The 529 Hack You’re Not Using

Worried about rising school costs? Check out this 529 loophole to effectively save money on your education.

If you’re a current student and you’d like to optimize your 529 plan, the following tricks could help you save thousands on your final tuition bill. If you’re not a student, maybe you know one. Want to help them out? Share this article.

As a brief refresher, the 529 plan is a college savings education plan that allows you to take a state income tax break on contributions. Those contributions grow in a federal and state tax-deferred manner and, if spent on a qualified education expense, any gains in the 529 plan will never be subject to future federal or state income tax.

The 529 hack for current students

Did you know that you can open up a 529 plan in your own name and designate yourself as the beneficiary? While it might seem circular, it’s perfectly within the rules. That means that if you’re both working and paying for qualified education expenses, you can divert your income into a 529 plan and then pull out the same money to pay for qualified education expenses. By moving it through this process, if you’re in a state that gives a tax benefit to 529 contributions, you can effectively get a discount on your tuition.

It works like this.

Current Calendar Year

Work –> Contribute to 529 –> Save on State Taxes –> Withdraw Money for Qualified Higher Education Expense

Let’s talk through a concrete example. While this would work for any student that is working while in school, I’m going to use the example of a law student going to school in Massachusetts but spending a summer working for a biglaw firm in New York (a situation strikingly similar to the facts of the author’s history).

As you may know, biglaw starting salaries for first-year associates are currently $180,000 a year. Summer associates are paid the same annualized salary, prorated over the summer program. That means a summer associate attending a 10 week summer associate program generates $34,615 in summer income.

Even if they don’t live permanently in New York, they’ll be required to file a part-year resident tax return and that means paying New York taxes. But, if you contribute money to a New York 529 plan (up to $5,000 for an individual or $10,000 for a married couple), you can exclude those contributions from your New York State income, saving yourself some money in the process.

That means a law student who earned $34,615 in New York over the summer could send $5,000 to his 529 plan, withdraw the money to pay for his tuition bill, and only report $29,615 in New York State income, thus dropping his New York State tax bill from $1,372 to $1,049 for a savings of $323.

I don’t know about you, but saving $323 for about an hour worth of work sounds like a pretty good rate of return for a broke law student.

But wait, it gets better.

The IRS doesn’t care when during the calendar year you make a withdrawal from your 529 plan, so long as you had a qualified education expense during the same calendar year.

You’ve already created a 529 plan with yourself as a beneficiary. You funded it with money earned during your 2L summer and you withdrew it during the fall semester to pay for qualified education expenses.

Are you seeing the other opportunity?

If not, don’t feel bad. I missed it too.

Since you’ll be paying qualified educational expenses in the spring and final semester of your 3L year, you can also make a contribution to your 529 in the fall of the same year once you’ve started working at your full-time job.

For example, if you start working at the same New York firm on September 1st, you’ll earn about $60,000 by the end of the year. If you contribute $5,000 to a 529 plan and then withdraw it a few weeks later (to cover the expenses you had in the beginning of the year while you were a student), you’ll drop that year’s state income tax bill from $3,009 to $2,686, adding another $323 to your bottom line.

How’s that for a quick $626?

Find a 529 Plan

How to implement the strategy

If you want to implement this strategy, here’s what you need to do.

First, you need to consider the following points to make sure the strategy applies to you:

  • Make sure your state has a tax deduction. This only applies to the state where you’re paying taxes. Obviously, if that state doesn’t give a tax benefit for 529 contributions, this strategy won’t work (e.g. California doesn’t offer a state tax deduction, bummer). Check here.
  • Does your 529 have a holding period?. Some states, like Michigan, require you to hold the funds in the 529 plan for a certain amount of time before you withdraw the money. In New York, this appears to be only 10 days.
  • Invest safely. You’re putting this money into investments in a 529 plan but should be withdrawing it a few days (or weeks) later. Don’t invest it in an index fund. Put it in something stable like a money market fund.

Next, if you’ve decided this works for your circumstances, you might as well open a 529 plan today. If you’re in New York, that means clicking on this link and opening up an account.

Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.

Save more money than your friends

One email each week covers personal finance, financial independence, investing and other stuff for lawyers that makes you better.

    Fifteen thoughts on The 529 Hack You’re Not Using

    1. I’m a rising 3l who is a resident of Tennessee but just finished as a summer associate with a firm in NYC. I’ve already paid my law school tuition for the fall semester…is it too late to open a NYC 529, fund it, and withdraw, to get the tax deduction? In your article you say the IRS doesn’t care when you withdraw as long as there is a payment for a qualified educational expense (law school tuition) during the same year. But, does that apply even if the qualified expense happened before the 529 was even opened? I know I can definitely use it in 2018 for my 3l spring tuition i’m just wondering if its too late for the fall. Thanks! 🙂

      1. I think this is going to be a gray area.

        As a New York part-year resident, you file IT-203. The instructions for IT-203 direct you to IT-225 for your New York State Modifications. The IT-225 Instructions tell you to enter your S-103 (i.e. 529 contributions) on form IT-225 which are then reported on line 29 of IT-203.

        The problem is that the IT-224 Instructions tell you that part-year resident individuals “also enter in the New York State allocated amount column any such contribution(s) made while a resident of New York State.” While this sounds like bad news, I’m not really seeing that the form only counts those contributions made while a New York State resident (in fact, it asks you to add up the total of Column A, which is just the amount that you’ve contributed to the New York State 529 plan). In other words, you’ll need to track down this distinction because if you need to make the contributions while you were a resident of New York, this might not work.

        Of course the above is separate from your original question, which isn’t so much whether you needed to be a New York resident when you made the contributions but whether you can open a 529 account after a qualified education expense and then make/withdraw contributions later in the calendar year.

        Since the forms never ask you what date you made the contributions, I’m inclined to believe that this means you can make them at any point during the tax year. There’s an IRS publication 2008-17 about how there’s really no guidance from the IRS about timing of contributions/withdrawals. You may find this Boglehead forum post helpful as well.

        Finally, this IRS page makes it looks OK as long as the qualified education expense happened during the year:

        Taxable earnings. Use the following steps to figure the taxable part.

        1. Multiply the total distributed earnings shown on Form 1099-Q, box 2, by a fraction. The numerator (top part) is the adjusted qualified education expenses paid during the year; and the denominator (bottom part) is the total amount distributed during the year.

        Ultimately, I’m not sure of the answer though and you’d have to contact an accountant or tax professional to be certain. Keep in mind that I’m not a tax professional, this is not tax advice and all the usual disclaimers. This is simply based on some internet searching and reading I did. Please do let us know what you do though and thanks for the interesting question!

    2. Don’t forget, you can’t double-dip your tax breaks. Whatever you pay out of the 529, you can’t also claim on your federal taxes as counting toward the American Opportunity Tax Credit.

      However, you can pay for housing expenses out of a 529 as a qualified expense, but housing is NOT a qualified expense for the AOTC. Thus, if you go to a reasonable state public university, it makes sense to pay your first $4,000 of tuition out of pocket, then start using your 529. If going that route means you’ll have a pile of money left in the 529, you can use the 529 to pay rent up to the amount your university charges for on-campus housing.

      We’re doing this with my son now to maximize our tax breaks. We get the full $2,500 back on the federal taxes and save 5% on his housing because we pay that out of the 529.

      1. Good point. No double-dipping in tax breaks or salsa when you’re at a party. Good rules to live by. Thanks for pointing out the housing expenses are a qualified 529 expense, so you can maximize the tax breaks.

    3. I love your thinking, but there is one caveat. Some states, like Wisconsin, do not allow you to put money in a 529, take the deduction and then pull out the money. In Wisconsin they changed the tax law a few years back requiring you keep the money in for 365 days before withdrawing. You may need to time contributions and distributions accordingly to receive the tax benefit.

      Other comments and your post also address concerns to receive the maximum value of the 529 plan.

      1. Yeah, some of the states have caught on and abolished the ability to contribute/withdraw in the same calendar year. New York doesn’t seem to be one of those states. Lots of lawyers flood into New York during the summer to work here for the summer, so it’s a no brained for them. Thanks for the comment!

    4. I’m a little confused. I’m entering graduate school in the fall. Why wouldn’t I just use the tuition and fees deduction instead of adding money to a 529 account?

        1. He used it for housing.—If I am just using it for tuition and my total tuition is less than 4k a year, I don’t see the benefit of using a 529 account since I will reduce my tax liability by 4k with the tuition and fees deduction. If I use a 529— wouldn’t that count as double dipping? I might be missing something…

    5. That’s a cool trick. I didn’t realize you can do that.
      However, students really don’t make that money and probably won’t pay much state tax anyway. How much state tax does a student making $35k pay anyway? In Oregon, I’m pretty sure they pay very little state tax.

      1. In New York, they’d pay $1,372 in state taxes and can shield up to $5,000 (saving $323), although the loophole where you contribute and then immediately withdraw the money would work for anyone so long as your state allows you to do so. As Keith pointed out, some states have wised up.

    Leave a Reply

    Your email address will not be published. Required fields are marked *