Laundering College Expenses Through a 529

In less than two months, my oldest starts her freshman year at college.

Yikes!

To put it mildly, it’s going to be different starting college during a pandemic. Most of her classes are online and a couple are “hybrid”, mixing in-person and online components. Everything after Thanksgiving is online.

Like I said, it’s going to be a little different this year.

College Ain’t Free

So how to pay for it?

In 2006, I opened a 529 account using a small inheritance after my grandmother passed away. It’s nearly tripled in size (13% year-over-year return), but it’s still short of paying for college for all six of my kids. I even came up with a complicated but (in my opinion) fair method of dividing the 529 between them.

Who am I kidding.

A college education is important to me. I’m willing to pay for it.

Beyond my one time contribution in 2006, I haven’t made any additional contributions. Instead, I’ve prioritized maxing out 401(k) contributions, paying down debts like my own student loans and mortgage, and investing in a brokerage account. When I started the 529, I lived in Washington state, a state with no income tax and thus no tax advantage for contributing. I opened the 529 in Ohio–a state I’ve never even stepped foot in–because it had relatively low fees and access to Vanguard funds. But with still limited investment options, higher fees than a regular brokerage account, and steep penalties for non-qualified withdrawals, the 529 just didn’t seem worth it.

I was possibly being short-sighted.

State Income Tax Deduction

We now live in a state, Virginia, where we’re subject to a 5.75% state income tax. We can deduct up to $4k of contributions for each 529 account, saving up to$230 for a full year’s contribution. If I contribute more than $4k, I can just roll the excess contribution into future tax years, assuming I continue to live in Virginia in the future. Gift tax limits apply, but I should probably be well under that limit. In addition, my wife can open accounts for each child, doubling the amount that we can deduct each year. All told, we can deduct up to$48k a year ($4k over 12 accounts) against our state income tax. That’s tax savings of$2,760 tax each year.

Am I going to hit that limit? Probably not.  Expect future posts on this.

Doing the Laundry

How does this help right now, when my daughter enters school in less than two months?

There doesn’t seem to be any minimum holding period for 529 funds before they are used to pay for expenses. In theory, I could even contribute to the 529 after I pay tuition, possibly months later. My contribute needs to come before the end of the year and so do the expenses and subsequent withdrawals. I should be good. Sure, the contribution will have next to no time to appreciate any gains, but this late in the game I’m in it for the tax deduction, not for the market gains. I’ll probably put the money in a fixed income option to avoid any sudden downturn in the few weeks that it will sit in the account.

Here’s a quick animation of the steps:

Other Considerations

Any 529 funds used to pay for expenses reduces the amount I can apply against other tax credits like the American Opportunity Tax Credit (AOTC) or the Tuition and Fees deduction. However, the income phaseouts already preclude me from using them, but it’s something to consider with this strategy.

Conclusion

Turns out, I’m not the only one who has thought of laundering college expenses through a 529.

Tell me what you think. Any gotchas that I’m not paying attention to? Is this too good to be true?

Hasta luego.

4 thoughts on “Laundering College Expenses Through a 529”

1. We do $10k/year to 529’s, which is our max deduction. State marginal tax rate is ~7%, so it’s about$700/year in subsidies.

Regarding the “laundering” technique, I’m equally flabbergasted that this opportunity exists. In our state there **may** be a 1-year holding period requirement for contributions, but I’d have to double check. In any regard, people would be crazy to not take advantage of it; a 7% discount on college.

If you’re ever interested in funding a 529 out-of-state, CA has the best (i.e. lowest cost) plan. 0.06% all-in fees for domestic index fund: https://www.scholarshare529.com/research/fees.shtml

What are your cost-sharing agreements for your kids’ education? Are you fully paying for everything? Only tuition? Do your kids have savings?

We’ve yet to figure out the answers to the above. My 13 year old woke up at 4am today to detassle (https://www.youtube.com/watch?v=MfCNIzoCV08) in the corn fields on a humid 100°F day, making $9/hr in the process. By the time she’s a freshman in college, she’ll probably have saved >$15k, much of which I’ll help her funnel into Roth IRAs. I assume my other kids will be similar.

1. Our deduction is $4k per account. They use the term “account owner” which I think might mean I can open one separate from my wife. They also have unlimited carry forward so if I have to funnel more than the annual limit, I can count it against future tax years. Currently, I’m expecting to pick up the tuition tab for 8 semesters of college. If they score scholarships or get done earlier than needed (e.g. using AP credit and not taking underwater basket-weaving) then I’ll give them the difference. I’m also planning on paying for the first year in the dorms. We’ll see after that. My two oldest, 18 and 15, are lifeguards with the local homeowner association and make around$10 to \$14/hour. I’ve told them I’ll match dollar-for-dollar for whatever they put into their Roth IRAs. I think that’s going to pause/stop when I’m paying tuition. More here: https://www.ochosincoche.com/2019/11/22/matching-your-childs-roth-ira-contributions/

1. I went down the path of trying to create it with http://diagrams.net/, then when it got too complicated, I switched over to a Google Slide with animations and used Giphy Capture to make the gif.

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