How A 529 Account Can Help With Taxes Even If You Don’t Have Anything In It

June 12, 2018

We’ve all heard about 529 plans as a vehicle to save for college, but what about using them strictly as a way to pay, even if you don’t put a cent in before tuition is due? We typically look at these plans through a long-term savings lens to accumulate larger sums of money for a child’s education. But there is also a short-term view that allows you to use a 529 plan to save money on state income taxes, even if you haven’t been saving into a 529 all along — and it’s not just for your kids! If you’re thinking of going back to school, keep reading.

Who it works best for

This strategy really only works if you meet both of the following criteria:

You live in a state that has income taxes AND offers a 529 tax incentive, for example, Minnesota residents can invest in any state’s plan and get a tax deduction, while Colorado residents are only incented to use the Colorado plan. California residents are out of luck — there is no tax benefit to contributing to a 529 plan.
You will be paying qualifying college costs not covered by other forms of financial aid such as scholarships, grants and student loans.

How it works

Assuming you meet the above two criteria, here’s how you can still take advantage of a 529 plan even if you’re opening it just in time to pay college costs. Since I live in Colorado, I’ll use that as an example to illustrate how it works:

I want to go back to school to get a graduate degree, but don’t have any money saved in a Colorado 529 — my plan is to pay the costs out-of-pocket as I go.
Let’s say my first tuition payment of $10,000 is due in 2 weeks and I’m using money in my savings account to pay it.
I open a Colorado 529 plan and deposit $10,000 into the plan today. In two weeks, I send a payment directly from my 529 account to pay my tuition.
At tax time, I deduct $10,000 from my Colorado income taxes.
Important note about investment choice: Since I would be planning to spend the money in the account right away, I would make sure I chose the money market option and not one of the other mutual funds, out of the risk that the market is likely fluctuate during those two weeks and I could end up with less than $10k on my tuition due date.

Where the tax benefit comes in

Colorado allows me to deduct the full contribution of $10,000 from my state income taxes (assuming I have at least $10k in income) that year. Since Colorado state income is taxed at 4.63%, I would save $463 ($10,000 x .0463) in state income taxes the year I paid my tuition. Pretty good deal, right?

Make sure you read the fine print on timing

Most plans have a holding period that specifies how long money must stay in the account before it qualifies as a tax-deductible contribution, so you may have a plan ahead a few weeks. Colorado’s holding period is 7 days, which is why I used two weeks in my example above — I like to leave a little room for error.

A few other things to consider

Now, while most 529 plans are similar, each state has their rules around how much you can deduct on 529 contributions – and this would not apply in states that do not have a state income tax. Most states put a cap on how much of your annual contribution is deductible. So if I lived in Arizona, where it’s capped at $4,000 per year for married people, I’d probably only put $4,000 of my $10,000 tuition bill into my account, since that’s the max I can deduct in one year.

Before you start this strategy, make sure you’re clear on the rules for your state.

Maxing out all the tax credits

Paying for college may qualify you for various tax credits, so you want to make sure using a 529 this way does not disqualify you from receiving those. Costs incurred during the first four years of college may qualify you for the American Opportunity Tax Credit (check the income limits to see if you qualify).

For costs after the first four years (5th year seniors or grad school for instance), you may qualify for the Lifetime Learning Credit, again subject to income limits.

In my example above, paying the full cost of tuition by routing through a 529 would impact my ability to claim my credit, which may cost me more than I gain with the state income tax deduction. Assuming I would qualify for the federal tax credit it may make more sense for me to pay the first $4k straight from my savings for the federal tax credit, then run the rest through the 529 for the state tax deduction.

Consult your tax professional to make sure you are following the strategy that makes the most sense for you and capturing those valuable tax credits.

What if my job has a tuition reimbursement benefit?

As long as you’re on the hook to pre-pay your tuition, even if you’re later reimbursed by your job, you can still take advantage of this tax saving strategy.

One thing to think about, however, is if your job also has a student loan reimbursement benefit — if your job will reimburse you for tuition AND match some student loan payments, you may be able to get far more benefit from taking out a loan to pay your tuition instead of paying out of pocket. However, for people with kids in college, this can be a great way to save on taxes.

Paying for college can feel like an uphill battle at times. Hopefully this hack gives you one more tool to help you reach your family’s educational and financial goals!