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Let’s say that I am maxing out my 401(k), IRA, and HSA; I’m putting away $250 a month in a 529 I own with my kid as the beneficiary; and any take-home income left over at the end of the month goes into a taxable brokerage account invested for early retirement, or whatever I want. So, I am prioritizing aggressively saving and investing for retirement, but also trying to save some for my kid’s education.

Let’s say I’ve also got $80,000 in a savings account generating something like $250 a month in taxable interest. I don’t expect to need this reserve for anything, but I don’t intend to invest it either. I want a large, safe, liquid cash reserve just to have it.

The 529 plan I’m in has an investment option that aims to provide capital preservation and is FDIC-insured. This option is designed to offer stability and security similar to a traditional savings account, with returns potentially comparable to those of a savings account. So, it occurred to me that if I stick $80k cash reserves in there, ~$250 per month would be kicked off tax-free right inside the 529 where I can direct that to a longer-term investment option I’m investing in for education, without having to make comparable, post-tax monthly contributions to the 529.

It is my understanding that I can take the contributions out of the 529 tax and penalty free whenever I want. (It’s the earnings that can be subject to tax and penalties, not post-tax contributions.) So that $80k would still serve as safe, liquid reserves for any purposes, even if I contributed it to the 529, so long as I kept the basis in the FDIC-insured option in there.

I just want to know if there’s any reason I didn’t think of that this would be a bad idea?

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    The first part (contributions are tax and penalty-free) is correct, but 529 plan withdrawals are done on a pro-rata basis, so if you have $80k of contribution and $20k of accumulated earnings, every non-qualified distribution will be 80% non-taxable and 20% taxable.
    – Stan H
    Nov 27, 2023 at 5:02
  • Well, that blows up the whole idea, then. Thank you. Nov 27, 2023 at 5:39
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There are several things you have to be concerned about.

The details regarding the 529 vary by state. Some of the states give a state tax break to people who are tax residents of their state. If you take the tax break, and then you don't use the funds for education, some of them (all?) will claw back the tax break.

The contribution is considered a gift, so if a person gifts more than the annual gift tax exclusion, they will have to count the excess against their lifetime exemption. The IRS does allow a person to superfund the contribution where they combine 5 years of contributions, and then include the contributions on their next 5 years of tax forms.

All withdrawals either for qualified expenses, or for non-qualified reasons, are always split between contributions and earnings. Those earnings will be taxable and subject to the 10% penalty.

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  • Good. Thanks. Your state tax break point doesn’t apply, but I didn’t specify the plan, so you’re right to raise it. Your first two points can be worked around by using an out-of-state plan (if applicable) and spreading the large contribution over multiple years (to work around gift tax law), so valid concerns, but minor arguments. Your last point, though, is that withdrawal rules work out such that each withdrawal consists of return of both contributions and earnings. So, every single non-qualified withdrawal is penalized. That makes it hard to justify the idea regardless of implementation. Nov 29, 2023 at 12:25

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