We don’t often think about 529 plans as a way to reduce our immediate tax liability. But I was recently talking to a friend of mine who pointed out an interesting strategy that might help him reduce the amount of state income taxes he would owe this year.
Traditionally, 529 plans act sort of like a Roth IRA for college. You put money into the 529 for your child’s future college expenses, allow that money to grow over time, and then withdraw that money tax-free so long as you use it for college expenses. If you start right when your children are born, you can basically get yourself 18-22 years of tax-free growth. Considering the fact that the S&P 500 has never lost money over a 20 year period, you’ve got pretty good odds you’ll come out with some tax-free money for your kids by the time they enter college.
The above scenario is the traditional way to use a 529 plan. But a 529 plan can be opened up in anyone’s name, including your own. This opens up a number of interesting possibilities that most people don’t think about.
Specifically, if you work in a state that offers a tax deduction for 529 contributions, you can potentially funnel some of your income through your 529 plan and then use that income to pay for school. You get the tax deduction and still pay for your school expenses. When used in this way, it acts sort of like an educational HSA in that it’s one of the few ways you can pay no taxes on money both going in or coming out.
What Is A 529 Plan?
A bit of background might be helpful just in case you aren’t familiar with what a 529 plan is. A 529 is a tax-advantaged account that can be used for qualified educational expenses. For the most part, 529 plans are run by each individual state. However, you don’t need to open a 529 in the state that you live in. You can actually open it up in any state that you want. For example, I opened up my own 529 plan in New York because they offer Vanguard funds and have really low expense ratios.
The way the 529 plan works is pretty simple. You fund the 529 with post-tax money. You then invest that money into whatever fund choices your plan offers. Once invested, you can then withdraw the funds tax-free, so long as you use the funds for qualified educational expenses. Think of things like tuition, rent, and textbooks. The good thing is that a 529 isn’t limited to just your undergrad education. You can use it for a wide variety of schooling, including grad school.
Funneling Money Through Your 529 Plan To Reduce Your Taxes
Being able to open up a 529 plan in your own name opens up some interesting, non-traditional uses for the 529. Since you can open up the plan in your own name, you can pay for some of your own schooling expenses right out of it. For most people, it won’t matter all that much since most students probably aren’t earning very much money while they’re in school. If you’re a law student or business student, however, you could easily earn over $30,000 in a summer. If you’re smart, you’re probably going to use some of that money to pay for your school expenses.
This is where the 529 plan comes into play. If the state that you work in offers a tax deduction, all you need to do is open up a 529 plan and name yourself the beneficiary. Then, you just contribute up to the maximum deduction that your state offers. Since we’re using that money right away, we’ll want to put it into something safe, like a money market account.
By doing this, you’ve now reduced your state tax liability by whatever amount you contributed into your plan. Then, when you have more school expenses, you just take the money right out of your 529 plan and pay the bill with it. You pay no state taxes on the money going in or coming out. It’s a win-win for you!
How My Friend Plans To Use His 529 Plan
An example probably will help, so here’s how my friend is planning to use this 529 strategy. He’s got a big law summer associate position locked up in New York for this upcoming summer. A first-year associate at a big law firm in New York starts out at a $180,000 annual salary. Summer associates make the same amount, pro-rated for 10 weeks. That means my friend stands to make about $3,461 per week or $34,615 for the entire summer. (I know, that’s a crazy amount of money for someone to make).
Using a tax calculator from SmartAsset, it turns out that his New York state income tax will be about $1,372. New York offers a state tax deduction of up to $5,000 per year for contributions to the New York 529 plan. That goes up to $10,000 per year if you’re married.
My friend plans to open up a 529 plan with New York, name himself as the beneficiary, and contribute $5,000 into the plan. Later in the year, he’ll just withdraw the $5,000 and use it to pay his tuition for the upcoming year. Doing this lowers his state taxable income down to $29,615 and reduces his state taxes down to $1,049. That’s $323 in tax savings. And in essence, all he’s doing is just funneling money that he would be using anyway through his 529 plan in order to make that money tax-free.
Things To Think About Before Doing This Strategy
You’ll want to make sure you consider the following questions before implementing this strategy:
- Does your state have a tax deduction? Obviously, if it doesn’t, then there’s no point doing this strategy.
- Is there a holding period? Some plans might require you to keep your money in the plan for a certain amount of time before you can use it. Make sure to double-check how long your plan requires you to keep money in the plan. In New York, it appears that you only have to keep the account open for 10 days. My guess is that, at most, you’d have to keep the plan open for a year, which means most people should still be able to take advantage of this strategy, even with a holding period.
- Make sure to consider the impact of being a resident versus a non-resident taxpayer. This is the thing that might throw a wrench in this strategy. A lot of people live and go to school in one state, but work for a summer in another state. My thought is that this should still reduce your income taxes for the state that you work in, but I’m not quite sure what type of effect this would have on your resident state income taxes. I would think that if you earned no money in your resident state, then it wouldn’t matter and doing this strategy still makes sense.
If you’re in a high earning graduate school field where you can make a lot of money over a summer – law school and business school come to mind – then this strategy is something for you to consider. Someone earning over $30,000 as a student will have to spend at least some of that money on school expenses.
Check to see if your state offers a tax deduction for 529 contributions. If it does, consider contributing money to it. It’s an easy way to reduce your tax liability right now and snag a bit of tax-free money too.
Addendum:
The great thing about a 529 is that you can use those funds to pay rent. You just can’t exceed whatever your school estimates your room and board expenses should be. (Sorry, no luxury apartment for you). Everyone has to pay rent, right? It’s not too difficult to just funnel some of your income through a 529 and then pay rent with it.
Kevin is an attorney and the blogger behind Financial Panther, a blog about personal finance, travel hacking, and side hustling using the sharing economy. He paid off $87,000 worth of student loans in just 2.5 years by choosing not to live like a big shot lawyer.
Kevin is passionate about earning money using the sharing economy and you can see all the ways he makes extra income every month in his side hustle reports. (If you want a quick side hustle win, check out Job Spotter)
Kevin is also big on using the latest fintech apps to improve his finances. Some of Kevin's favorite fintech apps include:
- Personal Capital. One of best apps to monitor your portfolio and track your net worth. Plus, it's free to use and you get $20 for creating an account.
- Dobot. This is a great microsaving app that monitors the cashflow on your bank account and saves away small amounts for you each week. It's free and you'll get $5 when you use it.
Feel free to send Kevin a message here.
Smart Money MD says
January 16, 2017 at 2:42 pmInteresting scenario and creative use of the 529!
This probably would only work for law students since there really aren’t many other careers where you can rack up a nice salary before graduation. It took me 6 years AFTER medical school before I could generate an income higher than minimum wage.
That being said, if your income bracket is still relatively low, I’d still try to max out my Roth IRA and 401k before working on a 529 for myself. The stakes are much higher once you are in the high income big law firm.
Financial Panther says
January 16, 2017 at 6:48 pmIt definitely is limited to a subset of students who earn a significant income during a summer. I just thought it was an interesting scenario that my friend pointed out. For someone in law school (or business school), it makes sense to put some of your summer money to work instead of blowing it all or even investing it. Assuming you’re paying for school yourself, you’re either taking out loans or cash flowing school.
The good thing is that I think 529 funds can be used for reasonable rent costs. You have to pay rent, right? So why not funnel your earnings through the 529 and snag some tax benefits while already paying rent anyway.
Jack Catchem says
January 16, 2017 at 10:03 pmMy only comment is:
*Begins Slow Clap*
I often have to investigate fraud, theft, and embezzlement and (important disclaimer: I’m not an attorney!) seems legit! Smart way to use funds on yourself in a manner the state wants you to. The state wants educated people, you want to be educated, keep your would be tax money and drop it into your education. Brilliant!
Financial Panther says
January 17, 2017 at 6:09 pmThis is really good if you have to pay for school anyway! If you’re in school and earning some money, it makes complete sense to funnel money that you’re paying towards rent or something through your 529 if your state offers the deduction. My state doesn’t offer a tax deduction, but a lot of people that work for a summer in New York (which is a lot of big law lawyers) could easily utilize this technique to pay for part of their law school expenses.
Miss Mazuma says
January 17, 2017 at 8:13 amFabulous – I never looked into 529s but my BFs kids are almost college age so this caught my eye. I have been thinking of going back to school just to finish my associates! I started flying at 23 and never needed a degree so I didn’t bother to finish. Now that I am on the path to FI I figure I may not be doing this flying gig forever. This strategy would be great for me to fly and go back to school may the same time. Time to look into it! Thanks for a super idea!
Financial Panther says
January 17, 2017 at 6:10 pmGlad it could help! There’s definitely more to it I’m sure. I’m by no means a tax expert, but it seems like this is definitely something a lot of people earning money and paying their way through school could do.
[email protected] says
January 17, 2017 at 10:05 amWe contribute to our kids’ 529 plans here in NY and it’s good to get the tax deduction. It crossed my mind about this hack to contribute even when my kids are in college to get the tax deduction and used that money to pay for tuition. I do need to check the holding period though…didn’t think about that. Unfortunately, I never thought about this when I was in law school and since I went part-time and worked full time during the day, I had some money I could have contributed to my own 529 plan.
Financial Panther says
January 17, 2017 at 6:12 pmThe thing I didn’t think about was rent! If you’re in law school, you’re definitely going to have to pay rent. If you can pay some of your rent with tax-free money, why wouldn’t you?
It definitely might be something to consider doing if you’re cash flowing your kids current school expenses (like rent, for example).
I’m pretty sure the holding period isn’t a long time, but I might call the NY 529 people just to double check. The info isn’t really clear.
NinjaPiggy says
January 17, 2017 at 5:54 pmI love this strategy and I’m surprised more people don’t use it. Any parents that are planning to do a pay-as-you-go for their children should also look into using this strategy.
One of the best sites out there for learning more about 529s in your own state is: http://www.savingforcollege.com/college_savings_201/
You can find out if your state offers a tax deduction and/or matching contribution to your 529.
Financial Panther says
January 17, 2017 at 6:13 pmSaving for College is an awesome site! Honestly, the reason more people don’t do this strategy is probably because it’s not really obvious. When I think about a 529, I think about it being for my kids sometime way in the future. You don’t really think of a 529 as a way to funnel money through to avoid state taxes.
FIRECracker says
January 17, 2017 at 10:19 pmInteresting. Your 529 plan is the American version of our Canadian RESP (“Registered Education Savings Plan”). In our version, the government gives us a 20% match for whatever we put in there.
I read some where you can you also take money out of your traditional IRA to pay for higher education costs. (the penalty for withdrawing before 591/2 is waived in this case) Is that true?
Financial Panther says
January 18, 2017 at 11:23 amThe Canada RESP sounds awesome! 20% match!? I did some quick googling and it looks like you get a 20% match on up to $2,500, which is amazing! That’s a freebie 500 bucks!
That’s true that you can take money out of a traditional IRA. The only reason it’s not necessarily recommended is because you’re pulling money out of your own retirement. Better to use a separate vehicle to pay for your education and keep your retirement vehicle in another bucket.
FIRECracker says
January 18, 2017 at 11:53 amThat makes sense. Man you guys have so many tax sheltering vehicles, whereas we only have 2 (RRSP, TFSA). I think this is why most FIRE bloggers are American. You have more options to shelter your income and get to FIRE faster. On the flip side, we do have free healthcare, so at least there’s that advantage.
Tchmaster says
May 2, 2019 at 4:38 pmHi Kevin,
Great post, I just started following your blog this week. I’ve been researching the benefits of 529.
I currently work full time while also doing my MBA online with one year left. My wife just finished year 1 of pharmacy school.
I am thinking of opening a 529 to pay my tuition & book since I pay out of pocket right now and get reimbursed after each semester by my employer. Do you think the education deduction works for a mortgage as it does for rent?
What strategy will you recommend as far as opening a 529 for my wife, she goes to school in Illinois and pays rent.
I see Missouri allows up to 16k and Illinois up to 20k in the deduction for a married couple filing jointly.
Financial Panther says
May 15, 2019 at 8:45 amYou’ll probably need to look at whether your wife pays Illinois state income taxes. If so, then I’d just do whatever Illinois 529 deduction requirements are.