In Part 1 of this series on advanced 529 plan strategies, we discussed creating a state tax deduction for private elementary and secondary school tuition under the new tax law for 2018. This change in the tax code is also the driving force behind strategy number two.
To recap, in 2017 and prior years, tax free distributions from 529 plans were only available for “qualified higher education expenses” paid to accredited post-secondary educational institutions. But the “qualified” definition was expanded in 2018 to include up to $10,000 per year, per child, for tuition paid to public or private elementary or secondary schools. Each state plan needs to approve this change for it to work.
The thrust of the strategy is this: If you have an existing 529 plan and you’re paying over $10,000 for your child’s private school tuition out of pocket anyway, why not request a $10,000 distribution from the child’s 529 plan, pay the school, and then add the $10,000 in cash you had earmarked for this year’s tuition back to the 529 plan to replace the distribution. In doing so, you will drain taxable appreciation from the account, and replace it with $10,000 worth of new tax basis. It’s a free basis step-up!
What does that mean? Let’s walk through it in more detail. Like any investment account, a 529 plan has a “tax basis,” which is equal to the amount you have contributed to it over the years. The difference between the basis and the market value is the untaxed income you’ve earned in the account, which can potentially be distributed tax free for qualified expenses, as discussed above. When you take distributions from the account, a pro-rated portion of the basis and the earnings are paid out with each distribution.
For example, if Sam has $100,000 in a 529 plan account with contributions of $60,000 funded over the years, then a distribution of $10,000 would be considered a return of principal of $6,000 and a distribution of $4,000 worth of untaxed income. The $6,000 of principal is always nontaxable and the $4,000 of earnings is nontaxable to the extent the entire $10,000 is used for those qualified expenses discussed. In this example, Sam would eliminate $4,000 of potential taxable income by going through this exercise, increasing the tax basis in the account to $64,000.
For those of you who have been diligently saving in 529 plans for years, you likely don’t want to deplete your child’s college savings by spending it now on primary or secondary education. If you can afford to pay for your child’s private school out of pocket and continue saving for college in your 529 plan, that’s likely the best way to go. But the strategy above can provide a small tax benefit if you execute it. It also has the potential to create additional state tax benefits. In Ohio, for example, an additional $10,000 of Ohio income tax deduction for each child carries over to future years. (This is explained in detail in Part 1 of the series.)
Granted, this will take a little extra effort, and it may never result in any federal tax savings. For example, if you end up withdrawing the entire account and spend it all on qualified college expenses, it’s all tax free anyway. But, if you have large account balances, and you think your children may be able to obtain some scholarships, you may end up with sizeable balances in their accounts when they finish college. (Yes, we are being optimistic here!) But if that’s the case, that’s where stepping up the tax basis over time can benefit you. You could distribute the 529 balance out to yourself or your child with a smaller tax impact and a smaller 10% penalty charged on those taxable earnings. This also works if you have a child who ends up not going to college, which could leave a large untaxed balance in that child’s 529 plan.
A few caveats to all of this:
- First, you want to ensure you fund the contribution after the distribution and not the other way around. There is a waiting period applied by each state before contributions can be withdrawn, and you don’t want to get hung up on that.
- Secondly, this strategy might disrupt the investment earnings of the 529 account a bit by being out of the market from the point of distribution to the point of the re-contribution, although this could also work in your favor.
- Lastly, there is a timing issue with 529 plan distributions where IRS guidance is lacking, so the conservative approach is to ensure the tuition payments and the 529 plan distributions both occur in the same calendar year. See Part 1 of this series for more details.
Keep an eye out for part 3 of this series focused on transferring your 529 plan to your heirs, coming soon
Contact Scott Swain at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.