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A 529 plan is typically associated with saving for education expenses, offering substantial tax advantages for this purpose. However, a creative approach can help high-wage earners to also utilize 529 plans as part of their retirement strategy. While this approach may not be conventional, it can provide additional benefits when planned strategically.
Understanding 529 Plans
529 plans are tax-advantaged savings plans designed to encourage saving for future education costs. They are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code. When used for qualified education expenses, earnings in a 529 plan are not subject to federal tax and generally not subject to state tax.
However, if the funds are withdrawn for non-qualified expenses, the earnings portion is subject to federal income tax and a 10% penalty. The definition of qualified education expenses is broad and can include tuition, books, supplies, and even room and board at eligible educational institutions. Beneficiaries can range from unrelated people to the very owner of the account.
Utilizing 529 Plans for Retirement
High-wage earners often max out contributions to conventional retirement accounts like 401(k)s and IRAs. As such, they are constantly looking for additional tax-advantaged ways to save. A 529 plan can be part of this strategy, albeit indirectly.
One way to use a 529 plan for retirement savings is to fund education for future generations. Let’s assume the person wants to set up a gifting strategy. They can contribute to a 529 plan for their children, grandchildren, or even future grandchildren, thereby reducing their taxable estate. Overall contribution limits are set by each state and range from around $235,000 to $529,000 per beneficiary depending on the state in which you reside. Once the contributions reach the limit set by the state, you can't contribute any more to it, but the account can continue to grow through investment earnings. The funds grow tax-free and can be withdrawn tax-free for education expenses, thus potentially saving substantial amounts in taxes. If the designated beneficiary does not need the funds for education, the plan owner can change the beneficiary to another family member.
But what if you don’t have a beneficiary and would rather spend the money on yourself or yourselves? High-wage earners can establish a 529 plan with themselves as the beneficiary to pursue lifelong learning in retirement. Many retirees go back to school to pursue passions and interests, so setting aside funds for this purpose can be a smart strategy.
Moreover, the IRS rules allow for the withdrawal of up to $10,000 per year from 529 plans for repayments of student loans. This means that high earners who have outstanding student loans can potentially contribute to a 529 plan, let the investment grow tax-free, and then withdraw the money to pay off their student loans, gaining a tax benefit.
What if you have no further educational pursuits, but a large amount in a 529 that you’d like to use for yourself? The draws would be “non-qualified”. One option here could be to wait until retirement, thereby forcing your income and tax brackets down to very low levels. State and Federal rules state that, for non-qualified 529 draws, only the earnings portion of the non-qualified withdrawal is subject to federal income tax. Additionally, the earnings portion is typically subject to a 10% federal penalty tax. For non-qualified withdrawals, California typically mirrors federal treatment. This means the earnings portion of the non-qualified withdrawal would be subject to California state income tax. So, imagine a person who recently retired, and wishes to take a non-qualified distribution from their 529 account. The account may have $200,000 in contributions over time and have earned $200,000 in capital gains. You want to take $50,000 for a long, bucket-list vacation, so you draw the $50K from your 529. In essence, you’d pay a low federal tax rate (let’s assume an effective rate of 11%), plus California state tax of 10%, plus the 10% Federal penalty. It seems high but remember that your other income sources are very low since you’re not earning income. If you include the standard deduction or your itemized deductions along with other tax write-offs, your overall tax rates on the 529 draw could be minimal. Of course this takes careful planning.
While a 529 plan is primarily an education savings vehicle, it can be a part of a comprehensive retirement strategy for high-wage earners when used creatively and strategically. However, given the complexities and potential risks involved, individuals should consult with a financial advisor or tax professional before implementing such a strategy. With careful planning and execution, high earners can leverage 529 plans to further their retirement savings goals. Don’t hesitate to reach out to our team at Aspire Planning Associates if you have any questions! Call us at (925) 938-2023, and schedule an appointment today.
