Case study: Could a 529 state tax deduction offset the costs of a non-qualified withdrawal?

http://www.savingforcollege.com/articles/case-study-could-a-529-state-tax-deduction-offset-the-costs-of-a-non-qualified-withdrawal

It is widely understood that 529 plans are flexible savings vehicles intended for covering college, graduate school, and now (as of 2018) up to $10,000 of K-12 tuition expenses. A central tenet to this point is that a 529 account is fully-liquid, meaning that there are no investment-related penalties (long- or short-term) associated with distribution(s) from a 529 plan for non-qualified expenses. There may be taxes and penalties imposed on the EARNINGS portion of a non-qualifying distribution, but not on the original contribution amount, which has already been taxed. Over 30 states also offer a tax deduction or credit for 529 plan contributions. This presents an opportunity for some clients to take advantage of the tax-deferred savings, even if they aren't planning to use the funds for education expenses.

So, with the prior paragraph as context, here are the primary points to consider both in favor of, and against, taking a non-qualifying distribution. At the core of this decision are the tax ramifications: Federal 10% penalty tax on the account earnings, income tax on the earnings, and possibly a state recapture tax based on whether a prior tax deduction or credit was taken or not.

Whether to take the 529 state tax deduction or not:

The contributor is a New Mexico resident, 50 years old, has a 2017 NM Adjusted Gross Income (AGI) of $150,000, and contributes $100,000 to a New Mexico 529 plan on December 29, 2017. For illustration purposes, the hypothetical return on the account is 6%, and the money remains in the account, growing, for 15 years. Also, the New Mexico income tax rate is 4.9%. Finally, this contributor is also the 529 account beneficiary and has no plans on returning to school for a degree or certificate.

Table 1: $100,000 contribution, invested for 15 years, 6% assumed growth rate:

Table 2: $4,900 tax savings also contributed, invested for 15 years, 6% assumed growth rate:

Table 3: Total $104,900 contributed, invested for 15 years, 6% assumed growth rate:

In this case study, Table 1 represents what happens to the original $100,000 contribution amount when it grows at 6% for 15 years. The three columns in the table represent, from left to right, a taxable investment account, a tax-deferred 529 plan investment with all taxes (income tax, 10% federal penalty, and NM state recapture tax) being deducted from the final value after a non-qualified withdrawal, and then a fully tax-free 529 account.

Table 2 is included in this example to show the client's choice to contribute the New Mexico tax savings amount of $4,900 ($100k x 4.9% NM income tax rate). Contributions to a New Mexico 529 plan are fully deductible in computing state taxable income. The client has 'grossed-up' his investment by the amount saved on state taxes.

Compare tax benefits and recapture provisions by state

Table 3 reports the final, aggregated financial results from Tables 1 & 2.

The conclusion from running the numbers is that it is NOT in this client's best interest to open and contribute to the 529 account if he plans to take a non-qualified withdrawal. Doing so would cost him $7,787, which is the difference between the 'Taxable,' left-hand column account value and the middle, 'Tax-deferred' account value in Table 3. ($203,011 - $195,224 = $7,787)

Additional calculations, Table 3: Based on the non-qualifying distribution occurring, the following taxes were imposed on the final account 'Tax-deferred' (middle column) value:

Try the State Tax Calculator to see how much a state's 529 tax benefit is worth

Additional observations:

Look at the difference between the client in this case using the 529 account for qualified expenses versus a non-qualifying distribution: $48,388! That amount is the difference between the 'Tax-Free' and the 'Taxable' columns in Table 3. ($251,399 - $203,011)

The client must also understand that they have an inevitable future liability to pay their state tax deduction back if the account is distributed for non-qualifying expenses: $4,900 in this case, to New Mexico; the owner must be sure to keep this upcoming tax recapture liability liquid and safe.

Alternative ways to take a qualified distribution

Could this client change their mind and decide to go to school for some type of additional degree or certificate? Absolutely. Based on the difference above of $48,388, (the reduced tax consequences of this change of mind) the additional account value could pay for all or most of that additional coursework! Think creatively - there are lots of qualifying programs and institutions out there, both in the US and abroad, to choose from, such as golf school, ski area management, culinary institutes and even wine academies.

Another strategy is to use the account as a gifting mechanism to other qualifying family members in the future: think nephews, nieces, etc. The owner could systematically transfer/rollover amounts over time, tax-free, to a family member's 529 plan. A rollover avoids gift taxes, except where the beneficiary is changed to a lower generation.

Finally, under current laws, 529 accounts never mature, endow, or face a forced liquidation event, so the tax consequences cannot be forced artificially. Could an account be established in a trust, and last indefinitely? Yes. Check with specific state laws relative to this detail, but it is becoming fairly common practice to have 529 accounts owned by a family trust, or similar - which can alleviate other future problems as well.

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