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529 E-ditorials

00-22: Run, Don't Walk, To Get This Tax Benefit
Joe Hurley
Thursday, November 30th 2000

I donít mean to foist another 529 E-ditorial on you so soon after the last one, but this one is important. Not that they all arenít important. But this one can mean money in your pocket. And thereís a deadline involved.

Iím talking about your opportunity to secure a state-level income tax deduction for some or all of your contributions to your stateís 529 college savings plan. All you have to do is live in a state that grants this benefit, and get your money into the plan by December 31. Voila, your tax bill goes down.

If you think about it, you will agree that this is remarkable. Weíre used to getting tax deductions when we SPEND money on certain things, not when we SAVE money. Sure, a contribution to a traditional IRA or to a 401(k) will reduce your federal and state taxable income, but you have pay tax on it when you draw on these retirement accounts in the future. With a 529 plan, your principal is not taxed when you draw on your account for college. Thatís because it represents an after-tax contribution for federal purposes. But you get the same result even in those states that gave you an upfront deduction. Some of these states will go even further and exempt the earnings portion of the withdrawal from state tax.

So which states are the ones bestowing this benefit on their in-state college investors? They are Iowa, Kansas, Louisiana (a partial match, not a deduction), Michigan, Missouri, Montana, New Mexico, New York, Ohio, Utah, and Virginia. State tax deductions begin next year (2001) in Coloradoís and Wisconsinís existing savings plans (so you may want to think about waiting). Several of the states listed above also provide tax deductions to purchasers of prepaid tuition contracts, along with Maryland, Mississippi, and West Virginia. (But prepaid tuition contracts generally work much differently than the savings plans, so the net benefit may not be as clear-cut.)

Many families with children already in college think itís too late to save with a 529 plan. Think again. If your state allows you to make a contribution to its 529 plan, and then turn around and pay college expenses from that account, in essence youíve turned college into a tax-deductible expense for state purposes.

Letís take my home state of New York as an example. My total contributions this year to the New York College Savings Program, up to $10,000, will result in a tax refund of as much as $685. Itís easy money. Unfortunately, the program rules say that if I take a withdrawal for any purpose before my account is 36 months old, Iím hit with the 10%-of-earnings penalty. But if I can prove to New York that I actually used the withdrawal to pay for college, then I donít have to recapture my state tax deduction. This means that if my kidís college tuition bill is paid in January 2001, get to keep my year 2000 tax refund, possibly incurring a small penalty (but I canít expect to earn much in one month). The icing on the cake is that starting next year New York also gives me another tax deduction or tax credit for the payment of undergraduate tuition. Thatís a double benefit.

If you are a New Yorker with a kid in college, this is a deal that could be too good to pass up. If you are not a New Yorker, you should forward this e-mail to your friends who are. They may be so appreciative that theyíll send you an extra fruitcake for the holidays.

We canít give you tax advice. That job belongs to your own tax adviser. And we caution you that the state tax rules with respect to 529 plans can be unclear, unsettled, or subject to legislative or administrative changes. Some of these states have waiting periods that prevent immediate use of your 529 account for college without triggering recapture.

But if you have some cash to put into a 529 plan, there could be a real benefit here if you act soon. Remember, it can take some time to get the materials, understandwhat you are doing, and possibly talk to your adviser. Donít wait until the very last minute.


Speaking of last minute problems, I recommend you make your year 2000 contributions to a 529 plan well before December 31 for another reason: gift taxes.

You may be assuming that your year 2000 contribution to a 529 plan is on time as long as you mail the check in by December 31. You may be wrong. For federal gift tax purposes, a gift is made when you have parted with dominion and control as determined under the laws of your state. It may very well be that your state says you have parted with dominion and control once your check has been deposited and CLEARED the bank. As you may know, this process can take several days from the time you pop the check in the mail.

The IRS in 1996 issued a ruling that provides an exception to the above, and allows your contribution to be a gift in the year you mail the check if, among other things, your check was deposited in the calendar year for which the completed gift treatment is sought. This means that your check doesnít have to actually clear the bank by December 31. But according to a couple of court decisions, this exception does not apply if you were to die in the following year prior to the day the check actually clears.

States that provide a state income tax deduction for your contribution generally say itís okay to mail your contribution on December 31 to qualify for the deduction. But to avoid any possibility of problems with the gift tax treatment of your contribution, and with your state income tax deduction, make the contribution early, not on the last day of the year.

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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