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So Says the 529 Guru

No. 14
Joe Hurley
Wednesday, July 28th 2004

Question: I have a good chunk of money to set aside for college in a 529 plan but I’m a little concerned that it might grow to be more than my child will really need if she attends the state university. Please explain how it works if I withdraw from my 529 account when there is extra money in it after paying all the college bills, and whether it might be worth using a 529 plan even if I eventually have to pay some tax and penalties. Chris A., New York

Answer: A nonqualified distribution occurs whenever 529 plan withdrawals exceed the account beneficiary’s qualified higher education expenses. Let’s assume you withdraw $10,000 from your 529 account in a year, but your child (the 529 plan beneficiary) incurs only $7,000 in qualifying tuition, fees, room and board, books, and supplies during that same year. You’ll have to deal with a $3,000 nonqualified distribution when filing your taxes.

Under federal tax law, the earnings portion of the nonqualified distribution is taxed at your ordinary income rate plus a 10% penalty rate. Only a pro-rated portion of the nonqualified distribution represents earnings; the rest is a non-taxed and non-penalized return of contributions. You will receive a Form 1099-Q from the 529 plan administrator that breaks out these components. You may also owe state income tax on the earnings (and perhaps on the contributions as well, if you previously deducted them against your state income tax). California is the only state that imposes a separate earnings penalty (2.5%) on 529 nonqualified distributions received by its residents.

The 10% federal penalty, but not the ordinary income tax, is waived where the withdrawal is attributable to the beneficiary’s death, disability, or receipt of a tax-free scholarship. The penalty is also reduced or eliminated in cases where tuition costs must be subtracted from 529-qualifying college costs because the Hope or Lifetime Learning credit is being claimed.

Now let’s take a look at how the risk of future nonqualified withdrawals may affect your decision to use a 529 plan. Using The 529 Expense Analyzer (a calculator that Savingforcollege.com has developed and is currently testing)—along with some reasonable assumptions concerning the investor’s tax rate, future tax law changes, and 529 expenses—I can show that today’s $5,000 contribution into a 529 account invested in a 50/50 mix of stock and bond funds will produce about $13,200 for college18 years from now. That’s 10% more than the $12,000 produced by an equivalent investment in taxable mutual funds over the same time period. If the 529 funds came out as nonqualified distributions, however, the net after-tax withdrawals would be only $10,200, or almost 15% less than the mutual fund investment.

Based on that analysis, it’s easy to see that “over-funding” a 529 plan may not be a wise decision.

Another way to look at this issue is by determining the “breakeven” year for nonqualified distributions. In other words, how long does it take for the tax deferral benefit in the 529 plan to overcome the tax and penalty cost of a nonqualified distribution?

The answer is not good news for anyone who may be viewing a 529 plan as a supplemental retirement account. The annual tax deferral benefit in my example analysis is less than the additional 0.40% expense ratio I’ve assumed for the 529 plan. Breakeven never occurs. Even if we assume the 529 plan has no additional expenses beyond the underlying fund expenses, breakeven is 53 years away.

The breakeven analysis is sensitive to many factors. For example, it produces more favorable results for 529 investors who prefer the no-fee “guaranteed” options available in some 529 plans; the interest earned on that type of investment outside a 529 plan is highly taxed. If we substitute a 4% fixed return for the 50/50 mix of stocks and bonds used in the example above, the tax deferral benefit of the 529 plan exceeds the tax and penalty cost beginning in year 27. Another situation where the tax impact of a nonqualified distribution is lessened is where your future ordinary income tax rate is lower than your current tax rate. This can happen as a result of your retirement. It can also be accomplished in some cases by making your beneficiary the “distributee” of the 529 withdrawal, so that the earnings are taxed at his or her lower tax bracket.

If you find that you have more money in your 529 account than you can take out on a qualified basis, despite your best intentions to use it for your child’s college expenses, your best bet may be to keep it parked in the 529 plan. As long as you don’t have an immediate need for the funds, you may ultimately want to pass it down to future-generation family members for their college costs, and in so doing you will avoid the tax and penalty cost of a nonqualified distribution.

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