I have written a lot about 529 college savings plans, the grotesque transfer of millions of dollars of additional wealth to the richest people in the country, which were expanded and made even more valuable in the Smash-and-Grab Tax Act of 2017 when qualified “higher education” expenses were expanded to include up to $10,000 per year in tuition at private elementary and secondary schools.
In an exchange with reader calwatch in the comments to an earlier post, I touched on one of the most misunderstood elements of 529 plans, and realized it really deserved its own post.
The difference between tax-free and penalty-free withdrawals
I’ve gone over the basic conceit of 529 plans many times before: contributions are made with after-tax income (although some states allow tax deductions if you contribute to the plan in your state of residence), compound internally tax-free, and can be withdrawn tax-free for qualified “higher education” expenses (now including up to $10,000 in private elementary and secondary school tuition, as I mentioned above).
It’s essential to understand three types of withdrawals that can be made from a 529 plan:
- withdrawals for qualified higher education expenses paid out of pocket or with student loans are completely tax-free;
- withdrawals for qualified higher education expenses covered by grants and scholarships are penalty-free, but subject to income tax on the earnings portion of the withdrawal;
- and withdrawals for non-qualified higher education expenses are subject to income tax on the earnings portion of the withdrawal and a 10% penalty on the earnings portion of the withdrawal.
The key difference between tax-free and penalty-free withdrawals is this: tax-free withdrawals must be made in the year the qualified educational expenses are paid (or billed), while penalty-free withdrawals can be made at any time and “attributed” retroactively to the grant or scholarship.
For folks who choose to enroll in high-deductible health plans eligible for tax-free health savings accounts, this should sound familiar: withdrawals from HSA’s must be “attributed” to a qualified health expense, but they don’t have to be made in the same year the health expense is incurred. Indeed, they can be made years or decades later, as long as you keep good records.
A well-timed penalty-free withdrawal is a tax-free withdrawal
What this allows you to do is time penalty-free, taxable withdrawals for years when you have low taxable income, for example if you stop working before age 70 but want to take advantage of the Social Security magic trick. During years in which you don’t earn any ordinary income, you can “fill up” the bucket of your $12,000 or $24,000 standard deduction with 529 plan withdrawals attributed to decades-earlier grants and scholarships, and then meet any additional income needs with withdrawals from Roth accounts or taxable capital gains in the separate 0% capital gains tax bracket for those transactions.
Conclusion: yes, I’m trying to kill this loophole
Tax-advantaged programs like 529 accounts, while offering hilariously small benefits to the middle class and no benefits at all to the poor and working classes (who for obvious reasons are not saving anything at all) offer preposterous tax incentives to the rich, the very rich, and the ultra-rich.
The answer is waiting for us whenever we’re ready for it: shut down the 529 scam once and for all.
Can you provide a IRS or US code source for the portion about penalty free withdrawals being able to be applied retroactively?
I agree with Bob, the example of “Sara” in Publication 970 uses a calendar year where the distribution from the 529 was taken but was offset by a tax free scholarship. https://www.irs.gov/pub/irs-pdf/p970.pdf
Section 529(c)(6) of the law states that you follow Coverdell rules in calculating any penalty. https://www.law.cornell.edu/uscode/text/26/529 and looking at Coverdell rules I don’t see anything that applies the penalty like it would for
The fact that retirement account “distributions” for higher education expenses can only occur in the year higher education expenses occur is well established. See, for instance, Lodder-Beckert vs Commissioner, https://www.ustaxcourt.gov/ustcinop/OpinionViewer.aspx?ID=6448
However, it seems that fighting the 10% additional tax for distributions under 529(c)(6) and 530(d)(4) is novel enough that I couldn’t find anything (the only example is a man who took an early distribution out of his children’s 529 and redeposited it into the same account rather than effecting a indirect rollover, which led the court to conclude that the regular income tax on the earnings was due, with the basis reset, but that no additional tax was due basically in the interest of justice). But the general construction of tax law, that the additional tax is required with a taxable distribution UNLESS exceptions apply, seems to lead me to disagree with Indy, although if you get an assessment from the IRS, you’re more than welcome to make a pro se case to Tax Court and answer it for everyone!
To add on to the comment which appears to be stuck in moderation: notice 2004-50 (Internal Revenue Bulletin 2004-33) specifically answered the question on HSA and current year deductibility of prior year (which is fine). That question has been answered in the negative for retirement plans per the Tax Court decisions cited above. To my knowledge and Google of Internal Revenue Bulletins and Tax Court decisions, it has never been answered one way or another if Indy’s assertions are correct, but I believe the parallel construction of HSA does not apply because that was specifically intended for HSA only.
calwatch,
Sorry about that, it was probably all the hyperlinks, cleared now.
Whenever I write about these tax shelters folks make a version of the point you’re making, that there’s “no evidence” or “no ruling” or “no regulations.” And that’s true. But these techniques are not being exploited by ordinary people to save $20 in early withdrawal penalties. They’re used by the very wealthy to save millions of dollars in taxes and penalties. What makes tax planning “aggressive” (such a delightful euphemism) isn’t getting away with every single thing you try, it’s trying so many things that it’s worthwhile even if one or two is eventually disallowed.
To put it another way, now that I’ve explained the loophole, do you think rich people *aren’t* using it?
—Indy
I think it is irresponsible of you to make these claims that you can do X, Y, Z to make the point that rich people do things that are not necessarily legal without claiming that these methods are of dubious legality at best.
Obviously these ultra rich are not part of your audience. All you’re doing is misleading your readership. If you want to make the point about the ultra rich, that’s perfectly fine, but at least disclose which parts are legal and which are not.
Bob,
Do you understand that I don’t want people to use these loopholes? I don’t want them to exist! The ultra-rich isn’t my target audience, but there aren’t very many of the ultra-rich. There are a lot more people who are being lied to that 529 plans increase college affordability, when in fact they merely reduce the taxes the ultra-rich pay on their investments and *reduce* the affordability of higher education and every other public service financed with the taxes they’re dodging!
—Indy
I understand that, but nowhere in the post do you say that this is not a legal method.
The penalty for pushing the limits – interest and 20% of the taxes that should have been owed – is a speed bump for most of the rich. After all, over 40 million speeding tickets are issued every year, and a $10,000 understatement of income would only lead to a few hundred dollars in penalty if you got caught. On the other hand, just like going 75 in a 55 isn’t legal, you can’t say that paying the income tax but not the 10% additional tax on withdrawals for prior year legal expenses is legal either. But, I would like someone to try it, appeal the assessment to Tax Court, and get an official ruling for everyone. It’s not going to be me, though.
I don’t see the issue. In the scenarios you laid out, the money still has to be spent on higher-education expenses. It’s only the tax optimization that you have an issue with, that’s hardly a loophole.
Now, if I could game the 529 plan as a 401k for myself, that’s another story.