Using a 529 Account for Retirement Savings

Does it make sense to invest in a 529 plan to help fund your own retirement? This is a question that Dr. Jim Dahle has been asked a number of times.

Yes, these plans are designed to be used for educational expenses, and there is a penalty when you use them for other things. On the other hand, there can be up-front tax deductions when making contributions, and the money in the plan grows tax free. Could the tax advantages offset the potential penalty?

The good doctor runs some numbers in an attempt to get to the bottom of this strategy. Interestingly, his conclusion differs from that of the FI Physician, but they used different taxation assumptions and time horizons.

This post was originally published on The White Coat Investor.

 

529 account for retirement savings

 

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.

 

 

 

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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 (PoF: plus state income tax where it exists). 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.

 

 

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.

 

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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!

 

8 thoughts on “Using a 529 Account for Retirement Savings”

  1. Thanks for the mention, and my blog does provide a nice contrary opinion in this case.

    The main issues one might have with WCI’s post is in his last sentence: “Plan on spending yours on someone’s education.” (Emphasis mine).

    If you spend the 529 on your education, then there is no tax and no penalty, and clearly you are better off saving in a 529 rather than a brokerage account.

    The point: 529’s have amazing flexibility to be used for your retirement (educational) expenses, and worse comes to worse you leave them to the grandkids.

    Reply
    • That is my plan for the leftover 529 funds from my kids. I’ll let it grow tax free until I retire. Then, I’ll use it for my education. I’m going to really enjoy that semester at sea.

      Reply
  2. Subscribe to get more great content like this, an awesome spreadsheet, and more!
  3. Hard to find a list of adult educational activities that would qualify as a 529 expense. Golf lessons? US sailing certifications? Education abroad (minus the travel)? Online classes? Yoga retreat? CME? Annual medical meetings? Anyone have any insight on this? There has to be a way to use the 529 in (semi-) retirement for qualified educational expenses!

    Reply
  4. If you saved for an expensive private school and your child goes to a cheaper state school and you appear to have over-funded, you can make withdrawal(s) each year directly to your child, pay the 10% penalty, and likely pay little or no taxes, assuming that your child files as an independent (wealthy people probably don’t get much for claiming college-aged kids), utilizing their $12400 exemption and then low tax rate. They also get tax credits that would be phased out for wealthy parents…..including stimulus money! Use that excess 529 money to buy junior a car or a trip to Europe backpacking during the summer, etc or something that you would have paid for anyway.
    Keep in mind that when your child applies to graduate school that any money that they have will count against them when being considered for financial aid so do just keep it in their name.

    Reply
  5. Thanks for a good review. A couple points to add for those still saving.
    1) not all expenses you will have when your child goes to college are covered expenses.
    I ended up about 8% overfunded. If not careful you could greatly overfunded.
    2) the year I retired I did take an online public health class from UNC. Not only did the 529 cover the tuition, it also covered the laptop I needed to meet the requirements of the course. It’s been 6 years. Time for another class!
    3) and now that I have a grandchild, I rolled the remainder into her account. From what I understand any disbursement from my account will count as income for her.
    But if my payments are reserved for the junior and senior years it won’t impact financial aid (under current guidelines), except maybe if grad school occurs.

    Reply
  6. Does the GI Bill count as scholarship in this case?
    I have transferred the GI Bill to my oldest 2 (of 3) kids, so one of them will get college cost covered, if I wanted to, could I withdraw from their 529 account penalty free if they were on the GI Bill?
    The more likely scenario is transfer their 529 to one of the other kids, but trying to think through possible options.
    Thanks!

    Reply

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