. You could let that grow for 5-10 more years until they have their own child/children. You can then start transferring the remaining money (say it’s $200K) to each grandchild up to the gift exclusion without incurring a gift tax penalty. In this example if there are 2 grandchildren you could do 2, 5-year contributions ($70K each) and keep doing that until the remaining 529 funds are exhausted. Does this make sense? It is correct?
This does make sense. Going back through my memory, the questions I asked my CPA were with respect to a Coverdell account, not a 529. Just to be sure, it might be worth posting on bogleheads to see what Alan S. has to say…
The generation skipping tax, like the gift tax, doesn’t matter unless you have an estate tax problem. So unless you have a state estate/inheritance tax, that’s $11M and growing for a married couple.
Sorry, forgot to leave the article:
http://www.jhwfs.com/5-most-frequently-asked-529-plan-questions/
Recognize this is an older thread, but saw this analysis (different target audience for sure) touting the benefits of a 529 for very high-income earners: http://rpgplanner.com/529-plan-opportunity/ Curious if you can assist my novice brain in reconciling how they did a fairly equivocal or 529-beneficial analysis since WCI’s above is so straightforward that the 529’s ability to eschew tax drag rarely wins out.
Part 1 of their 529 set up can be found here: http://rpgplanner.com/exploiting-529-plans/
And I did come across this on the WCI facebook page so I will continue to watch those comments.
Those articles are about using a 529 to save for college, not retirement, which this post is about. I think 529s are a great way to pay for college. But not a great way to save for retirement.