529 Retirement Account

Using 529 Plans as Bonus Retirement Accounts

Investing for Retirement with a 529 Plan

Let’s talk about 529 plans. Should you use them as a bonus retirement account?

Of course, 529 plans are intended for future educational expenses.

They grow tax-deferred, and qualified educational expenses are distributed tax- and penalty-free. Kind of like a Roth IRA.

What about using a 529 as a bonus retirement account for those who are already maxing out available retirement plans, Health Savings Accounts and backdoor Roth IRAs?

Let’s look at investing for retirement in a 529 plan to see advantages and disadvantages.

Why Bother?

Why Bother?

I want to answer this question first, because it is important.

Super-Savers already maxing out available retirement plans including backdoor Roths and HSAs in order to maximize tax sheltered accounts. They are ultra-tax efficient and conscientious about their future.

What is the next step with your investment? Brokerage account investing is acceptable, as is Real Estate investments. We are not big fans of using variable for fixed indexed annuities around here (for the tax-deferral), so why not use a 529 plan for retirement? But They are Not Intended for Retirement, you say?

Think about this: Roth IRAs are not intended for use as retirement accounts for those who make above a certain amount (that’s why they have income limits). Yet, we use them through the backdoor!

HSAs are not intended as retirement accounts. Yet, they are! Possibly the best bonus retirement account.

Why not consider a 529 plan as a retirement account? We already use Roths and HSAs in an advanced way. Why not a 529? Is it worth it?

This is not a basic review of 529s. Don’t invest for your children’s education based upon what you read here. This is presented as a review of the advantages and disadvantages as using 529 plans as additional retirement accounts.

Advantages of Investing for Retirement in a 529

529s have no contribution limits, thus you can stuff as much money into one (or multiple plans) as you want. Individual states have contribution limits, but you can name yourself beneficiary of the 529 and use multiple state plans. In addition, there is no income limit.

You also might get a state tax deduction. For instance, a single person can get a 5.9% state tax saving on $3000 ($6000 for couples) in my home state. Free Money for contributing to a tax-deferred account!

That is the key: tax-deferred. There is no tax drag on the money invested in these accounts compared to money that is otherwise destined for a taxable brokerage account.

Consider using tax inefficient assets (such as REITs) or fully taxable bonds in your 529 retirement account, as called for depending on your asset allocation. Remember, asset location is important when you have different tax treatment of your accounts.

Downsides of 529s as Retirement Accounts

The largest downside is a whopper, but there are ways around it.

For non-qualifying withdrawals of 529s , you pay ordinary taxes plus a 10% penalty. This, seemingly, is a large hurdle to get over, but let’s break it down.

First of all, you don’t pay any tax or penalty on your basis. If you put in $100,000, you get that out free and clear.

Taxes and penalties are only paid on growth. Say your $100,000 grows to $150,000. If you pull the whole thing out, you would owe ordinary income taxes on $50,000 and have a $5,000 penalty. If you only pull out $75,000, you would owe ordinary income taxes on $25,000 (since 2/3 is your basis) and have a $2,500 penalty.

Let’s talk about these individually: ordinary income taxes and the penalty

Ways to Avoid Ordinary Income Taxes with 529 Retirement Accounts

Folks who retire early have an amazing Tax Planning Window, when their income is low after retirement (and prior to RMDs). This is the ideal time to do Capital Gain Harvesting with 0% taxes, partial Roth conversions, and even Roth ladders. What about harvesting your 529 retirement account in your 10 and 12% tax bracket? Or, if you can fill your standard deduction with a 529 withdrawal, there are no taxes owed.

Or, what if you have qualifying expenses during retirement? Do you want to be at least a half-time student in Europe for 6 months? No taxes owed for qualified expenses!

Finally, even if you don’t have children, 529’s are flexible. Someone in your extended family will have qualifying expenses. If you have enough money yourself, give it away. 529 plans can be a near-perpetual family education trust.

Or, if you need money, barter your 529. Name your niece or nephew beneficiary to get at the 529 tax-free; have your brother or sister gift you up to $15,000 a year.

Is that legal? In no way do I suggest doing anything shady. Tax evasion makes Uncle Sam sad. Just saying there are creative ways to use a 529. And this is for entertainment purposes only and not tax, legal, accounting, or other professional advice. Just saying.

What about the Penalty?

That 10% penalty is crux.

Without tax-drag—and this is key—how long does it take to make up that 10% on your investment?

Of course, that depends on what how you invest.

If you put the bonus retirement 529 in ultra-tax efferent assets, such as total stock funds with low turnover and qualified dividends, it will take decades. Qualified dividends are taxed at 0, 15, 18.8, and 23.8% rates, which are favored over ordinary income rates. Capital gains are taxed similarly, and you pay these (for the most part) only when you sell.

But if you are paying 23.8% on capital gains and need extra space if your tax-deferred accounts, a 529 retirement account effectively avoids paying taxes on dividends and capital gains.

So much so, consider the alternative. Some consider variable annuities or even permanent life insurance as a tax shelter for extra post-tax money. Though there are low cost investment only variable annuities out there, the expenses for those products is still more than the expenses of a 529.

I should mention expenses. Expect the expense ratio of 529 plans to be higher than those you pay for similar funds in a brokerage account. Some state programs are cheaper than others, but a 0.25% or higher increase in expense ratios is common.

Other Issues to Consider Before Investing

There are estate tax issues with 529s. They are considered irrevocable gifts, so not included in your estate for estate tax purposes. With an $11 Million plus exemption, this won’t be an issue for most.

In addition, many states have asset protection laws for 529 plans.

There may be issues with re-capture tax in your state.

In essence, 529s have issues that are state specific. You must do your own research!

Let’s look at an example to see if we can do 1% better with a 529 retirement account.

Example Demonstrating the Use of 529s as Retirement Accounts

Let’s look at a 30-year-old planning on retire early in 20 years. She makes $200,000 a year and contributes fully to her 401k with a match and a backdoor Roth IRA. Her healthcare plan is not HSA eligible.

She has a 45% savings rate and plans to take art and language classes in Spain during her early retirement.

She wants to look at contributing $6000 a year to a 529 for her own future use. Compare the 529 contribution with the alternative: $6000 additional saved in her taxable brokerage account.

529 Retirement Account

Figure 1 (Net Worth and Taxes using a 529 Retirement Account)

In figure 1, see the effect of a yearly 529 contribution over time on net worth and taxes owed. This doesn’t take into effect any state income tax deductions that may be present.

On the top, the blue shade is net worth after 30 years (thought $6000 is only added the first twenty years while working) compared to keeping everything in a taxable brokerage account in green. There is an additional $161,000 after 30 years as a result of less tax drag.

Taxes are on the bottom. Squint a little. Here, the light green sliver demonstrates the additional taxes paid if everything is kept in a taxable brokerage account. In dark green this time is the 529. Taxes saved:  $91,000 over 30 years.

So, in essence, the net result of 20 years of contributions to a 529 after 30 years: over $5000 more saved a year and $3000 less a year in taxes.

Components of Taxation for 529 Retirement Accounts

the 529 retirement plan

Figure 2 (Components of taxation for the 529 retirement plan)

In figure 2, we can see taxation of the brokerage account on the top, and with the $6000 yearly 529 contribution on the bottom.

Ok, you do have to squint again to see the difference. In blue is taxable salary. In green you have taxes paid on investment income. Note that on the top there is more green prior to and after retirement. In retirement, the brokerage account is used for income, so taxes paid on this account decrease over time.

Let’s look at the account balance over time using a 529 as a bonus retirement account.

Account Balances after 10 and 20 years

529 plan as a retirement account

Figure 3 (Amount in brokerage account, 529, and total amount after 10 and 20 years, in $100k)

After 20 years, there is $440,000 in the 529. This example is a bit absurd, I doubt anyone would want to save that much in a 529 Retirement Account, but work with me here a second.

After 10 years, you have $8,000 more (a 0.6% improvement), and after 20 years you have $55,000 more (1.6%). Using a 529 retirement account you can improve your return by more than 1%.

Lump Sum Example for a 529 Retirement Account

Instead of putting in money over time, what if you had a windfall of $500,000 that you wanted to invest? You could put it in your brokerage account, or you could put it all into 529 plans.

Again, there are no contribution limits and you don’t have to concern yourself with the yearly $15,000 gift tax exclusion since you are your own beneficiary of the plans.

 lump sum invested into a 529 retirement account

Figure 4 ($500,000 lump sum invested into a 529 retirement account)

Figure 4 shows account balances 20 years after lump sum investment. In this case, this woman earns $400,000 a year, so the numbers are a bit larger.

Here, there is more than $1.5M in a 529 after growth. Benefit from reduced tax drag over 20 years: $304,000 (5.4% more). Returns from lump sum investments will be higher than for yearly investments due to the fact all of the money is exposed to tax drag immediately with the lump sum.

Conclusion of 529 plan as a bonus retirement account

If you are a Super-Saver and already maxing out all of your tax preferred space, look into a 529 as a bonus retirement account.

This is especially true if you get a state tax deduction for a contribution, and there is no re-capture tax in your state.

There the money grows tax-deferred. Use it for your bond location, or other tax inefficient investments.

Next, spend the money! Give it away to grandchildren or other family members. Or, spend it on yourself. Pull it out during low income tax years and pay the taxes and 10% penalty. Or, take a 6 month education in Europe without paying penalties, or something else equally as juicy.

Using a 529 as a retirement account won’t rock your world, but for efficient Super-Savers neither will backdoor Roths or HSAs.

Consider it tax diversification; it’s always nice to have options.

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4 Comments

  1. Really interesting and novel take on the 529. I have read a lot about HSA accounts being stealth IRAs but not with 529s.

    I thought there was an upper limit to how much you can have in a 529. I belive it was capped at 300k. Maybe that is the most you can contribute and not final value of account.

  2. I had been wondering how the math would work out in cases like the ones you present. Thank you for doing the work!

    I had been on the fence on whether or not to continue funding our kids’ 529s, but we might as well keep on contributing to take the state tax deduction if nothing else.

  3. A very interesting point/deep dive into the tax ( or lack thereof ) implications of the 529ers. The tightrope walk between tax evasion & tax avoidance is a nuanced one. Great content per usual. It seems in the land of FIRE “Tech Bros”have been joined by a large number of physicians in this “space”. FIPhysician is on the Mount Rushmore of physicians with a FIRE tilt.

  4. Could be a good idea! I think it would give me incentive to eat better and live longer as well to have grandchildren.

    But I feel like I’m saving too much already. My four-year-old has $288,000 in his 529 plan. Perhaps instead of contributing another $15,000 a year from me and another $15,000 a year from my wife, we just let it ride.m

    We’re busy going through a pre-retirement checklist now.

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