Should You Stop Funding Your 529 College Savings Plan for Tax Savings?
You are about to read a strategy that may reduce your adjusted gross income and save you thousands in taxes. I strongly urge you to read the entire blog and think long and hard about how you can work it into your 529 plan savings strategy. I'm a big believer that when there is a will, there is a way. S0 let's get to work!
No one enjoys paying taxes, and many of us spend a lot of time figuring out how to avoid them. If you fund your child's 529 plan, you might already know it's a tax-favored account, when used for qualified educational expenses but contributions are made with after-tax dollars. However, you may be able to change that and effectively reduce your taxes today!
Often, parents and grandparents don't open a 529 plan for at least a few years after the child is born or even later. Life gets in the way, other immediate expenses come up, time flies and before you know it, well, you get it.
Since the real benefit of a 529 plan is tax-free growth for qualifying educational expenses that benefit isn't all that great unless you have a long time horizon.
It's also apparent when a 529 plan is used for k-12 expenses because of that same issue, a relatively short time horizon.
In either case, funding the 529 plan later or using it earlier make it a lackluster tax savings strategy. Not everyone gets it immediately, but when your run the numbers, it's not that great.
I'm not saying you should avoid the 529 plan but there may be a better way to save tax-free. I'm going to share a strategy I use to help my kids fund their 529 plans (and all their accounts, including their Roth IRAs and Coverdell ESA) while avoiding taxes on those contributions.
It's not illegal, and part of it is even promoted on the IRS website. Keep reading to learn more!
The 529 Plan
In case you're unfamiliar with the 529 Plan, it's an after-tax, state-sponsored investment account specifically designed to help families save for future education expenses. The money you invest grows and can be withdrawn tax-free for qualifying expenses. Here's how the 529 plan works:
Fund the account with after-tax dollars, similar to a Roth IRA. You won't receive any federal tax deductions for your contributions, but some states offer state tax deductions or credits for contributions to their respective plans. However, not all state's that have a state income tax offer benefits for using their own state's 529 plans.
Invest your contributions in various options, such as stock and bond funds, which can potentially grow over time. Investment options vary greatly from 529 plan to 529 plan and your state 529 plan may not be your best investment option.
Withdraw funds tax-free for qualified education expenses (such as tuition, fees, books, and room and board), as long as you use the earnings in the account for these purposes. In most cases, state income tax does not apply either.
Use 529 plan funds for various educational expenses, including K-12 tuition, college, and trade schools. You can also change the beneficiary of the account to another family member if the original beneficiary doesn't need the funds for education.
While the 529 plan offers numerous benefits, you still pay federal income taxes on the money you put into the account since contributions are made with after-tax dollars. You are also allowed to use any state's 529 plan but the benefits for your specific situation may vary.
The Real World 529 Plan Issue
Now that you have a primer on 529 plans, let's talk about the real world. Because, well, we live in the real world and as I mentioned above, time gets away from us. The 529 plan benefits may not be as substantial as they should be, primarily due to the limited window of time available to fully capitalize on the tax benefits. A small change could get you the benefit of a tax credit, tax deductions and tax-free savings all at the same time.
Here is an example of a short time horizon when dealing with a 529 plan.
If you contributed $500 every month for 5 years at an 8% rate of return that would grow to $36,983. The total contributions are $500 x 12 months x 5 years = $30,000 and the growth is $6,983.
However, if you're in the 22% tax bracket, you would be earning $641 per month to make that $500 after-tax contribution to the 529 plan. $641-$500 is $141 in taxes per month over 5 years is $8,460 in taxes.
If you started right after your child was born and only funded the 529 plan for 5 years and waited until they were 18 years old the account would grow to $104,272. That's a ton more, $74,272 in gains, more.
Again, I'm not trying to stop you or anyone from funding a 529 plan. I just think there is a better way. A way that if it doesn't work for you now, you should strongly consider figuring out a way to make this strategy work for you!
The Solution: Hiring Your Kids Federal Income Tax Loophole
The good stuff: If you're a sole proprietor, 100% owner of an LLC that files as a Schedule C, or a partnership 100% owned by you and your spouse, hire your kids and pay them as employees of your business. It's a business tax deduction with multiple benefits.
This allows you to avoid paying FICA taxes, and since it's your child's income, they won't pay taxes up to the standard deduction on those earnings. It's a sudo tax credit on the FICA taxes and tax deductions because it's a business expense. They can then use that money to fund their own 529 College Savings Plan tax-free.
By hiring your children in your small business, you create a win-win situation that benefits both your company and your kids' future education expenses. Here's a detailed breakdown of how this 529 plan tax strategy works:
Hire your children as employees if you own a sole proprietorship, are a 100% owner of an LLC that files as a Schedule C, or have a partnership 100% owned by you and your spouse. Ensure you treat them as any other employee, with proper documentation, such as an employment contract, time records, and job descriptions.
Pay your child a reasonable wage for the work they perform. The amount should align with industry standards and their experience level. Keep in mind that excessively high wages can attract scrutiny from the IRS.
Federal Income Tax savings:
Since your child is a dependent and an employee, their income is subject to the standard deduction. In 2023, the standard deduction for a single taxpayer is $13,850. This means that if your child earns less than this amount, they won't owe any federal income tax. Additionally, as their employer, you won't have to pay FICA taxes (Social Security and Medicare) on their wages, further increasing your tax savings.
529 plan contributions:
Your child can now contribute to their own 529 plan with their earned income. Since they have already paid taxes on their wages (if any), the contributions will be made with after-tax dollars. This means that the money they put into the account will grow tax-free, and withdrawals for qualified education expenses will not be subject to taxes.
As an added bonus, you get to deduct the wages you pay your child for their work in your business as a business expense, reducing your taxable income and lowering your overall tax liability. In the end, it can help you reduce your adjusted gross income too.
By implementing this tax strategy, you can effectively fund your child's 529 plan without paying taxes on the contributions. This allows you to maximize the potential growth of the account and make the most of the tax advantages offered by the 529 plan. Remember to consult with a tax professional to ensure you are following all IRS rules and regulations.
Lower Federal Income Taxes and FICA Taxes
The tax benefits come in the form of a business deduction for federal income taxes and an exemption from FICA taxes. This works because, as a business owner, you can deduct the cost of wages paid to your employees, including your children. It also exempts you and your child from FICA taxes. Let's examine the potential tax savings from this strategy:
Income tax savings:
If you pay your child up to the full amount of the standard deduction for someone filing as single in 2023 ($13,850) and you're in the 24% tax bracket, the wages paid to your child can reduce your taxable income by $13,850. This results in a tax savings of $3,324 ($13,850 x 0.24) from your income tax liability.
If you go over the standard deduction, your child may still have a federal income tax liability but it may be at a much lower rate than your personal taxes. You are not required to stop at the standard deduction and it's likely still a huge benefit.
FICA tax savings:
As a business owner, you're generally required to pay FICA taxes (Social Security and Medicare) on your employees' wages. FICA tax is a total of 15.3%, with half paid by the employee (7.65%) and the other half paid by the employer (7.65%). However, when you hire your children, you can be exempt from paying the employer portion of FICA taxes (7.65%) on their earnings as long as they are under 18 years old. In our example, since the child's wages are $13,850, you would save an additional $1,059.58 in FICA taxes. This is calculated as follows: $13,850 x 0.0765 (employer's portion of FICA tax rate) = $1,059.58.
In total, by hiring your child and paying them the full standard deduction amount, you could save $4,383.58 ($3,324 in income tax savings + $1,059.58 in FICA tax savings) in taxes.
FICA Tax Issues
The FICA tax avoidance strategy doesn't work if you're not the sole owner(s) of the business or if you file as a corporation. Also, they must be an employee and not an independent contractor. I know I said this above, but that's a huge mistake that will destroy this 529 plan tax-free savings strategy.
These tax savings can be significant, especially if you have multiple children working for your business. However, it's essential to ensure that their wages are reasonable for the work performed and that all employment requirements are met. Consulting with a tax professional can help you navigate the rules and regulations to implement this strategy effectively.
More Opportunities for Your Child
By earning income through working for your business, your child can also contribute to their own Roth IRA. There's no minimum age requirement for contributing to a Roth IRA, but they do need earned income.
Additionally, they can contribute to a Coverdell ESA, even if they don't have earned income. You could gift them the money or use the earned income for the Roth IRA, but make sure the amount your child is earning is legitimate. They must actually work to earn the money.
Using this tax loophole can supercharge your financial plan and help you save on taxes. The 529 Plan, Roth IRA, and Coverdell ESA all offer great tax benefits, and this strategy can help you make the most of them. If you're interested, check out the IRS website for more information.