Pssst! Want to get a quick discount on K-12 or college tuition? A loophole in state income tax rules in some states enables it.
How does the loophole work?
Three dozen states offer a state income tax deduction or state income tax credit based on contributions to a 529 savings plan. In order to claim the benefit, most states require residents to use their home state’s plan. However, if you live in Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana and Pennsylvania you can claim a state tax deduction or credit for contributions to any 529 plan.
Except in four states, nothing stops you from making a contribution to the state’s 529 plan and immediately taking a qualified distribution to pay for college tuition and other qualified education expenses.
In effect, this provides you with a discount on college costs at your marginal state income tax rate, which can be as high as about 3% to 10%, depending on the state. The discount on your state income taxes is capped at an annual limit or your state taxable income, whichever is less, but it provides a decent discount just for pushing college, graduate school or other education costs through your 529 plan.
As of January 1, 2018, 529 plans can be used to pay for tuition expenses at private, public and religious elementary and secondary schools. In some states, parents can also take advantage of the tax loophole when paying for K-12 tuition. However, be sure to check with your state’s rules before claiming a deduction. Not all states have conformed to the federal law, and if you use your 529 plan to pay for pre-college expenses you may be subject to recapture.
In a bit of magic, you can even take advantage of the 529 tax deduction loophole after the fact, with the distribution coming after the expenses, so long as both events occur within the same tax year. The distribution must also occur within a reasonable amount of time after the expenses.
Exceptions to the loophole
Two states, Michigan and Minnesota, block the loophole by basing the state income tax deduction or tax credit on annual contributions net of distributions. If you take the distribution in the same year as when you made the contribution (assuming you had nothing in the account to begin with), the two zero each other out, leaving you with no net state income tax benefit. However, you can still take advantage of the loophole every other year, making a contribution one year and waiting until the next year to take the distribution to pay for education costs. Effectively, they require a one-year waiting period on distributions.
Two other states, Montana and Wisconsin, block the loophole by imposing time limits. Montana recaptures the tax deduction for contributions when distributions are made within three years of the opening of the 529 plan account. Wisconsin recaptures the tax deduction for contributions when distributions are made within 365 days after the contribution, if the account balance was less than the distribution amount prior to the contribution. Again, there are workarounds that let you take advantage of the loophole in a more limited manner.
Won’t the states close the loophole?
The states are aware of this loophole, but so far very few taxpayers have taken advantage of it, so it isn’t worth trying to close the loophole. Moreover, most of the people who are aware of the loophole use 529 plans for their intended purpose, to save money for college.