I have been known to be creative when it comes to retirement accounts. I encourage my readers to have multiple 401(k)s if they qualify, to do Backdoor Roth IRAs, to view a Defined Benefit/Cash Balance Plan as another 401(k) masquerading as a pension, and to look at their HSA as their best retirement account. However, some readers have wondered if it might be a good idea to use a 529 account for retirement.
You can see why it would be attractive — one can put a ton of money into 529s every year. You can put in $15K/beneficiary and you can even front load 5 years at once. But there are two very big reasons why this is not a great idea — the 10% penalty and the fact that gains are treated as ordinary income. In essence, a 529 used for retirement is like an annuity with its additional costs, but with an additional 10% penalty. Sure, there's no Age 59 1/2 Rule, but that's not enough to make up for that 10% except in very unusual circumstances. Let's run the numbers to see why.
Running the Numbers
Naturally, we'll have to make some assumptions to run the numbers.
First, we'll assume that you're already maxing out your other tax-advantaged accounts because it would be monumentally stupid to use a 529 for retirement when you haven't even used your 401(k) or Roth IRA for that year. So we'll be comparing a 529 to a taxable account.
Second, we'll assume an 8% pre-fee, pre-tax return on investments.
Third, we'll assume that you invest $15K at once and leave it there for 30 years, then pull it all out in one year, pay any taxes and penalties due, and spend it, just to keep the calculations simple and straightforward.
Fourth, we'll assume there is no up-front state tax benefit on these dollars. If your state offers one, you already used that amount to actually pay for your kids' education and this $15K represents additional savings.
Using a 529 for Retirement
Let's use the Utah 529 for our example. If it isn't the best 529 in the country, it is certainly in the top 5. (If you're wondering, other top candidates include Nevada, New York, and California). The Vanguard Total Stock Market Index Fund in the Utah 529 has an expense ratio of 0.02%. The Utah 529 tacks on an additional 0.18% fee. In a taxable account, you can buy the Vanguard Total Stock Market Index Fund for an expense ratio of 0.04%. So the additional expense of investing in the 529 is 0.18% + 0.02% – 0.04% = 0.16%. So we will use a return of 8% – 0.16% = 7.84% in our calculations. After 30 years, the account will be worth:
=FV(7.84%,30,0,-15000) = $144,374
Now, we must pay taxes and penalties on it. The penalty is easy, it's 10%. The taxes, not so much. I mean, we have no idea what the tax brackets will look like in 30 years and only some idea of which bracket we will be in. So let's make a few assumptions and run the numbers a couple of different ways. First, we'll assume the Utah state income tax rate of 5%. Second, we'll run the numbers both in the top current tax bracket of 37% (plus 3.8% of course) and a lower tax bracket of 22% (no 3.8% PPACA tax due.)
Top Tax Bracket
=(144374 – 15000)*(100%-10% -37% – 3.8% – 5%)+15000 = $72,183
22% Tax Bracket
=(144374 – 15000)*(100%-10% -22% – 5%)+15000 = $96,506
Wow! Those taxes and penalties are a big bite out of your account when compared to investing in a Roth IRA–50% and 33% respectively. But how does it compare to a taxable account? Let's take a look.
Using a Taxable Account for Retirement
Again we'll assume a return of 8% per year. We will assume that 2% of that comes from qualified dividends and 6% from long term capital gains. There are, of course, different qualified dividend/LTCG tax brackets, ranging from 0% to 23.8%, and it is possible, indeed even probable, that a lower bracket will apply after 30 years than applied during those 30 years. So we'll calculate three tax scenarios that seem reasonably likely for readers of this blog:
- 15% the entire time
- 23.8% during the 30 years and 15% at the end
- 23.8% the entire time
Again we'll use a 5% state tax throughout, so add 5% to all of those numbers.
20% the Entire Time
A 20% tax on a 2% yield is equal to a tax drag of 0.40%, so the investment grows at 8% – 0.30% = 7.76%. After 30 years, that $15,000 is worth
=FV(7.6%,30,0,-15000) = $135,039
It would be relatively easy to just apply that 20% tax to the entire gain, where it would look like this:
=($135039-15000)*0.80 + 15000= $120,277
but that's not technically accurate. You see, as those dividends are paid, taxed, and reinvested, they actually increase the basis of the investment to a number above $15,000. That basis doesn't get taxed at the end. So the actual figure is HIGHER than $120,277. We could go through the trouble to calculate how much higher, but since $111,031 is more (much more) than you get under EITHER scenario investing in the 529, it seems kind of pointless, so we'll let it go.

529s are for these guys, not retirement.
28.8% during the 30 years and 20% at the end
A 28.8% tax on a 2% yield is equal to a tax drag of 0.576%, so the investment grows at 8%- 0.576% = 7.42%. After 30 years, that $15,000 is worth
=FV(7.42%,30,0,-15000) = $128,424
Even if you just applied the entire 20% tax at the end
=($128424-15000)*0.80 + 15000= $105,739
you would be well ahead of both scenarios investing in the 529.
28.8% the entire time
A 28.8% tax on a 2% yield is equal to a tax drag of 0.576%, so the investment grows at 8%- 0.576% = 7.42%. After 30 years, that $15,000 is worth
=FV(7.42%,30,0,-15000) = $128,424
Even if you just applied the entire 28.8% tax at the end
=($128424-15000)*0.712 + 15000= $95,758
you would do about as well as the best scenario in the 529. Once you accounted for the additional basis from the reinvested dividends, I'm confident you would come out well ahead.
529s Are For School
As you can see, 529s (and also Coverdell ESAs) are for school. Not only do you come out behind using them for retirement, but you also lose lots of benefits of a taxable account such as lower fees, tax-loss harvesting, tax gain harvesting, the donation of appreciated shares, the ability to invest in non-traditional assets, and the step-up in basis at death. 529s don't even really enjoy particularly robust asset protection in most states.
Of course, if you actually use the 529 for its designed purpose, paying for school, it comes out well ahead of the taxable account, especially if there is also a state tax break associated with contributions. I hope you don't need me to run the numbers to demonstrate that tax-free growth and withdrawals are going to easily best taxable growth and withdrawals, even at lower qualified dividend/long term capital gains rates.
The curious reader will, of course, now be trying to calculate exactly how much is needed for education and not put a dime more than that into their 529 account. However, there is a wonderful fail-safe with 529 accounts in the event that you accidentally (or even intentionally) overfund them. You can change the beneficiary. You can change it to yourself, a sibling, a niece or nephew, or even a grandchild. So if you have too much in there for your kid and no siblings that can use the extra, just leave it in there for your eventual grandkids. It'll just keep compounding tax-free while you pester your kid to get married and pump out some grandkids for you. I mean, what kind of person who over saved for their own kid's education isn't going to save/contribute something for the grandkid's educations? I rest my case.
What do you think? Do you think it's wise to save for retirement in a 529? Why or why not? Comment below!
Agree with the conclusion, of course. But, why did you use an 8 percent return in your calculation? If I recall correctly, in your boot camp book you used 5 percent, I think? Also, an investor might not take out all of the money in one day (at the end), so it might compound more. And, when it is withdrawn perhaps 100 percent won’t be withdrawn at once. Hence, the penalties would not be applied in one fell swoop. All that said, I do agree with the conclusion of the article. Sometimes, as the astute author points out, it is a wonderful generational gift to the grand kids as a nice safety valve.
The fun thing about showing my work is that if you don’t like some assumption I made you get to change the numbers and rerun them yourself without too much difficulty. I’m sure I’ve used lots of different numbers at times over the years. I often use 5% real and 8% nominal though, so perhaps that’s the issue.
You state:
You can change the beneficiary. You can change it to yourself, a sibling, a niece or nephew, or even a grandchild.
I am always confused about changing a beneficiary from a child to a grandchild. It appears that there are no income tax consequences, but there may be gift tax consequences.
If the new beneficiary is a member of the family of the old beneficiary but is in a later generation-for example, if the beneficiary is changed from a child to a grandchild-then the change is treated as a gift. The IRS is unclear at this point whether the gift is from the old beneficiary or from the account owner to the new beneficiary. Whoever is deemed to be making the gift could apply his or her gift-tax annual exclusions and even make the five-year election to mitigate the tax consequences of the gift.
That’s correct. And yes, it isn’t very clear is it?
I do have one question, I have heard that over funding 529 is a great idea for generational wealth as it is not taxed, and there is no mandatory distribution for the beneficiary. What do you think?
It’s only a good idea if the funds will be spent following the 529 guidelines.
[From Consumer Reports] You can use funds from a 529 account for a wide range of education-related expenses. That includes tuition, fees, books, supplies, and computers. The money can also go toward expenses for room and board, as long as the student is enrolled in school at least half-time. Dorm expenses are always covered, but if your child is living off campus, check the college’s “cost of attendance” figures to find out the amount that’s considered qualified for off-campus housing.
Otherwise, the taxes and penalties make it a terrible option for generational wealth transfer. At some point down the road, I expect it will fall into the hands of a beneficiary who has no interest in attending and/or paying for eduction. That person will cash out the fund regardless of the financial penalties. At the other end of the spectrum, it’s easy to picture accounts with funds that couldn’t possibly be spent in any rational way.
It really depends on how much “control’ the donor wants over the money. That’s always been the issue with these types of plans – the donor’s wishes don’t necessarily align with the recipients down the road.
It’s fine as long as it is used by future generations for education.
Morningstar’s 2019 gold star 529 ratings: Illinois, Virginia, Utah, California
https://www.morningstar.com/insights/2019/11/05/529-ratings
I attended a seminar on use of our state’s 529. The executive director stated he was filling his for next generation use. This week I’ve been depositing to ours for next generation use.
Illinois huh. That’s new for them. Although I have little trust for a ranking that doesn’t put NY and NV in the top category. As I recall, VA has two plans, one broker-sold and one for DIYers. The broker sold one isn’t so hot.
Gift tax consequences? The current unified exemption is approx. $11.5 million / person.
Yes, gift tax can apply. No, most docs won’t have an issue with it.
Your math is correct if you use a 529 plan for a stock portfolio, but as I’ve argued before a 529 plan is ideal for holding non-municipal bonds.
Bond interest is taxed as ordinary income anyways and tax deferral is worth the 10 percent penalty.
I’d have to run the numbers but I doubt it would be worth putting taxable bonds in a 529, paying the additional costs, and paying the penalty instead of just using munis. If it comes out ahead, it can’t be by much and probably not enough to justify the hassle in my book.
I was considering using a 529 plan as being permanently disabled (per the IRS definition) is an exception to the 10% penalty rule. Under those circumstances it’s slightly better than taxable as you don’t have tax drag on fixed income. It’s not better for stocks/long term capital gains with limited investment options, higher expenses, etc., for running the math on my investments.
I’ve decided not to invest in a 529 plan as you still have to meet the disability exemption when you withdraw. I don’t think it’s worth the audit risk (maybe the 529 custodian can somehow make it a qualified withdrawal if you send proof of disability to them.) Right now with the insanely low yields of bonds it’s just a lot of work to avoid some tax drag. Plus you’ll pay the taxes on any re-balancing you do anyways which is likely larger than amortized tax drag from bonds. It’d be annoying to re-balance between the 529 account and the taxable account. You don’t get any margin buying power credit for your bonds being in a 529 plan either for those of us doing Life-cycle/mortgage your retirement philosophy of investing.
REITs are probably the only thing I’d consider throwing into a 529 fund instead of taxable but I’m not a fan of REIT indexes as they’re too heavy on the commercial side and thus have high stock market correlations. I’d rather throw my real estate allocation into the accredited investor opportunities you’ve mentioned in other articles and get some awesome deprecation/other tax advantages for the first few years.
Proof: https://www.irs.gov/pub/irs-pdf/p970.pdf
Page 60, 529 plans are known as “Qualified Tuition Plans” under the tax code.
Exceptions. The 10% additional tax doesn’t apply to the
following distributions.
2. Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she can’t do any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration.
Interesting twist.
Funny to hear the phrase “mortgage your retirement” again. I thought that went out of favor in the 2008 Bear.
https://www.bogleheads.org/forum/viewtopic.php?t=5934
Ha! I’ve read through the whole market timer thread. It’s not the way to go leveraging up 100% stocks. Not counting the most recent stock market event the kelly criterion ratio is like 114% stocks, so very small amounts of leverage due to their sheer amount of volatility.
What’s in fashion now is taking a high sharpe/sortino ratio portfolio and applying leverage to it. Take two portfolios for example, one 50% SPY and one 50% TLT, and the other 100% SPY. Then just simply lump sum 100k over the entire history PV has of TLT. You’ll see both have very similar CAGR of 9% but the 50% TLT portfolio has a sortino ratio of 1.50, vs 0.88 of SPY. A max drawdown of -21% compared to -50.80%. A worst year of -4.86% compared to -36.81% A US Market correlation of 0.59 to 1.00. Both have close final portfolio values of $463k for 50/50 and $458k for SPY.
Note: PV only has data up to end of February before the current crisis.
https://www.portfoliovisualizer.com/backtest-portfolio?s=y&timePeriod=2&startYear=1985&firstMonth=1&endYear=2020&lastMonth=12&calendarAligned=true&initialAmount=100000&annualOperation=0&annualAdjustment=0&inflationAdjusted=true&annualPercentage=0.0&frequency=4&rebalanceType=3&absoluteDeviation=5.0&relativeDeviation=25.0&showYield=false&reinvestDividends=true&portfolioNames=true&portfolioName1=50%25+SPY+50%25+TLT&portfolioName2=100%25+SPY&portfolioName3=Portfolio+3&symbol1=SPY&allocation1_1=50&allocation1_2=100&symbol2=TLT&allocation2_1=50
It’s surprising that this particular 50% stocks and 50% bonds portfolio does as well as 100% stocks. If you run total bond market during the same time period that portfolio does a lot worse. TBM is roughly 60% government, 40% corporate, so it has higher correlation to US equities as people dump corporate bonds in a crisis. The 60% government includes mortgage backed securities which are callable, so likewise you don’t see benefits of rates dropping. If mortgage rates drop people refinance. In the past a ton of people flee to US treasuries for safety during market downturn, so 50% to TLT is viewed more as an insurance policy vs chasing yield.
So what’s in fashion now is taking a very safe and hedged portfolio like that and adding leverage to your risk tolerance. Around 3x is roughly equivalent to having the risk tolerance of 100% stocks, just with different correlations and fundamental factors. Adding that into the mix yields some impressive returns:
https://www.portfoliovisualizer.com/backtest-portfolio?s=y&timePeriod=2&startYear=1985&firstMonth=1&endYear=2020&lastMonth=12&calendarAligned=true&initialAmount=100000&annualOperation=0&annualAdjustment=0&inflationAdjusted=true&annualPercentage=0.0&frequency=4&rebalanceType=3&absoluteDeviation=5.0&relativeDeviation=25.0&showYield=false&reinvestDividends=true&portfolioNames=true&portfolioName1=50%25+SPY+50%25+TLT&portfolioName2=100%25+SPY&portfolioName3=50%25+SPY+50%25+TLT+3x+levered&symbol1=SPY&allocation1_1=50&allocation1_2=100&allocation1_3=150&symbol2=TLT&allocation2_1=50&allocation2_3=150&symbol3=CASHX&allocation3_3=-200
Now with the 3x levered portfolio you’re at a better worst year than 100% SPY (-17.39%), slightly more draw down risk (-58.96%), but CAGR is 24.14%, and final balance off the $100k is an eye popping $4.5m. Of course feel free to adjust leverage to your risk tolerance. 2x is still very nice and much less drawdown.
In order to get the leverage needed safely the Bogleheads have been using 3x ETFs. See Hedgefundie’s write ups:
https://www.bogleheads.org/forum/viewtopic.php?f=10&t=272007
With 2x or 3x ETFs you won’t be margin called and they have done well vs straight up margin loans, even in the volatility of 2008 using simulated data of the ETF borrowing expenses, etc, of the 3x *daily* leverage. The ETFs do have a slightly smaller portfolio value than borrowing on margin (about 5-10% less than spy/tlt on margin at interactive brokers rates), but in a taxable account the tax drag of 50% TLT’s dividends is about roughly equal to the ETFs which spit off very little dividends. In a tax-advantaged account you can’t borrow on margin so you’re stuck with using the ETFs. Only use ETFs for this as you get entitled to the underlying assets if they go to $0. ETNs are nothing more than an IOU note. That’s why SVXY is around while XIV bit the dust in the volatility ETFs.
Disclaimer: Now may not be the time to jump into specifically levered SPY and TLT with the current crisis. Right now there are proposals of funding various economic stimulus proposals in Congress by selling 25 and 50 year treasuries. 1 or 2 trillion hitting the market at once may increase yields and it could be a case of both stocks and treasuries going down. Or enter a position with some insurance with puts on the treasury side. Or the US treasury market is more liquid than anyone imagines and we dollar cost average the bonds over time to not disrupt the treasury market. Obviously this portfolio goes down massively if both stocks AND bonds go down and down. It’s also a bet on the current Fed being smart and not having rampant 1970s-1980s bond yields going up.
I think using leveraged ETFs is a bad idea. I disagree that most Bogleheads are using them. You have no evidence of that and to say such a thing is completely misleading. You’re also using the present tense when you should be using the past tense when describing results.
https://www.whitecoatinvestor.com/leveraged-index-funds-friday-qa-series/
Points to support PoF:
May not be worth for high income and high savers!
Chances are you already saving 25k – 30k via 401k/403b etc. double that if you are dual income household! If you have self employment income – add additional 20k at minimum towards self employed 401k + can easily double that for spousal. chances are 7k per year HSA. Some of lucky guns are doing Mega Backdoor Roth (don’t confuse with Backdoor Roth IRA) – that could be 20k/year.
You are saving nearly 100k/year or possibly more in various pre-tax/tax-efficient buckets already! You do your FV compounding math over 70 years – you’ve built a multi-generational wealth empire ! (Betcha real life wont be a smooth sailing- except for a few lucky ones!)
If you want to FIRE, or lean earning years (subattical, long life-experience vacations) – you could get opportunities to Roth Convert from Traditional IRA to Roth – occasionally)!
Are you quibbling you missing out a few tax advantaged bucks via Backdoor Roth (with the associated paperwork, and possible IRS questions) !?
To Support Brokerage accounts – the most important (and untold story) – is that, you can save practically UNLIMITED $$ amounts in there. There is no $6k etc limit on it ! Just shovel bucket loads of your savings into there paycheck after paycheck – and invest!!
Also – brokerage accounts allow you to Gift appreciates stocks to $15k- $30k as Gift to your near and dear who may be in lot more need and near/under 12% tax bucket (possibly double if recipient is married) who could use some help (I know it gets Sticky point among family circles! But you ‘could‘ do this is the point!!). These type of gifts could help some one needy in your own extended family circle to maintain dignity, go to decent college, or down payment for a house etc!
In addition- in current year like this – you possibly wipes clean TLH, last 3+ years of investments (or bad lots) in Brokerage, possibly earned $3k in tax write-off. Such TLH windows (bears/recessions) keep popping up once every decade !! Be TLH optimistic:-)
To support WCI points;
If you are currently in state-income tax free state – build a formidable Roth account there – then retire on a Beach when you retire. Touch wood – your Roth withdrawal remain tax free. In essence you didn’t pay state tax when you saved into Roth; and you are not paying state-income-tax upon withdrawals either. Nice !!
Roth building while in NY, and retirement in Florida- what a wasteful efforts doing Backdoor Roth (you will still come out ahead, but was all that backdoor-Roth effort worth it !?).
Hi Jim,
My wife and I have recently opened a 529 plan for our daughter and will partake of a small tax deduction on our state income taxes (NY).
Do you know, if separately, my parents can also open a separate 529 plan for our daughter (their granddaughter) and also partake of their own tax deduction on their state income taxes (also NY)
Thanks.
If they live in New York they can.
Get a state income tax deduction
If you’re a New York State taxpayer and an account owner, you may be able to deduct up to $5,000 ($10,000 if you’re married filing jointly) of your Direct Plan contributions when you file your state income taxes. Please consult your tax advisor. **
Thanks for the info!
Yes.