529 investment over state tax break amount?

[tmark]

I am not sure we are doing the right thing with our daughters (ages 1yr and 4 1/2yrs) 529 plans.

Is it better to invest more into the 529 plans (over the Maryland state tax break amount) since the money is tax free at withdrawal if used for their higher education or is it better to invest in a taxable account outside of the plan for flexibility? I like the idea of having the money "ear-marked" for each of them instead of a catch-all account.

What happens to the 529 money if it is not used by one/both of them? Can we withdrawal it and just pay taxes on it? Is the penalty greater than if we just put it in a taxable account to begin with?

Thank you for your thoughts!

[jfoxcpacfp]

If the money is not used for higher education and you withdraw it, you will pay taxes plus a 10% penalty on all earnings unless it is not used because your child got a full scholarship, then the penalty (but not the taxes) is waived.

You can change the beneficiary once a year but, if you do not have any more children, that might not be feasible unless you wait until your grandchildren go to college. In the meantime, your money is locked up in a 529. I'm definitely not one who thinks you should sock away lots of money in a 529, but you should contribute enough to get your state tax break.

You can also contribute $2k per child to an ESA (Education Savings Account) annually (small but more flexible), then I would recommend a taxable account.

[conniebird]

Most MDs cannot do an ESA as there is an income limit

[conniebird]

Also, if you do just the min, you won't have anywhere near the amount needed for college. If your kids don't go to college or grad school, you can hand it off to grandkids.

You can also do a UTMA if you're worried about not being able to use 529, but the money then belongs to them once they turn 18-25 meaning you cannot control what they spend it on.

[jfoxcpacfp]

conniebird wrote:

Most MDs cannot do an ESA as there is an income limit

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Yes, i understand, but there is an easy workaround. Just gift the $ to the child, a grandparent, or friend (anyone who qualifies) and they make the contribution. Sorry, s/h included that in my original answer. Don't recommend an UTMA or UGMA, kids at 18 tend to be highly unpredictable and that's the age of majority in almost all states.

[tmark]

Thank you! Appreciate all the feedback.

[conniebird]

jfoxcpacfp wrote:

conniebird wrote:

Most MDs cannot do an ESA as there is an income limit

Click to expand…

Yes, i understand, but there is an easy workaround. Just gift the $ to the child, a grandparent, or friend (anyone who qualifies) and they make the contribution. Sorry, s/h included that in my original answer. Don’t recommend an UTMA or UGMA, kids at 18 tend to be highly unpredictable and that’s the age of majority in almost all states.

Click to expand...

Oh that's pretty sweet actually. The child can have an ESA in their name???

[jfoxcpacfp]

Yes, the child can make the contributions.

[TheGipper]

jfoxcpacfp wrote:

You can change the beneficiary once a year but, if you do not have any more children, that might not be feasible unless you wait until your grandchildren go to college. In the meantime, your money is locked up in a 529. I’m definitely not one who thinks you should sock away lots of money in a 529, but you should contribute enough to get your state tax break.

 

Click to expand...

I believe you can change to another qualifying beneficiary (ie younger sibling) as often as you want.  It is the same beneficiary rollover (ie changing between different state 529 plans) that is limited to once year and the interplan change of investments (ie change from target date to static) that is now limited to twice a year.

I think saving 50% of one's total anticipated needs in a 529 (with the rest in a taxable account) is a smart move provided that one is willing to keep it heavily invested in equities, preferably can frontload it, and is in a high marginal income bracket.  Otherwise the tax free growth benefit probably doesn't outweigh the risk and loss of flexibility vs a taxable account.

[MichaelB]

I personally have put all of my kids' college savings in our 529 (no state tax deduction to speak of) and none in taxable accounts. I like having the money specifically earmarked for college so there is no temptation to spend it on something else. Having the earnings compound and grow tax free at that age is huge also. There is a risk they don't use it all and you will get hit with taxes and penalty but you can transfer from one to another.

A compromise would be to put enough in a 529 to cover 4 year in state undergrad costs (no idea what that projects at but wild guess is you would need $150 to $200k each in 14-17 years when they are 18), then on top of that fund a taxable college account to cover private colleges, grad school, etc. Check with a fee only planner to help with estimating college costs. Good luck!

[ShadowDoc]

jfoxcpacfp wrote:

conniebird wrote:

Most MDs cannot do an ESA as there is an income limit

Click to expand…

Yes, i understand, but there is an easy workaround. Just gift the $ to the child, a grandparent, or friend (anyone who qualifies) and they make the contribution. Sorry, s/h included that in my original answer. Don’t recommend an UTMA or UGMA, kids at 18 tend to be highly unpredictable and that’s the age of majority in almost all states.

Click to expand...

Wouldn't you lose the federal income tax deduction if you do this 'backdoor ESA' ? I live in an income tax free state with a lottery and free state U tuition and therefore there seems to be little to compensate for the illiquidity of the ESA and 529. I have been considering using a taxable account to keep the money as a 20's fund like WCI talks about rather than locked in to pay specifically for tuition. I wonder if anyone else is in this situation.

[jfoxcpacfp]

ShadowDoc wrote:

Wouldn’t you lose the federal income tax deduction if you do this ‘backdoor ESA’ ? I live in an income tax free state with a lottery and free state U tuition and therefore there seems to be little to compensate for the illiquidity of the ESA and 529. I have been considering using a taxable account to keep the money as a 20’s fund like WCI talks about rather than locked in to pay specifically for tuition. I wonder if anyone else is in this situation.

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What federal income tax deduction are you referring to?

[ShadowDoc]

My mistake I thought ESA contributions were pre-tax.

[Raster]

One factor not yet mentioned is the asset protection benefits of 529 plans.  In most states they are very strongly protected which is very attractive to some people.  Given the cockamamie asset protection schemes some doctors are using, a fully funded 529 plan seems sensible.  The 529 plan is also outside of your estate for estate tax purposes, which is very helpful in some states with low estate tax thresholds.  You can do all this, and NO taxes or penalties are due on the basis of the 529 plan contributions, only the earnings.

I'm planning on using the entire account for the kids/grandkids college and grad school, but it's nice to know that even if they don't take advantage of it, the contributions and minor penalty will be probably worthwhile.

 

[TheGipper]

For the cost conscious out there and those without a state tax break,  MA Fidelity Index 529 is now the lowest or among the lowest cost, with even target date 529 options weighing in as low as .11%, now that Fidelity has markedly cut index costs to match Vanguard.  This puts it below the cost of Vanguard 529 plans NV (0.17%), NY (0.16%), and UT (prob around .22% at lowest depending on your portfolio).  Now an extra .11% of Fidelity over Utah isn't going to break the bank, but given Fidelity's excellent customer service and reported ease of withdrawal to rival Utah, it is an excellent choice for those who want to stick to index funds and don't care particularly for DFA.  Also, if most of one's other investments are with Vanguard, its also a nice hedge to park some at another institution.