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tax deductions if you contribute to the plan in your state of residence), compound internally tax-free, and can be withdrawn tax-free for qualified “higher education” expenses (now including up to $10,000 in private elementary and secondary school tuition, as I mentioned above).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.