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I have two young children and am thinking about how to best save for their futures. I have read a lot about 529s and mutual funds (index, tax efficient ones) and was trying to get an outside opinion. I am shying away from 529s because the money can only be used for college expenses. In 13 years, colleges may be non-existent, free, or something else unpredictable. In addition, my students will have the choice of studying in the US or the EU, but it seems like 529s limit them to the US. Finally, if they get a scholarship for their tuition, I feel like in using the 529, they will come up against a lot of restrictions.

On the other hand, with a mutual fund, they are free to spend the money as they please. Yet, there are a lot more taxes and fees involved too. Since we are not talking about great sums of money, and since I am in the 25% tax bracket, I'm not sure which would be better.

Could I please have some advice?

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One big advantage that the 529 plan has is that most operate like a target date fund. As the child approaches college age the investment becomes more conservative. While you can do this by changing the mix of investments, you can't do it without capital gains taxes.

Many of the issues you are concerned about are addressed: they are usable by other family members, they don't hurt financial aid offers, they address scholarships, they can be used for books or room and board.

Many states also give you a tax break in the year of the contribution.

  • 529s can hurt financial add offers. – mkennedy Jun 15 '15 at 19:44
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I'm in a similar situation.

First, a 529 plan can be use for "qualifying" international schools. There are 336 for 2015, which includes many well known schools but also excludes many schools, especially lower level or vocational schools and schools in non-English speaking countries.

I ran 3 scenarios to see what the impact would be if you invested $3000 a year for 14 years in something tracking the S&P 500 Index:

  1. Invest in Vanguard's 500 Index Portfolio in their 529 plan and withdraw it for qualifying use.
  2. Invest in the same 529, but withdraw it for non-educational use.
  3. Invest in Vanguard's S&P 500 Index Fund in a taxable account

For each of these scenarios, I considered 3 cases: a state with 0% income tax, a state with the median income tax rate of 6% for the 25% tax bracket, and California with an income tax rate of 9.3% for the 25% tax bracket.

California has an addition 2.5% penalty on unqualified distributions. Additionally, tax deductions taken on contributions that are part of unqualified distributions will be viewed as income and that portion of the distribution will be taxed as such at the state level.

Vanguard's 500 Index Portfolio has a 10 year average return of 7.63%. Vanguard's S&P 500 Index fund has a 10 year average return of 7.89% before tax and 7.53% after taxes on distributions.

Scenario 1

Use a 529 as intended:

                                      No State Tax   6% State Tax    California
                                      ------------   ------------   ------------
Investment Return Rate:                      7.63%          7.63%          7.63%
State Income Tax Rate:                       0.00%          6.00%          9.30%

Total Contributions:                   $45,000.00     $45,000.00     $45,000.00
Gains:                                 $31,148.36     $31,148.36     $31,148.36
Value After 14 Years:                  $76,148.36     $76,148.36     $76,148.36
State Income Tax Deductions:           $     0.00     $ 2,700.00     $ 4,185.00
Total Value Including Deductions:      $76,148.36     $78,848.36     $80,333.36

Taxes and penalties on withdrawal:
Federal Income Tax     @ 25%:          $     0.00     $     0.00     $     0.00
Federal Capital Gains  @ 15%:          $     0.00     $     0.00     $     0.00
State Income Tax       @ State Rate:   $     0.00     $     0.00     $     0.00
Federal Penalty        @ 10%:          $     0.00     $     0.00     $     0.00
State Penalty          @ State Rate:   $     0.00     $     0.00     $     0.00
------------------------------------  ------------   ------------   ------------
Total after taxes and penalties:       $76,148.36     $78,848.36     $80,333.36 

Effective return rate:                       7.63%          8.06%          8.29%

Scenario 2

Use a 529 but do not use as intended:

                                      No State Tax   6% State Tax    California
                                      ------------   ------------   ------------
Investment Return Rate:                      7.63%          7.63%          7.63%
State Income Tax Rate:                       0.00%          6.00%          9.30%

Total Contributions:                   $45,000.00     $45,000.00     $45,000.00
Gains:                                 $31,148.36     $31,148.36     $31,148.36
Value After 14 Years:                  $76,148.36     $76,148.36     $76,148.36
State Income Tax Deductions:           $     0.00     $ 2,700.00     $ 4,185.00
Total Value Including Deductions:      $76,148.36     $78,848.36     $80,333.36

Taxes and penalties on withdrawal:
Federal Income Tax     @ 25%:          $ 7,787.09     $ 7,787.09     $ 7,787.09
Federal Capital Gains  @ 15%:          $     0.00     $     0.00     $     0.00
State Income Tax       @ State Rate:   $     0.00     $ 4,568.90     $ 7,081.80 
Federal Penalty        @ 10%:          $ 3,114.84     $ 3,114.84     $ 3,114.84
State Penalty          @ State Rate:   $     0.00     $     0.00     $   778.71
------------------------------------  ------------   ------------   ------------
Total after taxes and penalties:       $65,246.44     $63,377.54     $62,349.64 

Effective return rate:                       5.70%          5.33%          5.13%

Scenario 3

Invest in a S&P 500 Index fund in a taxable account:

                                      No State Tax   6% State Tax    California
                                      ------------   ------------   ------------
Investment Return Rate:                      7.53%          7.53%          7.53%
State Income Tax Rate:                       0.00%          6.00%          9.30%

Total Contributions:                   $45,000.00     $45,000.00     $45,000.00
Gains:                                 $30,537.35     $30,537.35     $30,537.35
Value After 14 Years:                  $75,537.35     $75,537.35     $75,537.35
State Income Tax Deductions:           $     0.00     $     0.00     $     0.00
Total Value Including Deductions:      $75,537.35     $75,537.35     $75,537.35

Taxes and penalties on withdrawal:
Federal Income Tax     @ 25%:          $     0.00     $     0.00     $     0.00
Federal Capital Gains  @ 15%:          $  4580.60     $  4580.60     $  4580.60
State Income Tax       @ State Rate:   $     0.00     $ 1,832.24     $ 2,839.97
Federal Penalty        @ 10%:          $     0.00     $     0.00     $     0.00
State Penalty          @ State Rate:   $     0.00     $     0.00     $     0.00
------------------------------------  ------------   ------------   ------------
Total after taxes and penalties:       $70,956.75     $69,124.51     $68,116.78

Effective return rate:                       6.75%          6.42%          6.24%

Conclusion

Given similar investment options, using a 529 fund for something other than education is much worse than having an investment in a mutual fund in a taxable account, but there's also a clear advantage to using a 529 if you know with certainty you can use it for qualified expenses. Both the benefits for correct use of a 529 and the penalties for incorrect use increase with state tax rates.

I live in a state with no income tax so the taxable mutual fund option is closer to the middle between correct and incorrect use of a 529. I am leaning towards the investment in a taxable account.

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You can take the money back out of a 529 plan if you end up not having enough educational expenses to use it on. The penalty is 10% of the earnings (you don't pay a penalty on the principal).

You can also open a 529 in any state, not just the one where you reside. The minimums and fund selection for each state can vary widely, so it makes sense to look around and see if there's a state with a fund selection you like.

  • So, are you saying the 10% penalty would probably be less than any taxes and fees I'd pay on a mutual fund? – Acornrevolution Jun 15 '15 at 13:04
  • I'm saying that the impact of the penalty may be much lower than you previously expected if you thought that the penalty applied to the principal also. I can't tell whether or not it would be less than taxes and fees, I'm thinking of it more like being "not as bad" if you do a 529 and then don't use it for educational expenses. – briantist Jun 15 '15 at 16:50

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