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?
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.
Let’s talk about it. Have you implemented this strategy? I’m sure your fellow lawyers would love to hear about it. Tell us below!