529 or taxable account?

[Eastfolk]

So I was on another FIRE forum and someone had commented that it wasn’t advantageous to invest in a 529 if you plan on retiring early. Rather, just throw that money into a brokerage account since you can plan your withdrawals to be tax free anyway, and without the limitations of a 529 (having to use it for education). Now I think whether this strategy is advantageous will be dependent on your individual facts and circumstances as there are many factors and considerations at play (is it likely my child will even utilize the account, state tax benefits, ability to convert a portion into a ROTH courtesy of the SECURE Act, etc.).

Looking at my own situation though, I am on track to FIRE in my mid 40s (currently 36) with a healthy mix of pre/post-tax retirement accounts and a taxable account, so I should have plenty of years to convert my pre-tax accounts at favorable tax rates or even completely tax-free. I currently have about $22k in my child’s 529 and was planning to open another one when my 2nd kid is born later this year, but now I’m second guessing whether I should just max out each of my kids’ 529 plan at $30k (the amount allowed to be converted into their future ROTHs) and throw any excess into my taxable brokerage. I live in a state with ~3% income tax so there is marginal benefit there, but not sure if that alone is worth losing the flexibility that comes with investing in a taxable account vs. a 529.

Hoping to get some advice/insight from the community on whether there are other considerations I should be taking into account or if others here have performed a similar analysis.

 

[bloom2708]

How about a 50-50 split?

State tax deduction and tax free growth are the benefits of the 529.

If you don't get a state tax credit and have a short window (say kid is 14 already), then just go taxable. Kid 1 was born in 2000 and didn't have as much growth as kid 2 born in 2003. Just the way the gains/losses went. Even if you go 60-40 over 17-18 years you will get growth. Tax free if used for qualified college expenses.

We did 50-50. It has worked with kids 1 and 2. I paid with some from the 529 and some from taxable each semester. Kid 3 is 2 years from college.

 

[anothercog]

I'm not quite following how you can plan your withdrawals from your taxable account to be tax free.

In any event, I opened 529 accounts for each of my 3 kids when there were born and simply made contributions every paycheck for 15 years and I'm glad I did. Makes paying for college a breeze.

I live in CA so my gains would have been taxed at 10% in my brokerage account. Much easier decision for me, I think.

Kid #1 is off to college now and may end up with a $50k surplus in his 529 due to scholarships. Though I suspect at least one of my 3 kids will go to graduate school so I'm sure we'll use it.

 

[Texas Proud]

I will say that one thing that I did not like about the 529 is that it hurt when it was time to see what help was available...


The calculation for what you can pay toward college (from what I was told) took 1/4 of what you have in the account when calculation what you can pay... it really hurt as that thew us way past the ability to get reduced tuition...



The good thing is that we are in state and will not have us go broke...

 

[GrayHare]

I'm not quite following how you can plan your withdrawals from your taxable account to be tax free.

+1

 

[rodi]

I have 2 kids currently in college. I saved in their 529s even after I retired (they were in middle school). The growth was great and was tax free.

If we'd saved in our regular brokerage account, we would have paid taxes on divs/cap gains/int along the way. 529 is tax free on gains for qualified expenses similar to a Roth for retirement savings.

I agree if you have a short horizon, they don't make sense. But we started saving in the 529s when the kids were babies.

I can see the argument for not overfundng them. Just stop contributing when it looks like you have close to enough. My kids attend State universities... We saved about $120k for them and that seems about right for undergraduate degrees.

For us, 529s were a good decision.
.

 

[anothercog]

I will say that one thing that I did not like about the 529 is that it hurt when it was time to see what help was available...


The calculation for what you can pay toward college (from what I was told) took 1/4 of what you have in the account when calculation what you can pay... it really hurt as that thew us way past the ability to get reduced tuition...



The good thing is that we are in state and will not have us go broke...

Yes, the 529 does count as your asset for financial aid calculation. But so would a taxable account. Retirement accounts do not need to reported (at least on the FAFSA, private schools use their own rules).

If the 529 is in your child's name as opposed to them being a beneficiary they it will be the child's asset and i think they'll calculate that 100% can be contributed.

We didn't qualify for a dime of financial aid.

 

[Eastfolk]

+1

Please correct me if I’m not thinking about this correctly since it’s obviously a big assumption in my analysis, but I believe I should be able to recognize up to $90k or so annually in LT capital gains and stay within the 0% tax threshold. As long as my taxable income is also below threshold levels; thus, my comment about having a good mix of pre/post tax accounts so I can manage my income in retirement.

 

[Eastfolk]

I have 2 kids currently in college. I saved in their 529s even after I retired (they were in middle school). The growth was great and was tax free.

If we'd saved in our regular brokerage account, we would have paid taxes on divs/cap gains/int along the way. 529 is tax free on gains for qualified expenses similar to a Roth for retirement savings.

I agree if you have a short horizon, they don't make sense. But we started saving in the 529s when the kids were babies.

I can see the argument for not overfundng them. Just stop contributing when it looks like you have close to enough. My kids attend State universities... We saved about $120k for them and that seems about right for undergraduate degrees.

For us, 529s were a good decision.
.

Good point about having to pay for taxes along the way on a taxable brokerage. I forgot about that. And my first kid is only 3 so the time horizon is not really the issue for me. I guess my concern is still that even though I fully intend for both of my kids to go to college or some other qualified education, what if they don’t. Say I save $120k for each kid and assuming current laws don’t change, I’ll be able to convert $30k into each kids Roth IRA. Is the remaining $90k x2 trapped unless I can find another beneficiary to use it on?

 

[SecondCor521]

Please correct me if I’m not thinking about this correctly since it’s obviously a big assumption in my analysis, but I believe I should be able to recognize up to $90k or so annually in LT capital gains and stay within the 0% tax threshold. As long as my taxable income is also below threshold levels; thus, my comment about having a good mix of pre/post tax accounts so I can manage my income in retirement.

You're talking about the 0% cap gains bracket.

Things to know / consider:

The ~$90K assumes MFJ tax status. You probably are now and hopefully will be so when your kids get to college.

It only works on LTCG, not STCG.

It's on taxable income, so you can add the standard deduction to that $90K amount.

But ordinary income also eats into the capital gains brackets, so you need to subtract Roth conversions, interest, dividends, side gig income, taxable SS, and maybe some others.

The 0% cap gains bracket may or may not be sunsetting in 2026. I'm honestly not sure but in your shoes I would check.

You'd still owe state taxes on it (but 3% doesn't sound too bad).

Even though taxed at 0%, the LTCG still adds to AGI, which broadly speaking impacts FAFSA and ACA subsidies.

It may still be a workable idea, but I'd recommend researching all the particulars.

 

[GrayHare]

The cap gains tax question is complicated by your other income. What is your marginal rate currently? What if your income increases before withdrawals are needed to pay tuition? Unless you have an unusual tax situation that 1) causes your taxes to be low or zero, and 2) you know this will continue to be the case for the next 20 years, the 529 is better because you can know from the start its gains won't be taxed.

 

[Eastfolk]

The cap gains tax question is complicated by your other income. What is your marginal rate currently? What if your income increases before withdrawals are needed to pay tuition? Unless you have an unusual tax situation that 1) causes your taxes to be low or zero, and 2) you know this will continue to be the case for the next 20 years, the 529 is better because you can know from the start its gains won't be taxed.

Right now, our HHI is about $330-$350k, so 24% marginal bracket. I should have been more explicit in my original post, but to clarify, my wife and I are planning on retiring in our early to mid 40s (both currently 36) so I don’t plan on having income for about 20 years until SS kicks in aside from interest and dividends from my taxable investments. We may want to perform some Roth conversions during this time though so that may factor in but directionally speaking, it sounds like there should be a sizeable opportunity to sell taxable investments at the 0% LTCG bracket. I do recognize that there will be some leakage in this process and on a standalone basis, the 529 will be more tax advantageous than a brokerage account. My question/concern is does that advantage outweigh the risk that I don’t end up utilizing the 529 (ie my kids don’t go to college) and have to pay 10% penalty to release the funds.

 

[SecondCor521]

My question/concern is does that advantage outweigh the risk that I don’t end up utilizing the 529 (ie my kids don’t go to college) and have to pay 10% penalty to release the funds.

Notes:

1. The 10% penalty is only on the earnings portion of the withdrawal.

2. It may be offset by the tax free growth inside the 529.

3. It may be offset by any up front tax deduction.

4. 529s can be transferred very easily to younger siblings, cousins, grandchildren, or parents.

5. 529s can be used for some trade/technical schools I think.

6. 529s can be rolled over into the kids' Roth IRAs (subject to some restrictions).

7. There is no time limit on using 529 funds. The kid can go to college at age 35 and still use it.

8. The 10% penalty can be excused for a number of reasons, including scholarships, military academies, and a few others.

 

[pb4uski]

My guess was that they were taking full advantage of the 0% tax rate for qualified dividends and LTCG.

 

[Closet_Gamer]

I would go 529. Hunt down any tax break. Grow tax deferred and it comes out tax free. In your shoes you probably won’t get financial aid regardless of how you structure it. It doesn’t impact merit aid.

As always, check into mgmt fees and investing options before choosing a plan.

 

[punkinhead]

In my state we get a tax credit of 20% up to $1500/year. So $7500 invested only costs us $6000. That's hard to beat.

 

[FlaGator]

We put money in 529s for each of our two children before they were 5 years old. Figured it would at least double before they needed it and would cover most, if not all of their college expenses. We weren't planning on ER at the time, we saw that as "insurance"- no matter what happened, they could go to school.

Fast forward 20 years - I was widowed 10 years ago, left my job a year later, the kids got scholarships, and there will be substantial balances when the last graduates in 3 years. Like nearly 1.5x the contributions substantial. Did we overfund the 529s? In hindsight, yes. Also in hindsight, those accounts eliminated concerns about college funding as a consideration when our lives changed. That's an "upside risk" I'm glad we took so many years ago .

With your specific ER plan, my recommendation is to think about the 529 decision in terms of risk mitigation. Fund them while you can at a level that eliminates the risk of not being able to cover the costs later (if that is your intent). If it turns out they don't need any/all of it, you have assets with known tax consequences that have grown tax-free for years. Deal with it then, if it happens.

You will want a variety of types of assets to fund your life during ER. With a 529 you have a source of tax-free funds to cover those eligible expenses.

 

[punkinhead]

Fast forward 20 years - I was widowed 10 years ago, left my job a year later, the kids got scholarships, and there will be substantial balances when the last graduates in 3 years. Like nearly 1.5x the contributions substantial. Did we overfund the 529s? In hindsight, yes. Also in hindsight, those accounts eliminated concerns about college funding as a consideration when our lives changed. That's an "upside risk" I'm glad we took so many years ago .

The beneficiary can be changed or up to $35K can be rolled into a Roth for the beneficiary. So that money can still be put to good use. We had a bit left over from our son's 529B so we just changed the beneficiary to our grandson.

Something I never thought about, but I wonder if I could have opened a 529B for myself, rolled my son's 529B into it, then rolled that into a Roth for myself? I have no intention of doing it since I plan to fully fund my grandson's 529B for the next several years but I'm curious if the above scenario is legit?

 

[GrayHare]

OK, if you are going to FIRE, yes, there will be a time period of no earned income that should facilitate Roth conversions and tax-free cap gains. In that case, whether 529 will benefit you is too close to call, in part because there are unknowns such as whether the 529 funds will even be needed. You could plug guesstimates into a spreadsheet and compare with and without 529 scenarios, of course. Eyeballing here from a distance says to 529 or not is not a obvious choice in the situation you have described.

 

[ncbill]

never did 529s because of our low income due to illness.

kids all used the military to pay their undergrad tuition.

thankfully, by the time they were heading off to undergrad i was able to pay their room/board, but paying for tuition was out of the question.

 

[SecondCor521]

Something I never thought about, but I wonder if I could have opened a 529B for myself, rolled my son's 529B into it, then rolled that into a Roth for myself? I have no intention of doing it since I plan to fully fund my grandson's 529B for the next several years but I'm curious if the above scenario is legit?

You could do the first part of rolling his 529 to your 529.

The second part would be problematic. There are two or three restrictions in the new 529->Roth rollover law that would trip you up: First, the 529 account has to be 15 years old before a Roth rollover can be done. Second, there is a "money must be in the 529 for five years" rule. Finally, the person still has to have earned income to support the 529->Roth rollover - if you're retired you may not have earned income.

 

[Dash man]

We currently have five 529 plans for three grandkids and a great-niece and great-nephew that lost their dad. We’ll be opening another for a new great-niece born this morning. Since we’re not the parents, I don’t believe it will count against them for financial aid. If not used we’ve expressed our desires to change the beneficiaries to another family member that might use it, in case we’re not around.
We also have custodial brokerage accounts for the grandkids, but not as much goes into them.

 

[Eastfolk]

OK, if you are going to FIRE, yes, there will be a time period of no earned income that should facilitate Roth conversions and tax-free cap gains. In that case, whether 529 will benefit you is too close to call, in part because there are unknowns such as whether the 529 funds will even be needed. You could plug guesstimates into a spreadsheet and compare with and without 529 scenarios, of course. Eyeballing here from a distance says to 529 or not is not a obvious choice in the situation you have described.

Thanks for confirming my thought process. I was worried that I might have been missing something obvious in my analysis, which is that I feel I can essentially replicate the advantages of a 529 (tax free withdrawals) via tax-free capital gains in my taxable account and at the same time avoid the limitations of the 529 (having to use it for qualified education expenses). Seems like taxable may have the (slight) edge.

 

[Eastfolk]

We put money in 529s for each of our two children before they were 5 years old. Figured it would at least double before they needed it and would cover most, if not all of their college expenses. We weren't planning on ER at the time, we saw that as "insurance"- no matter what happened, they could go to school.

Fast forward 20 years - I was widowed 10 years ago, left my job a year later, the kids got scholarships, and there will be substantial balances when the last graduates in 3 years. Like nearly 1.5x the contributions substantial. Did we overfund the 529s? In hindsight, yes. Also in hindsight, those accounts eliminated concerns about college funding as a consideration when our lives changed. That's an "upside risk" I'm glad we took so many years ago .

With your specific ER plan, my recommendation is to think about the 529 decision in terms of risk mitigation. Fund them while you can at a level that eliminates the risk of not being able to cover the costs later (if that is your intent). If it turns out they don't need any/all of it, you have assets with known tax consequences that have grown tax-free for years. Deal with it then, if it happens.

You will want a variety of types of assets to fund your life during ER. With a 529 you have a source of tax-free funds to cover those eligible expenses.

Thanks FlaGator for sharing your experience. But I'm not quite following your comment regarding risk mitigation. Wouldn't I be addressing this risk regardless of whether I'm contributing to a 529 or a taxable brokerage account if the intent of those funds is to pay for education expenses (e.g. college)? My question isn't necessarily whether I should fund my kids education expenses but rather which mechanism should I fund it through (529 vs taxable brokerage). The way I'm thinking about this (perhaps over-simplisticly) is would I rather have say $200k in a taxable brokerage or a 529 when my kids are college-age, knowing that I can withdraw from either one tax-free (maybe nearly tax-free in the case of the taxable brokerage). Seems to me like taxable brokerage is the slightly better option given there's no limitations as to what you can use it on if, using your own experience as an example, my kids get full scholarships to school. If you don't mind me asking, what do you plan on doing with the excess funds in the 529s? Assuming you'll convert $35k to each kid's ROTH IRAs? What about the remaining?

 

[Texas Proud]

Just going to throw out a thought for people who have a taxable account and are not trying to keep income down for ACA...


Why not sell gains each year that would be zero tax so you can keep your total untaxed gains down a bit?


I would be doing this if not for the ACA credits.. resets the cost basis... and you do not have to wait to buy it back as it is not a wash as it it not a loss...