529 Accounts
March 18, 2024• [parenting] #financeWhat are 529 accounts?
Savings account you can create for your children (or yourself) to be used for the purpose of education. Think of it as another index fund (if you choose to use the money you put in to track the S&P 500). The main advantage is money you contribute can grow tax-deferred. Every state offers at least one 529 plan. Many states in the USA even offer some sort of tax deductions for these accounts.
Examples:
- Ohio offers $4000 per beneficiary each year.
- South Carolina offers the full contribution as a deduction.
California does not offer any type of 529 tax deduction, but the gains are tax-deferred, and qualified withdrawals are tax-free. You can also withdraw up to $10,000 without a tax penalty to pay for qualified expenses for grades K-12.
You can contribute a maximum of $18,000 each year. If you give more than $18,000 in cash or assets (for example, stocks, land, a new car) in a year to any one person, you're supposed to file a gift tax return.
What's the penalty if I use if for non-education purposes?
- The earnings portion will be subject to ordinary income taxes and a 10% penalty.
What's superfunding?
You can choose to front-load large contributions to a 529 plan without having to pay gift taxes. This is a maximum of $90,000 (in 2024) as a lump sum you can invest. It is treated as if it were spread over a five-year period.. For married couples filing taxes jointly, the maximum contribution is $180,000.
The advantage of superfunding is that the money can compound. As recorded on the wealthfront page:
To pay for your child to attend UCLA, you could either save $720 over 18 years, for a total of $155,520. Or you could deposit $103,439 today — and let it grow over the next 18 years.
Research from Vanguard suggests that if you’re deciding between investing a lump sum today or dollar cost averaging it into the market (where you invest a portion of the total sum on a regular schedule), lump-sum investing tends to yield a higher ending balance on average
What are the tax implications of superfunding in USA?
If superfunding, report to IRS and indicate it's being spread over five years. This must be done for each of the five years.
Aside from the superfunding, gifting more than $18,000 to an individual in a calendar year means you must file a gift tax return, but it doesn’t necessarily mean you’ll pay gift taxes. In addition to the annual gift tax exclusion, there’s also a lifetime gift tax exemption. Anytime you give more than the annual gift tax limit in a single year, the excess contribution will count against your lifetime gift tax exemption.
The lifetime gift tax exemption is $13.61 million in 2022 ($27.22 million for a married couple giving jointly). It’s been raised from $12.92 million for 2023.
Now show me the math
Using the calculator here
Base case: starting with an initial investment of of $18,000, we are going to allow it to compound over the next 18 years. The interest rate is 5% compounding monthly. Every month, we will contribute $1500. This means for every year for the next 18 years, we will be infusing the fund with $18,000. At the end of 18 years, our compounded results will be $567,993.18. So that's a total contribution of $324,000 over the next 18 years, for a return of approximately $243,000.
Regarding the interest rates chosen, I am using the S&P 500 returns as a frame of reference. For the 10 years ending December 31st 2023, S&P 500 had an annual compounded rate of return of 12.02%, including reinvestment of dividends. 5% is a conservative estimate, considering that adjusted for inflation, the 100-year average stock market return (including dividends) is 7.4%.
| Initial Investment | Monthly Contribution | Length of time | Interest Rate | Compounded Results |
|---|---|---|---|---|
| $18,000 | $200 | 18 | 5% | $114,030.56 |
| $18,000 | $1000 | 18 | 5% | $393,392.17 |
| $18,000 | $1500 | 18 | 5% | $567,993.18 |
| $18,000 | $1000 | 18 | 10% | $708,647.70 |
| $85,000 | $0 | 18 | 5% | $208,675.72 |
| $85,000 | $0 | 18 | 10% | $510,398.94 |
| $120,000 | $0 | 18 | 5% | $294,601.01 |
Which provider should I choose?
As mentioned above, each state has at least one plan. As of this moment, Ohio comes highly recommended for two reasons:
- Freedom to choose what to invest in.
- Communication and transparency regarding the investments.
Wealthfront offers its 529 plan as well, with fees ranging from 0.42% to 0.46%. The Vanguard 529 has an expense ratio of 0.14% in comparison.
For 529 plans by states, visit this page.
Does a 529 plan impact financial aid eligibility?
Maybe. Parent owned 529 plan seem to reduce aid by up to 5.64%. See here for details.
Can I move 529 account providers?
Yeah.
Resources
- Superfunding a 529
- IRS 529 fact sheet
- Comments on 529 as a great generational wealth transfer tool, and how expensive colleges in USA is. One can't go wrong in being aggresive with 529.