Now that the holiday season is behind us, it’s time to make some progress on those New Year’s resolutions to improve your control over your personal finances. This article is the first in a three part series focused on saving for college through 529 plans. Most are familiar with these tax-favored college savings vehicles, so we’ll skip the basics and discuss advanced strategies to “supercharge” the tax efficiency of these vehicles. Note that, in most cases, the larger your account balance is, the better these strategies will work.
The first strategy is a fairly simple one designed to take advantage of the changes to 529 plans made available starting in 2018 under the Tax Cuts & Jobs Act. 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. Note that the states sponsoring the plans need to approve this change to allow these expenses to qualify as tax-free distributions at the state level, so there could be some state taxes depending on where you live. Plans in Ohio, Maryland, Pennsylvania and Wisconsin, to name a few, have been updated to treat these as qualified distributions at the state level.
Some states also offer annual income tax deductions or credits for 529 plan contributions. Ohio, for example, offers a $4,000 tax deduction per year, per child for contributions made to the Ohio plan. The combination of the Federal K-12 provision and these state tax benefits create an opportunity to generate state income tax savings for school tuition that parents are already paying anyway. It’s a great reason to open new 529 accounts if you haven’t already.
Here’s a simple example of how the deduction could work for an Ohio resident. John has a child in a private elementary school that costs $4,000 per year after grants, etc. In the past, John paid the school $4,000 out of pocket. Now let’s say that, instead, John deposits $4,000 into an Ohio 529 plan at the beginning of 2021 and invests it in a money market fund. When the time comes to pay the tuition in the fall, John takes a withdrawal of $4,000 from the 529 plan to pay the tuition. He has now created a $4,000 Ohio income tax deduction, which at an assumed 4% income tax rate saves him $160 in Ohio taxes.
If that doesn’t sound like a lot, multiply that times 12 years of school, and you’re looking at $1,920 in tax savings, per child. It’s also fairly simple to do, particularly after the account is set up the first year, and doesn’t cost John anything. In fact, he keeps whatever interest he earns in the 529 on top of the tax savings and hopefully it encourages him to start saving for college as well. Note that these results will vary by state, as each state has its own rules regarding income tax deductions or credits.
Now let’s take this a step further. What if John is actually paying $10,000 a year for tuition for each child? Well, only $4,000 is deductible per year in Ohio, but the other $6,000 carries over indefinitely to future years. So, down the line, the tax deductions will keep rolling in for John even after he stops funding the 529 plan at the end of high school.
A couple of caveats here. One is that the deposit needs to remain in the account for some period of time before it can be withdrawn. In Ohio, seven days is the minimum currently, but this will vary by state. This isn’t a real deterrent to the strategy at this point, but the states may start to lengthen this time period to keep people from executing this strategy purely to create a tax deduction. Ideally, you would frontload the next tuition payment well in advance of when it’s due, but keep an eye on the time limit if you’re cutting it close.
The second caveat is that there is a timing issue with 529 plan distributions, particularly for second semester payments. Guidance from the IRS on this is unclear, so the conservative approach is to make sure tuition payments and 529 plan distributions both occur in the same calendar year. This is easy if the second semester payments are due in December. You simply take the distribution and make the payment in November or December. If second semester payments are due in early January, it can get trickier. In that case, you want to both take the distribution and pay the tuition in January. A direct payment to the school from the 529 plan in January might be a good option in this case.
Stay tuned for part two of this series focusing on boosting the tax basis in your 529 plan.
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.
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