529 plans vs. taxable savings (NYS)

[PSUgrad2]

Long time (10 year) lurker - I think this is my 3rd post or so. Have learned a ton from this place over the years, and will continue to read and learn

A bit about us - DW and I have been fortunate to both have solid professional careers, and to both have naturally good control of expenses. My 401k is more than maxed (salary growth has caused it to now drive a few $k of post-tax savings each year), her 403(b) is saving a healthy % (without match), and at least for now we're not eligible for Roth's. The rest of our savings goes to a taxable account (international and domestic index funds), or occasionally against our 4.875% mortgage. We're comfortable with the nest egg we've built so far (~$500k) and except to continue to save.

With our first little one on the way, I'm starting to rethink what to do with our extra savings for the next couple of years. The deduction for NY ($10k max for couples I think) is making the 529 plan pretty attractive. I'm thinking about maxing that out for 2-3 years right away, reducing our taxable savings by that amount. The NY fund allows Vanguard index investments with a 0.25% expense ratio, which while not the best available, doesn't seem that bad given the deduction for state taxes.

Anything I'm missing, or should really consider before doing this? While there are restrictions on how the 529 funds can be used, the state tax deduction seems worthwhile enough to warrant at least a few years worth of contributions early, while they have the max time to grow. We can always switch back to the taxable account after getting a strong and early start to the college savings.

Any thoughts?

[gindie]

Quote:

Originally Posted by PSUgrad2 and at least for now we're not eligible for Roth's.

Since there is no longer an income limitation for converting Traditional IRA's to Roth's, you can fund a Non-deductible Traditional IRA and then immediately convert to a Roth, thereby circumventing the stated income limits for a Roth.

If you have no other deductible IRA's, then you would owe very little (or probably no) tax on the conversion because it wouldn't have had time to grow. If you do already have some funds in a deductible IRA, then unfortunately, you'd have to prorate based on the Non-deductible vs. deductible ratio.

[PSUgrad2]

Quote:

Originally Posted by gindie Since there is no longer an income limitation for converting Traditional IRA's to Roth's, you can fund a Non-deductible Traditional IRA and then immediately convert to a Roth, thereby circumventing the stated income limits for a Roth. If you have no other deductible IRA's, then you would owe very little (or probably no) tax on the conversion because it wouldn't have had time to grow. If you do already have some funds in a deductible IRA, then unfortunately, you'd have to prorate based on the Non-deductible vs. deductible ratio.

Ah - is this what people mean when they "back door" a Roth? Couple of questions:
1) Can I rinse and repeat this every year, or is it a one-time event?
2) Does it matter that we already have Roth's that we started years ago? We contributed to them annually while we were eligible. Can I convert the traditional IRA into the existing Roth and manage them as one account?

[Lusitan]

I'm in the same boat as you -- well, a similar boat, just a few years ahead of you down the river ...

We started a 529 (NY as well) for our first child in the year he was born, and maxed out the 10K contributions to it for the first 3 years of his life. When kid #2 came around, we opened one for her and then split that year's 10K contribution between them.

I mulled it over same as you are doing, and decided that while a 529 was not perfect, it made sense to take advantage of it at least up to the maximum (state) tax deductible amount. NY's 529 is a decent plan with Vanguard, with reasonable expense ratios, and that was an important factor.

As for long-term plans, I suppose we'll continue funding the max pre-tax amount each year while we're still working (and, of course, still working in NY). I hope to be FIREd long before the youngest reaches college-age, so the contributions will stop at some point. In that sense, I'm front-loading the 529s just as you are considering.

We haven't decided exactly what our goals are in terms of paying for all or some of college for the kids, but I suppose I'd consider it a pretty good deal for them if we save enough for each of them to either (a) pay for a full 4 years at a good state school or (b) pay at least part of the cost of a more expensive private school, the balance of which they can cover with loans and/or scholarships. The choice will be theirs to make.

Like you, we were already maxing out all available tax-favored retirement options, so this was just a choice between taxable savings or the 529. I'm not planning on filing for bankruptcy soon (or ever) but the fact that 529 plans have built-in protection against creditors under federal law was a factor in the decision. (Any investment vehicle that puts my money out of reach of lawyers is a good thing, in my opinion.)

[jIMOh]

Ask this question-

Would you qualify for federal tax credits for education this year (if this was the year you paid for college). AGI under 180k=yes. Fast forward inflation adjustments to credits in 18-22 years, do you think you would still be eligible?

The credits are a good return, usually about a 75% return on money spent. Spend $4000 and get $2500 back (62.5% return).

The amounts change each year (now credit is 100% of first $2000 spent and 25% of next $2000 spent).


I would then ask a different question pertaining to mortgage and 529 plan.

If you invested $4000 now (this year) into 529 plan, what is the return on that money? The Vanguard fund would possible get a 62.5% return with a certain amount of risk taken (return is over the life of investment, not in one year). If you paid down your mortgage by $4000, would you save more than $2500 this year in mortgage interest? Obviously paying down mortgage is less risk than the 529 investment.

So if your mortgage would be paid off within next 18 years (before child starts school), it is possible that beats the state tax deduction savings+529 gains.

[PSUgrad2]

Thanks for the advice and comments - much appreciated.

Lusitan - sounds like we're in very similar spots, with similar long-term goals. Appreciate the perspective from someone a couple of years ahead of us.

jIMOh - will have to give the tax credit idea a bit of thought too - perhaps as we fine tune things we'll plan to work in both. Our eligibility will seemingly depend on whether we both continue to work 18 years from now, or whether one of us has retired by then. Probably not something we want to count on at this point, but something to stay cognizant of as a possibility.

[gindie]

Quote:

Originally Posted by PSUgrad2 Ah - is this what people mean when they "back door" a Roth? Couple of questions: 1) Can I rinse and repeat this every year, or is it a one-time event? 2) Does it matter that we already have Roth's that we started years ago? We contributed to them annually while we were eligible. Can I convert the traditional IRA into the existing Roth and manage them as one account?

"Back-door Roth" sounds like a way to describe it.

1) It can be done every year, unless Congress plugs the loophole.
2) I believe you can, as far as the IRS is concerned. That might be up to your Roth custodian. I've never read anything to the contrary.

Just remember, if you have ANY deductible-IRA money, then each conversion will consist of both a deductible and non-deductible portion, even if the actual monies converted came from only your "pass-thru" non-deductible IRA.

[sirion]

Keep in mind with the so-called backdoor Roth, that if you can roll any existing tIRA funds into your employer's 401k, then you can avoid the tax proration issue.

[urn2bfree]

529 not only gets you the tax deduction--but grows tax free and can be taken out tax free to spend on education....I gotta think 529 is the way to go.

[aida2003]

Quote:

Originally Posted by jIMOh Ask this question- Would you qualify for federal tax credits for education this year (if this was the year you paid for college). AGI under 180k=yes. Fast forward inflation adjustments to credits in 18-22 years, do you think you would still be eligible? The credits are a good return, usually about a 75% return on money spent. Spend $4000 and get $2500 back (62.5% return). The amounts change each year (now credit is 100% of first $2000 spent and 25% of next $2000 spent). I would then ask a different question pertaining to mortgage and 529 plan. If you invested $4000 now (this year) into 529 plan, what is the return on that money? The Vanguard fund would possible get a 62.5% return with a certain amount of risk taken (return is over the life of investment, not in one year). If you paid down your mortgage by $4000, would you save more than $2500 this year in mortgage interest? Obviously paying down mortgage is less risk than the 529 investment. So if your mortgage would be paid off within next 18 years (before child starts school), it is possible that beats the state tax deduction savings+529 gains.

That's a great post that drew my attention because we've been saving for our kids' education. Here's my question to Jim or anyone knowledgeable about this college saving and taxes.
If I save in a 529 plan, it means this particular money is not eligible for claiming the education credit on taxes, correct? But if today's $4k funding came from a taxable investment account, it would be eligible for the tax credit for education, right?
Would $4,000 of I-bonds qualify for a federal tax credit for education if that $4k is already not taxed on the federal level (not sure about states) assuming it's used for college expenses and parents' AGI is below the imposed threshold? My guess would be that double favorable treatment on the 1040 form is not allowed....

[jIMOh]

Quote:

Originally Posted by aida2003 That's a great post that drew my attention because we've been saving for our kids' education. Here's my question to Jim or anyone knowledgeable about this college saving and taxes. If I save in a 529 plan, it means this particular money is not eligible for claiming the education credit on taxes, correct? But if today's $4k funding came from a taxable investment account, it would be eligible for the tax credit for education, right? Would $4,000 of I-bonds qualify for a federal tax credit for education if that $4k is already not taxed on the federal level (not sure about states) assuming it's used for college expenses and parents' AGI is below the imposed threshold? My guess would be that double favorable treatment on the 1040 form is not allowed....

Always read the IRS documents on this.

http://www.irs.gov/pub/irs-pdf/p970.pdf
check page 10

Quote:

Did you use the same expenses to claim a deduction or credit, or to figure the tax-free portion of a Coverdell ESA or QTP distribution?

page 11 expands on above

Quote:

• Claim an American opportunity credit based on the scholarship or fellowship reported as income on the same expenses used to figure the tax-free portion of a distribution from a Coverdell education savings account (ESA) or qualified tuition program (QTP).

This could change year to year, so its important if you are "banking" on the credit to help fund college, or justify a specific part of a financial plan that you (or your tax person) keep up on this.

My interpretation

529=no tax credit
Ibonds in taxable account=yes tax credit