I'm hoping someone can either verify or correct my understanding of the tradeoff between overfunding a 529 versus putting that money in a taxable investment (in case you don't end up needing it for college expenses). What's got me thinking about this is that there is such a wide gap between the costs of in-state college tuition and out-of-state or private college tuition (e.g. ~10 years from now, a typical instate 4 year degree will cost ~$150K vs. ~$350K for a private) .
It seems possible to me that there is some sort of inflection point between those 2 amounts where the potential 10% withdrawal penalty for non-qualified expenses (ignoring for the moment any of the various techniques to use excess 529 funds such as changing to another beneficiary) exceeds the benefits from the tax-free growth of the investment, compared to a similar taxable investment vehicle like a mutual fund.
Below are some rough back of the envelope calculations I've done, but I'd like to know if I'm missing something major here?
Let's use the values above as a thought experiment and assume that college for the beneficiary is 10 years away, we already have a 529 with sufficient balance to equal $150K in 10 years and we are going to contribute an additional $600 per month to an either a 529 or a similar, taxable mutual fund. (For those following at home, let's also assume a 6% rate of return, 22% federal tax rate, and 5% state tax rate)
Based upon several online calculators I plugged number into, the 6% rate of return on the tax-free account shrinks to 4.5% for the taxable account. Hence, after 10 years the net new effective investment value is ~$100K in the tax-free 529, versus ~$93K for the taxable account (either a $28K gain or a $21K gain on the $72K principal).
What I'm unsure about is what that net effective investment value the online calculators show truly means in regards to paying capital gains taxes. I think what it means is that after 10 years, you've been paying annual taxes on the dividends in the taxable account, and hence the actual statement balances you would be seeing in both accounts would be $100K or $93K. Once you liquidated either investment you'd still need to pay capital gains tax (assume 15% on gains in both accounts), in addition to a 10% penalty on the 529 for unqualified expense withdrawal.
Hence, your in pocket amount would actually be $100K - 25% of $28K = $93K for the 529 or $93K - 15% of $21K = $90K for the mutual fund. Thus it actually makes sense to put that $600 a month into the 529 instead of the taxable mutual fund. Extrapolating this to virtually any level of investment seems to indicate there isn't any situation where it makes more sense to put the funding into a taxable account vs. a 529.
Is my logic sound here or am I missing some sort of factor that potentially would make a taxable investment better in the long run than then non-qualified expense penalty?
