Why 529s Are Not a Stealth IRA – The White Coat Investor – Investing & Personal Finance for Doctors

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:

1. 15% the entire time
2. 23.8% during the 30 years and 15% at the end
3. 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.

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!