529 Account Question

bilvihur

I've contributed to my grandkids 529 Education accounts for years, and there's probably more than will ever be used. Yet I still contribute to take advantage of NYS's $10K income tax deduction (6.57% marginal tax bracket). I know there's a 10% penalty on earnings for unqualified withdrawals. I figure I can leave the money in the accounts until after I've retired and in a lower tax bracket, but wonder if I should just stop funding and lose the deduction. Any comments?

msf

In NYS your tax bracket won't be that much lower in retirement - the first dollar of taxable income is taxed at 4%, and it doesn't take much ($23K for couples) to see that go up to 5.25% or even 5.9% (at $28K).

Of course NYS doesn't tax SS, so let's say that you'll be saving around 2% on the difference in rates between now and when you retire. (NY recaptures the deduction by taxing the past contributions when you make nonqualified withdrawals. See IT-201 Line 22.)

Assuming that the excess contributions earn a cumulative return of at least 20% over the years, the 10% penalty on the earnings will more than wipe out any savings on the NYS side.

Beyond that, what you've got is essentially a non-deductible IRA. The money goes in post-tax (federal), the earnings are sheltered, and then taxed as ordinary income rather than cap gains/qualified divs when withdrawn.

Post-tax contributions can make sense if you're planning to invest in very tax-inefficient funds, like the 529 Income Portfolio. But if you're planning on investing in something more tax-efficient, I don't think that nondeductible contributions pay off.

Here's another way to ask the question: are there readers who would contribute to a nondeductible IRA if they could not convert it to a Roth? If this is not a winner, and if the 10% penalty consumes any benefit you get from the (temporary) NYS tax deduction, then there's not an obvious benefit in making the excess contributions.

bilvihur

Thanks for that input, msf. What you say makes a lot of sense. Since what's done is done, I think I'll sit on it for a while, use it as a rainy day fund, then maybe use it for some charitable donations. Who knows, maybe the law will change for what a qualified withdrawal means.