Gaming the Tax System on College Savings Plans

by Kristina K. Bolhouse, CPA/PFS, CFP®

One of the enhancements of the Tax Cuts and Jobs Act of 2017, is the ability to use 529 College Savings Plans for K-12 tuition expenses. Specifically, up to $10,000 per year may be withdrawn from a student’s 529 plan for tuition expenses “at an elementary or secondary public, private, or religious school without incurring federal income tax on the earnings portion of the withdrawal.”

State income tax laws do not always mirror Federal tax laws. So, it is a good idea to be aware of the impact on a state level. For Arkansas residence taxpayers, the law does mirror the Federal law. Given that the state’s top tax rate is 7%, on its surface, this appears to be a good benefit.

Unlike Federal law, many states also provide a deduction in the year funds are contributed to the account. In Arkansas, this deduction is $10,000 on a joint tax return ($5,000 for single taxpayers.) We have heard rumors of various other tax and financial advisors suggesting that families attempt to “game the system”. That is, you put in $10,000 by the end of the tax year, and then take it out a short time later to pay for K-12 tuition. For most of our clients in the top state tax bracket, that appears to be $700 of “free money”.

We do not recommend this strategy for two reasons:

  1.  In a year like 2018 where the market lost money for the year, the taxpayer has created a lot of commotion for no real benefit. In the Arkansas accounts, the “aggressive growth fund” lost 9.26%, and most of that loss occurred in the last month of the year. That means $10,000 of funds deposited on January 1 would have lost $926 for the year. If the grand plan was to withdrawal to funds on January 1 the following year to gain a $700 tax benefit, the taxpayer would have come out on the losing end of that deal by $226. Funds deposited in December would have had even greater losses.
  2. The flip side of this scenario of “gaming the system” is what could be lost by pulling out funds when the market is quickly rising. The same aggressive growth fund that lost money in 2018 had a banner year in 2017—a gain of 23.16%. If a taxpayer pulled funds out on January 1st to pay K-12 tuition, they would have lost $2316 of potentially tax-free gain.

Most of our clients take a long-term view when they are planning for education expenses. They wisely know the power of compounding earnings and the advantage of keeping funds invested.

Conversely, we know situations come up where taxpayers may have financial emergencies and may need to pull funds out of a 529 Plan for K-12 tuition. This tax provision should be used more for that reason. Or, if it becomes apparent that a student has a change in the long term education plan—and there are no siblings for whom the account can be transferred. That too would be a possible legitimate use of this expanded tax rule.

Our point is simply this: Gaming this system for short term benefit may seem like a brilliant idea on its surface, but our recommendation is to skip this one. In the long run, we think taxpayers will come out ahead by sticking to their savings plan and reap the benefits of long-term tax free growth.

IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by The Arkansas Financial Group, Inc.-“AFG”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from AFG. Please remember that if you are a AFG client, it remains your responsibility to advise AFG, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. AFG is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the AFG’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request. Please Note: AFG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to AFG’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

Leave a Comment