Academic journal article Financial Services Review

Section 529 Plans as Retirement Accounts

Academic journal article Financial Services Review

Section 529 Plans as Retirement Accounts

Article excerpt

Abstract

Section 529 plans were created to provide tax incentives for savings for qualified higher education expenses (QHEE). Earnings in 529 plans are tax-free if withdrawals are made for QHEE, otherwise there is a 10% penalty on the earnings, which are taxed at ordinary rates. Although nonqualified withdrawals are subject to a 10% penalty on the earnings, taxes on the earnings are deferred until withdrawal. This paper examines the use of section 529 plans as retirement accounts by comparing after-tax and after-penalty future dollars from section 529 plans with after-tax future dollars from ordinary taxable investments and tax-advantaged annuities. © 2003 Academy of Financial Services. all rights reserved.

JEL classification: D91; Gl 1; G2; G23

Keywords: IRA; Retirement planning; Saving; Tax planning

1. Introduction

Federal legislation was passed in 1996 to allow states to create section 529 plans. The plans, named after the Internal Revenue Code section, are created by the states to provide tax incentives to save for qualified higher education expenses (QHEE). With legislative changes made in 2001, earnings in 529 plans are tax-free if withdrawals are made for QHEE. Otherwise, earnings are taxable when withdrawn and subject to a 10% penalty. (Because original investment dollars into the plan are made with after-tax dollars, their withdrawal is not taxed.) Though fund limits and institutional details differ from state to state, 529 plans are functionally (economically) equivalent to Roth IRAs for qualified withdrawals.

Investments in 529 plans may be subject to gift taxes if the lifetime exclusion has been fully used and the annual contribution exceeds the maximum exemption (currently $1,000,000 lifetime exclusion and $11,000 per donor per recipient per year exemption) but only earnings are subject to penalty and income taxation.

Although nonqualified withdrawals are subject to a 10% penalty on the earnings, taxes on the earnings are deferred until withdrawal. Thus, for individuals who have already optimized deductible IRAs and deductible employee savings options and are attempting to invest additional dollars for retirement, such plans may be a more optimal savings vehicle than investing after-tax dollars in traditional investment assets or in tax-deferred annuities.

This paper examines the use of section 529 plans as retirement accounts. Future dollars available for consumption from section 529 plans derived from nonqualified withdrawals (i.e., for retirement as opposed to education purposes) are compared to future dollars available for consumption from ordinary taxable accounts and to future dollars available for consumption from tax-advantaged annuities.

2. Previous research

A significant amount of research has analyzed tax-advantaged savings alternatives with much of the research focusing on traditional IRAs versus Roth IRAs. For example, Krishnan and Lawrence (2001) review the previous literature and analyze various IRA options and taxable investments. They compute after-tax future values for each of the various options and explore sensitivity to investment horizons, investment returns, and, more significantly, differing tax rates in the present and future. In general, the Roth IRA dominates the traditional, deductible IRA unless future tax rates at the time of withdrawal are less than current tax rates. This result depends on the assumption about available funds at time of investment. If one assumes equal before-tax investments in the deductible and Roth IRAs and tax rates do not change, both IRAs result in equal future after-tax values (see Grain and Austin, 1997). Krishnan and Lawrence (2001) assume the investor makes equal after-tax investments, and reinvests the tax savings from the deductible IRA in taxable investments that are taxed each year. Both the deductible IRA and Roth IRA dominate nondeductible IRAs and taxable investments. The comparison of nondeductible IRAs with taxable investments depends on the form (ordinary income vs. …

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