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 Specifically, up to $10,000 per year may be withdrawn from a student’s 529 plan for tuition expenses “at an elementary or secondary public, private, or religious school without incurring federal income tax on the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.

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