Any 529 experts out there?

[Morning Glory]

Starting this year my state is offering a tax deduction of up to $3000 for 529 contributions. I pay approximately 7% in state income taxes, so I would save $210/year by doing this.  I am in the 15% bracket for federal.  Without this deduction I would skip the 529 and just invest in taxable Vanguard, because I don't pay taxes on long term capital gains anyway. I would like to help my kids with college expenses but not necessarily pay the full amount. I have a 2 year old and another baby on the way, so college is far off for them, but I would also like for my hubby to go back and finish his degree.  I am already maxing my other tax-advantaged accounts.  Here are my questions:

I understand that if the beneficiary receives a scholarship, it is possible to withdraw the amount of the scholarship without taxes or penalties. Does a tuition waiver count as a scholarship for this purpose? (I have a side gig as adjunct faculty, and I get a waiver up to the amount of credits I teach in a given year that can be used by me, my spouse, or my child. Unfortunately these don't roll over from year to year.)

How about employer reimbursement programs? (I don't think so because this is not taxed, so it would be like double-dipping)

Will I still get the tax deduction if I contribute and withdraw the money in the same year?

Is a 529 in the parent's name penalized more than a taxable account in the parent's name for financial aid purposes?

Anything else I need to know here?

[seattlecyclone]

I understand that if the beneficiary receives a scholarship, it is possible to withdraw the amount of the scholarship without taxes or penalties.

This is false. You can withdraw the amount of the scholarship without the penalty only. You would still have to pay tax on the gains attributed to the withdrawal. Furthermore the gain would count as regular income and be taxed accordingly; the lower capital gains rate doesn't apply here.

Does a tuition waiver count as a scholarship for this purpose? (I have a side gig as adjunct faculty, and I get a waiver up to the amount of credits I teach in a given year that can be used by me, my spouse, or my child. Unfortunately these don't roll over from year to year.)

I don't know. Good question!

How about employer reimbursement programs? (I don't think so because this is not taxed, so it would be like double-dipping)

Pub 970 specifically calls out tax-free employer education assistance as an amount you must subtract from your expenses to determine how much you can withdraw from the 529 tax-free. But just like scholarships, you don't have to pay the 10% penalty on the amount you received from employer assistance.

Will I still get the tax deduction if I contribute and withdraw the money in the same year?

Depends on your state's rules.

Is a 529 in the parent's name penalized more than a taxable account in the parent's name for financial aid purposes?

On the asset side, the FAFSA treats them the same. The difference is on the income side: capital gains income from a taxable account counts (even if you're in a low enough tax bracket to not pay tax on this income), while qualified withdrawals from the parent-owned 529 don't count as income.

[Beriberi]

I think the risk of tax for money taken out to compensate for scholarships is pretty low, as it is taxed at the student's income tax rate. I suspect my kids will not be making a ton of money in college, so their income tax exposure will be minimal.

Example:

20k of qualified college expenses.
6k of scholarship
20k removed from 529.

(For the sake of argument, I put 10k into the 529, now it is worth 20k).

I removed 6k "too much".  3k of that was "earnings" the other 3k was "principle".  My child's income will increase by 3k that year.  Assuming they are working a part time making a few hundred a week, there is not significant tax liability change when going from 10k to 13k of regular income per year.

If I had put the 10k into a taxable account and it had grown to 20k, I would pay 15% tax on the gains.  So, 15% of 10k, instead of income tax on 3k.  If there were no scholarships, I pay no tax on the money withdrawn for qualified educational expenses.

tl;dr The risk is your child might pay income tax on <I>some</I> of the 529 proceeds, vs you paying capital gains tax on <I> all </I> of the proceeds.
            

[nwhiker]

"This is false. You can withdraw the amount of the scholarship without the penalty only. You would still have to pay tax on the gains attributed to the withdrawal. Furthermore the gain would count as regular income and be taxed accordingly; the lower capital gains rate doesn't apply here."

This has been something I'm looking into for my kids. So if my kids get a scholarship I understand that they can withdraw up to the scholarship amount correct? But you are saying that the withdrawal is taxed as regular income versus capital gains rate. I have been torn between a 529 and setting up a custodial account with Vanguard. I understand that the downside to that is the account has to be transferred to the kids when they turn 18.

[seattlecyclone]

This has been something I'm looking into for my kids. So if my kids get a scholarship I understand that they can withdraw up to the scholarship amount correct?

There's no limit to the amount you can withdraw per year. It's just that if you withdraw more than your valid educational expenses (minus any that are already covered by another tax break), part of the withdrawal will be taxable income for the beneficiary, and part or all of that taxable income may also incur a 10% penalty.

But you are saying that the withdrawal is taxed as regular income versus capital gains rate.

Yes. The gain on any non-qualified withdrawal counts as regular income for the beneficiary. Assuming your kid doesn't have a bunch of other income while they're in school, their tax rate should be minimal.

I have been torn between a 529 and setting up a custodial account with Vanguard. I understand that the downside to that is the account has to be transferred to the kids when they turn 18.

The exact age of giving the child legal control depends on the state. Regardless, the FAFSA counts an UTMA account as the child's asset, which can be much less favorable for financial aid purposes than a 529 (generally counts as a parental asset). Also with an UTMA the entire gain counts as income regardless of what you use it for. I don't recommend putting more into a 529 than you actually expect to need for college, but there are definite benefits to using the 529 for funds that you are pretty sure will be used for education.

[Morning Glory]

Thanks for the link to Pub 970. I think I will skip the 529 for now and just go taxable Vanguard. Having to subtract the amount used for tax credits swung me. Plus the fact that the student must be attending at least half time. Seems like there are a lot of traps here, and there are easier ways to save $210.

It looks like the waiver would count the same as an employer reimbursement program because it is not taxed.

[SuperSecretName]

don't forget that you can open a 529 in yours and your spouses's names, and change the beneficiary later.  So, if you want to put more than 3k/year, you'd still be able to get more state income relief.

[Morning Glory]

Nope, $3000 is the limit for MFJ. It would be $1500 for a single person.