Why I like tax-free internal compounding, and why you might (and might not)

Last month I wrote about a range of available non-retirement investment accounts and broke down some advantages and disadvantages of each. When it came to 529 college savings accounts, reader flyernick had some objections to my math:

“On one hand, you’re arguing that at withdrawal, you get to exempt $12000 in gains because of the std. deduction. Then you compare that, ‘In a taxable account, meanwhile, you’d owe taxes annually on every dividend and capital gain distribution’. But, you get that same $12000 exemption every year on annual distributions. And of course, ‘taxes on the sale of the asset itself’ would only apply to (un-distributed) cap gains. Your example here fails to convince me that paying an additional 10% tax 20+ years down the road is a useful strategy.”

I want to address flyernick’s specific objection and also expand on my logic to show why I think tax-free internal compounding is valuable enough that it’s worth paying some amount for under the right circumstances.

529 accounts are uniquely valuable because of the option of tax-free withdrawals

I know my readers have heard this a thousand times already, but let’s do a quick rundown of the benefits of 529 plans again:

1. limited, state-dependent tax benefits;
2. unlimited tax-free internal compounding;
3. unlimited tax-free qualified withdrawals.

The state tax benefits are typically not very interesting, but high-income folks in high-tax states should certainly maximize their home-state benefits before contributing to a low-cost plan like Utah’s My529 (formerly UESP) or Vanguard’s Nevada-based plan.

The tax-free internal compounding is a feature shared by 401(k)’s, 403(b)’s, IRA’s, and even variable annuities — more on this in a moment.

But the ability to make tax-free qualified withdrawals of both your contributions and your earnings turns 529 plans into super-charged Roth accounts for anyone who may ever spend money on anyone’s higher education expenses: they have preposterously high contribution limits, no income limits, tax-free dividends and capital gains, and tax-free withdrawals.

This is a crime against the American taxpayer, but as long as the crime is being committed for the benefit of the wealthiest people in the country, it would be irresponsible for the rest of us not to join in.

What is the value of tax-free internal compounding?

With that out of the way, we can focus on nickflyer’s specific question: what is the value of tax-free internal compounding, and how much should you be willing to pay for it? Let’s take two stylized, but true, historical examples.

• Between July 1, 2009, and June 30, 2018, Vanguard Total Stock Market Investor Shares had a price appreciation of about 200%: $100,000 invested at the beginning of the period would have turned into $301,900 at the end of the period, and this appreciation would be tax free under any circumstances, as long as you held your shares for the entire period, since we don’t tax capital gains until they’re realized. But you also would have received $32,212 in dividends and capital gains distributions, and those would have been taxed along the way. Capital gains tax rates have bounced around a little bit but if you were in the highest capital gains tax bracket (23.8%) for the entire period, you would have owed a total of $7,667 in taxes over the 10-year period. In the lowest long-term capital gains tax brackets, you would have owed nothing on those distributions.
• Between July 1, 2000 and June 30, 2009, Vanguard Total Stock Market Investor Shares had a price appreciation of negative 32%: $100,000 invested at the beginning of the period would have turned into $68,639 at the end of the period. During the same period, you would have received $12,349 in dividends and capital gains distributions, and paid a top federal tax rate of 20%, or $2,470.

Importantly, in these examples it doesn’t matter if you reinvest your dividends and capital gains; the taxes are owed no matter what you do with the money.

Using the same two time periods, with the same $100,000 invested in the same mutual fund, but with dividends and capital gains reinvested and allowed to compound tax-free, the corresponding final values would be $356,174 and $79,522, respectively. With the investment made in a 529 plan or other account with tax-free internal compounding, the investor has so far saved $7,667 or $2,470 in federal taxes owed, plus whatever rate their state levies on capital gains and dividends.

What happens when we try to get the money out of the 529 plan? For the 2000-2009 investor, this is not a problem at all: they’re allowed to withdraw their entire balance, including dividends and including capital gains, tax- and penalty-free, because the amount of the withdrawal is lower than the amount of their contribution. The 529 plan “wrapper” has saved them $2,470 in federal taxes with no downside at all (except the opportunity to harvest capital losses). Obviously they’d prefer if their decade of investing had a positive, instead of a negative, return, but that’s what you get when you invest at the peak of a stock market bubble and sell at the bottom of a global financial crisis.

What about the investor who put $100,000 to work in July, 2009? Sure, they’ve saved $7,667 in taxes along the way, but now they’re facing an account balance that is 72% gains ($256,174 of their $356,174 balance). For simplicity, say they convert their Vanguard Total Stock Market Investor Shares to cash at the end of the period, so they’ll face a total of $25,617 in penalties whenever they withdraw that balance: 10% of the gains on the account, plus of course their ordinary income tax rate on the share of the gains they withdraw.

Based on our stylized example, we can now easily see four possible outcomes:

• The account falls in value, and non-qualified withdrawals are completely tax- and penalty-free;
• The account maintains its value, and withdrawals are completely tax- and penalty-free regardless of whether they are qualified or non-qualified;
• The account increases in value, and non-qualified withdrawals are taxed and penalized;
• The account increases in value, and qualified withdrawals are tax- and penalty-free.

Only in one of the four cases, where you have an appreciated account with non-qualified withdrawals, does the 529 account have any downside compared to the same investment in a taxable account. In the case of accounts that fall in value or maintain their value, withdrawals remain tax- and penalty-free while dividends and capital gains compound internally tax-free, and in appreciated accounts used for qualifying expenses dividends, capital gains, and price appreciation are permanently tax-free.

Conclusion

I’ve assembled these facts not to give nickflyer a definitive answer to his question, but to reframe it slightly.

A person who has certain knowledge about the future trajectory of the stock market should invest in the stocks that are going to go up the most. In that case, tax loss harvesting, tax-deferred accounts, and other opportunities to game the tax code are a sideshow compared to the business of buying the stocks that are going to go up and selling the ones that are going to go down.

But if you have no idea which stocks are going to go up and which are going to go down, then 529 plans give you the opportunity to make lop-sided bets: if they go down, you’re allowed to withdraw your principle, your dividends, and your capital gains tax-free. If they go up, you only have to pay taxes and penalties on your earnings, and only for non-qualified distributions. And if you’re able to make qualified distributions, your earnings, dividends, and capital gains are permanently tax-free.

The 10% penalty and ordinary income taxes levied on non-qualified distributions has to be weighted by the likelihood and magnitude of non-qualified distributions of gains. And as I mentioned in the original post, you can make those odds even more lop-sided by opening multiple accounts and horse-racing them against each other: make qualified withdrawals from the most appreciated accounts, and non-qualified withdrawals from accounts that have fallen in value, maintained their value, or appreciated the least, while all your accounts compound internally tax-free.