For those following current events in the community, there was a recent “event” concerning 529 accounts. I suspect, however, that some of you are still a bit confused. Let’s explain it, starting from the beginning.
Once upon a time, college was not expensive. Colleges kept their costs down. Their buildings were old (so old that they had ivy growing all over them – hence, the term Ivy League), and I guess the professors did not earn that much. Over the years, the price tag has risen considerably. Colleges discovered that they are big business.
The government heard about the problem with rising college tuition, and they came up with a solution: Save! Yep – start saving money when junior is a baby, and then you will have money when he’s ready to depart for the dorm. (See Genesis 41 regarding similar advice given to Pharaoh.) That seems simple enough. People would just put money in the bank or a stock brokerage and save up. But the government felt that people needed an incentive to save. So, true to form, they used income taxes to create the incentive. They passed a law that goes like this: If you save for college, all the earnings in that account are tax free. Let’s explain: Say you save $2,000 a year for 10 years. You have therefore put in $20,000. Typically, this money is invested in mutual funds that invest in the stock market, which may pay dividends and also go up in value. The account might therefore have grown and now has $30,000 in it. This money can now be used for college. However, if you withdraw the money and do not use it for college, the earnings of $10,000 are taxable (although the original $20,000 remains “your money”).
The government needs to keep track of all this, so whenever you withdraw money from these accounts, the brokerage issues you a 1099. A copy is sent to the IRS, stating how much money you withdrew. On your tax return, you need to state (under penalty of perjury) that you used the money for college. If you did not, you owed taxes and perhaps a penalty. Let’s review: The original $20,000 is not tax deductible. Only the earnings are taxable. The goal here is for people to focus on the earnings, which means starting to save when the child is young: “Save early and save often.”
These special college savings accounts are called 529 accounts (named after IRS code 529) and are run by the states. Every state has one. Here in Maryland, only T. Rowe Price can run them. It seems to me that there is no charge to open these accounts, but T. Rowe Price benefits because they assume you will invest in their mutual funds, which pay fees to them.
One reason that the states run these accounts is that one kind of 529 has to do with prepaying tuition at a state college. The state wants to encourage their residents to attend college in state. To make these accounts even more attractive, the state of Maryland has added to the tax benefit that the IRS offered. The Maryland law is that parents can contribute up to $5,000 per child and get a tax deduction. A $5,000 tax deduction will save you about 8%, which is $400. (There are 34 states that give tax deductions; in New York it is $10,000 per child.) Let me point out that anyone can open a 529 for anyone else. Typically, it is parents, grandparents, and maybe uncles and aunts. But it can be friends and neighbors – anyone, really. (Of course, friends will probably not hand out thousands of dollars.)
The 529 accounts were not very popular with the frum community. Here’s why:
- People are too strapped paying K-12 private school tuition to even think about saving for anything.
- If you have a 529 account, the college sees that you have assets, which can lesson your financial aid.
- If you pay for college with a 529, you cannot claim the American opportunity income tax credit for the same costs, and the American opportunity credit is way more valuable.
- People are always worried that their kids’ yeshivas might not be classified as colleges. If they are not, then the 529 money would be ineligible.
- If people have extra cash, they are better off putting the money in their retirement account (typically a 401k pension plan). These contributions are tax deductible for federal and state income taxes, so you save much more than with the 529 contributions. Most frum people are behind the eight-ball on retirement savings, so this is more important. Junior can work his way through college, but grandpa cannot work his way through an old age home.
Last year, the state of Maryland noticed that the poor and middle class were not opening 529 accounts. Basically, it was the rich who owned them. The State therefore decided to take from the rich and give to the poor. (Are governments allowed to do that?) They made the following law: If you open up a new 529 plan and contribute from $25 to $100 (depending on your income), the state of Maryland will add $500 to the account.
And guess what folks. Nobody noticed! Yep. The state of Maryland is handing out $500 dollar bills and no one comes to take them. The year 2017 ended with most of the available money unclaimed and returned to the general fund. Wow! I guess we were all asleep at the wheel.
Then, on December 22, 2017, President Trump signed a new tax law. It made just one change to the law for 529s – but that one change would have a big effect. There was no change in the law regarding putting money into 529 accounts. People could continue to do so, and the state of Maryland continued to offer a tax deduction of $5,000 per child. You could continue to take out the money for college. But now, under the new law – drum roll – you can withdraw up to $10,000 per year for K-12 tuition.
That one little change created a domino effect of reactions. Immediately, people realized that you could put money into a 529 one day and withdraw it the next. Remember, if you put the money into the 529, you do not get a tax deduction for federal taxes, but you do get a deduction from the state. Therefore each parent would save $400 per year for each child. Indeed, in the last week of 2017, there was a rush to open 529s to get a state of Maryland tax deduction for $5,000. The new tax law went into effect on Jan 1, 2018. That means that the money that had been put into the 529 just one week prior could now be withdrawn. You saved $400 per child, and you got your money back in a week. Not bad.
Now let’s think. You can only put $5,000 per year into these accounts. But you can withdraw up to $10,000 per year. Therefore people rushed to open 529s in 2017 and then added another $5,000 in 2018 and withdrew $10,000 in 2018. They now scored a $400 savings in both 2017 and 2018.
First, a clarification: When you take out money from a 529, you do not have to give the same funds to the school. No one is tracing dollars. All you have to be able to state in your federal tax return is that you took money from your 529 and that you incurred K-12 expenses in the same year. If so – all is tax free.
Unfortunately, the State of Maryland was not happy. They saw that this had unintended consequences. They realized that each parent could save $400 per child even though the funds were not being used for college. They even contemplated changing tax laws to shut off this loophole. In the end, they decided against such a move. (A great thanks to Rabbi Ariel Sandwin, who successfully lobbied against the change.) Maryland decided to allow people to continue to be able to save $400 per child.
And then everything exploded. Someone finally noticed this Maryland program to give out $500, and saw that it said $500 per account, not $500 per child. And with that, a great feeding frenzy commenced. You see, many of us thought that it was $500 per child, and this came with a “but.” The but was that if you took the free money, you could not take the tax deduction. You must choose one or the other. Therefore this whole program was only saving you $100. It was either $500 from the state or a tax deduction worth $400. Pretty close. But then we realized that it was per account.
Let us assume that there is a child, Sam. His mother, father, grandparents, aunts, uncles, and friends can all open 529s and name him the beneficiary. He could easily be sitting on five accounts, or $2500 in free money. This can be repeated for Sam’s siblings.
We all thought that a 529 can result in savings of $400, max. However, the $500 free money per account sent things haywire. The government was offering $500 to each and every account, even if all the accounts had the same beneficiary. And accounts can be opened by anyone, for anyone. Yep, every one of your friends and relatives in Maryland can open a 529 for each of your children and be collecting $500 per account.
Is it really that simple?
Well, one more detail: In order to claim the $500, you have to deposit $25 to $100 yourself. Simply put the money in and take it right out. Not bad right? Well, there is also an income test. If your Maryland taxable income is under $75,000, you only have to put in $25. If your income is 75 to 125K, you need to put in $100. If your income is $125 to $175,000, you need to put in $250, and the government will only match $250 instead of $500. I want to stress that the income test is your Maryland taxable income, which is much lower than your total income. Your taxable income is after you have deducted your mortgage, charity, dependents, etc.
Is this all kosher?
Let’s ask a sensitive question. Let’s say that Sam’s parents ask their siblings (Sam’s uncles and aunts) to open accounts for Sam. They therefore need to put in $100 apiece. Sam’s father offers to reimburse them for this $100. Or perhaps Sam’s father offers to reciprocate and open 529 accounts for his nephews and nieces. Is this kosher? Well, none of this is what the State had in mind. The state never wanted this money to be used for K-12 in the first place. However, the scenario I am describing seems to be legal. There are many things in the tax world that create these quirky situations. Clearly, for parents and grandparents to open up accounts is perfectly fine. Personally, I would avoid all situations that appear to be less than 100% ethical.
I am often asked if the money coming out of a 529 has to go directly to the schools. The answer is no! The parent can withdraw the funds and put it into the family checking account. At the end of the year the parent will receive a 1099 stating that $5,000 was withdrawn. They will have to state on their tax return that they incurred at least that amount for K-12 tuition for that child in that year, and no taxes are due.
Another frequent question is whether the money can be withdrawn and used for preschool? Clearly not! However, funds can be transferred to siblings. That means that, if a three-year-old child gets the free money, they can transfer the money to an older sibling and withdraw the money in the name of the older sibling.
You need to keep records. I will say again that Quicken is the best program for this. You need to be able to run reports to know what you have done in regards to money going in and out of a 529 and also money being paid to colleges. When I prepare taxes, finding out what people have paid in tuition is often difficult to ascertain. I warn my clients that the government is definitely increasing tax audits to check for college tax credits being claimed. You had better understand the laws before you start transferring and withdrawing money.
The matching money program ended on May 31. I think it is slated to return next year – keep your antennas up. However, you can still open up 529s and get the tax deduction worth $400. And grandparents and relatives can open up accounts, but they will have to deposit money to get a tax benefit. I want to add my own point. We all love free money, and governments like to play Robin Hood and take from the rich and give to the poor. The essential problem with democracy is that it allows politician A to say to voter group B that if you vote for me I will give you money that I take from rich man C. I, too, jumped on the bandwagon and opened as many accounts as I could. However, none of this is a panacea to the tuition crisis. Even worse, this Band-Aid is actually a distraction from pursuing real solutions. Bear in mind that the states will likely close loopholes and lower income thresholds to ensure that they can buy the maximum number of votes for the least amount of money. Our tuition crisis will not be solved by programs such as this. We will solve the tuition crisis when the frum community is told that the support of our schools is a community obligation.
Eli Pollock CPA can be reached at elipollock2@yahoo.com.
