539 Plan Strategies

Copyright (c) 2009 Karen Bolton

Some states allow a state income tax deduction for a contribution to a 529 plan. The amount of this deduction is limited to a certain amount per donor (e.g., New York’s limit is $5,000 per donor per year). Therefore, to get the maximum state income tax deduction benefit, the donor should consider spreading out the contributions over several years instead of making a large lump sum that will exceed the annual deduction limit.

Rather than pay the upcoming tuition bill from other savings, you may consider investing money into your home state 529 plan so you can claim the state income tax deduction. You can then use the money from the 529 plan to pay the college bills. You will need to check with your state plan to inquire about the rules regarding withdrawals.

If you feel that the state 529 plan does not have a suitable investment plan, you can initially invest in the plan to receive the state income tax deduction or credit. After meeting the time requirements by your state, you can roll over the funds to a state plan that has a suitable investment plan.

You are not limited to the 529 college savings plan in your state. It is a good idea to look at your state 529 plan first to see whether tax incentives are offered to in-state residents. The tax breaks will usually be more beneficial to you than investing in an out-of-state plan with lower fees. For example, in Indiana a taxpayer receives a tax credit of 20% for amounts invested in the plan up to $1,000 per year.

If you decide to work with an advisor, it is important to ask the advisor how many different college savings plans they offer.

Note: Distribution of the earnings from the 529 plan will be subject to income tax if the amount withdrawn from the 529 plan exceeds the qualified higher education expenses. Refer to IRS Publication 970 for more detail. It can be found at www.irs.gov.

Example 1: In 2001, Angela Tucker’s parents opened a 529 plan for Angela. The total balance in the account in 2007 was $27,000 on the date the distribution was made. Angela incurred qualified education expenses of $6,700. Angela also received a partial tuition scholarship in the amount of $3100. In 2007, Angela parent’s took a QTP distribution of $3,700 ($1,200 of the $3,700 distribution is the earnings) and a Hope Credit of $1,650. To determine the taxable portion of the $3,700 distribution, you must determine the adjusted qualified education expenses. Total qualified education expenses $6,700

Minus: Tax-free education assistance ‘3,100

Minus: Expenses taken into account in determining the Hope Credit ‘2,200

Equals: Adjusted qualified education Expenses (AGEE) $1,400

The taxable portion of this distribution is:

$1,200 (earnings) x $1,400 AGEE $3,700 distribution = $454 (tax-free earnings)

$1,200 (earnings) – $454 (tax-free earnings) = $746 taxable earnings

Example 2: Last year you withdrew $25,000 to pay for the first year of college. At tax time, your accountant tells you that you will have to pay tax on about 60% of the earnings. Because your child received a grant, received a scholarship, and used the lifetime learning credit, your qualified expenses were decreased by $15,000. Your net qualified expenses are now $10,000. Unless you wanted to pay tax on some of the earnings, you should not have withdrawn more than $10,000. It is very important to pay attention to the exit strategy out of a 529 plan.

Karen Bolton