Inadvertent tax loophole discovery

[SecondCor521]

Hi all.

I erroneously made a withdrawal from my son's ESA earlier in 2019 that was in excess of the qualified educational expenses that I had incurred to that point. For the sake of example, assume I had $6K in expenses yet withdrew $9K.

The way I read Chapter 7 of IRS Pub 570 at approximately page 40, if I recontribute the $3K excess into that same son's 529 (aka a QTP), then that re-contribution counts as a qualified educational expense and I won't have to pay any taxes or penalties:

"Contributions to a qualified tuition program (QTP). A contribution to a QTP is a qualified education expense if the contribution is on behalf of the designated beneficiary of the Coverdell ESA."

I am planning on doing this just to avoid the taxes and penalties situation on that $3K excess.

My state has a tax deduction for 529 contributions. There does not seem to be any restriction on me taking a deduction this year for this $3K excess re-contribution; all they seem to care about is the fact that I added $3K to his 529 this year.

This brings up the possibility of deliberately removing money from my kids' ESAs and contributing that money back into their 529's and taking the state tax deduction. At Idaho's top rate gets me about 7% of the converted money back, although it can't reduce my taxes owed below zero. (ETA: Although I may not be at Idaho's top rate with this strategy, so the tax savings are less.)

Of course I would have to be fine with the money being in their 529's rather than their ESA's. I don't think I care much; I was planning on draining their ESA's first anyways, and once I drain the ESAs that means fewer accounts to manage, which I like.

Thoughts? Problems? Gotchas? What did I miss?

 

[kaneohe]

Nice find...........did you do the rollover within 60 days?

https://www.savingforcollege.com/article/when-to-consider-a-coverdell-esa-to-529-plan-rollover

see the last section

 

[SecondCor521]

Nice find...........did you do the rollover within 60 days?

https://www.savingforcollege.com/article/when-to-consider-a-coverdell-esa-to-529-plan-rollover

see the last section

Thanks for the reply and comment.

I didn't and haven't. I see in the article about the 60 day time frame and know that applies to IRA indirect rollovers, but the IRS documentation about ESAs and 529s doesn't say anything about a 60 day time limit. There are 60 day windows associated with ESA to ESA rollovers (Pub 970 page 45) and recontributions of refunds to QTPs (page 52), but that's not what I'm doing. I'm inclined not to believe the article author on that point.

I do plan on doing all of the relevant transactions in CY 2019.

 

[FlaGator]

Interesting find. I have both types of accounts and had not even thought about how to consolidate them. Just figured I would spend down the much smaller ESA first. Would be nice to be able to consolidate them for the college student, and will talk to my tax guy about that possibility.

Although it might meet the letter of the law, it "feels like" it violates the spirit (work, make money, put some away for your kids and we'll give you a tax break, but you're not working and moving over potentially untaxed appreciated gains).

What's the risk of a state tax audit? Is there enough money at stake to take that risk if you are audited and they rule against you?

 

[kaneohe]

https://www.bogleheads.org/forum/viewtopic.php?t=263821

see the post by Alan S.........agrees w/ you tho it looks like he had another answer first and then deleted it upon further thought.

 

[SecondCor521]

What's the risk of a state tax audit? Is there enough money at stake to take that risk if you are audited and they rule against you?

Pretty much zero risk of an audit. But my position has always been that I do my taxes to the best of my ability and understanding and try to have authoritative cites (from IRS or Idaho State Tax Commission) and take reasonable positions. If an audit comes and they determine that I've made a mistake, I'd accept the consequences.

I did go check the Idaho tax instructions and they basically say that if you contribute to an Idaho 529 in the current calendar year, you get a state income tax deduction (Form 39R line B-14 if anyone cares) up to $6,000 per year for a single filing status. It's like one paragraph with no exceptions, qualifications, or limitations.

At the end of the day, I'd probably only move over a few thousand dollars per year since I have a low tax liability, so only a few hundred dollars at stake anyway.

https://www.bogleheads.org/forum/viewtopic.php?t=263821

see the post by Alan S.........agrees w/ you tho it looks like he had another answer first and then deleted it upon further thought.

Thanks for that link. I respect Bogleheads and Alan S., so I'm glad to see that he sees things similarly.

 

[SecondCor521]

Although it might meet the letter of the law, it "feels like" it violates the spirit (work, make money, put some away for your kids and we'll give you a tax break, but you're not working and moving over potentially untaxed appreciated gains).

I'm not quite sure I follow you here.

Money inside an ESA or a 529 grows tax-free. I didn't get any deduction or up-front credit for the money I put into the ESA; the main thing I got with the ESA was the ability to use it for high school expenses. Moving it from the ESA to the 529 introduces those funds into the 529 world in the same way a fresh contribution would, so the state tax deduction seems legitimate. Since the money ends up getting used for qualified expenses or penalized when it's removed from the 529 for other reasons, I'm not sure what people would be getting away with.

In my original situation, as I mentioned, I overwithdrew in anticipation of some expenses which didn't happen. I investigated and found out about the 529 contribution being a qualified expense, and it seemed to work for me. Only later did it dawn on me that I might qualify for the state tax deduction on the 529 contribution, and that doing it on purpose could save me a little bit in state taxes.

If you want to clarify I would like that. I like to be able to lay out my reasoning and then learn from others (like you) where I might be missing something.

 

[FlaGator]

I'm not quite sure I follow you here.

Money inside an ESA or a 529 grows tax-free. I didn't get any deduction or up-front credit for the money I put into the ESA; the main thing I got with the ESA was the ability to use it for high school expenses. Moving it from the ESA to the 529 introduces those funds into the 529 world in the same way a fresh contribution would, so the state tax deduction seems legitimate. Since the money ends up getting used for qualified expenses or penalized when it's removed from the 529 for other reasons, I'm not sure what people would be getting away with.

In my original situation, as I mentioned, I overwithdrew in anticipation of some expenses which didn't happen. I investigated and found out about the 529 contribution being a qualified expense, and it seemed to work for me. Only later did it dawn on me that I might qualify for the state tax deduction on the 529 contribution, and that doing it on purpose could save me a little bit in state taxes.

If you want to clarify I would like that. I like to be able to lay out my reasoning and then learn from others (like you) where I might be missing something.

The bold part is where I see the potential for conflict with "spirit of the law." Is it really "new" money going in to the 529? How much has the ESA grown? Shouldn't be a question about deducting your basis, but what about the pro-rata portion of earnings?

Those musings aside, I know nothing about ID's taxation, much less the legislation that created the deduction. With a low audit risk it probably doesn't matter.

You spotted up a useful idea for me to consolidate my ESAs with 529s, and I appreciate that.

 

[SecondCor521]

The bold part is where I see the potential for conflict with "spirit of the law." Is it really "new" money going in to the 529? How much has the ESA grown? Shouldn't be a question about deducting your basis, but what about the pro-rata portion of earnings?

Those musings aside, I know nothing about ID's taxation, much less the legislation that created the deduction. With a low audit risk it probably doesn't matter.

You spotted up a useful idea for me to consolidate my ESAs with 529s, and I appreciate that.

Ah, I see what you're saying.

The way I look at it, that ESA money while it was growing in the ESA was growing tax deferred and tax free if used for education. Shifting it to the 529 means it continues to grow tax deferred and tax free if used for education.

What those earnings do, and this "loophole" does, is enable people like you and me to get a state tax deduction on that earnings portion. For those who are already maxing out their state tax deductions for normal 529 contributions, it also allows them to temporarily park additional money in an ESA and then use this loophole later, either for simplification or for additional state tax deductions.

Anyway, my conclusion is that this action is pretty clearly legal and provides me with some simplicity and a few hundred bucks off my state tax returns over the next couple of years, so I plan to do it. Whether they intended it or not I will leave up to my professional lawmakers to determine and "fix" if they deem it necessary or appropriate.

...

I actually dug into the Idaho statutes and found the actual law about the deduction. It's Title 63, Chapter 30, Section 3022:

"In the case of an individual for any tax period ending on or prior to December 31, 2016, deduct the amount contributed to a college savings program but not more than four thousand dollars ($4,000) per tax year. In the case of an individual and for any tax period starting on or after January 1, 2017, deduct the amount contributed to a college savings program, but not more than six thousand dollars ($6,000) per tax year. For those married and filing jointly, deduct the amount contributed to a college savings program, but not more than twice of that allowed for an individual. To be qualified for this deduction, the contribution must be made during the taxable year and made to an Idaho college savings program account as described in chapter 54, title 33, Idaho Code."