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If you’re in an MBA program or about to enroll in one, you’re going to pay a ton of tuition. And you’re going to earn money before and during your MBA. If you’re doing a full-time MBA, you’ll work half the year before you start, work a summer internship in the middle, and work half the year after you graduate. If you’re doing a part-time MBA, you’re working the whole way through. And you’re going to use some of that money to pay tuition and qualified higher education expenses.
What is a 529 Plan?
A 529 plan is a “tax-advantaged savings plan” that is supposed to encourage saving for future education costs. They can confer tax benefits in two ways: (1) in certain states, you get a tax deduction for the contribution and (2) the money grows tax free and can be taken out to use for qualified higher education expenses.
Why are they called 529 Plans?
They’re authorized by Section 529 of the IRS Tax Code.
Why is this useful for me as an MBA? I’m not saving for college for my kids yet.
You can open a 529 plan with yourself as the beneficiary. Most states offer some sort of tax incentive for contributing to a 529 plan such as a deduction or even a credit!
During your MBA, you have earned income in the year you start and from your summer internship. The income may even be in multiple states. In some states, you can use a 529 contribution to get a deduction or credit on that income and take the money out right away to pay tuition that you would have paid anyway. So you’re basically just dipping the money into the account and withdrawing it almost immediately. And you get a deduction!
To summarize, the 529 Loophole works like this:
Work and go to school in the same year
Contribute to 529
Get a deduction or credit on your state income taxes
Withdraw the money for qualified higher education expense that same year (or the next year if you want)
What are the steps?
Step 1: A person interested in taking advantage of this loophole should first check the state(s) where you have earned income from your pre-MBA job or summer internship to see if those states offer a state tax deduction for 529 contributions. Then check whether someone has to contribute to that state’s 529 plan (each state has their own 529 plan) or whether you can contribute any state’s 529 plan in order to take the deduction. A guide to whether you have to use your own state's plan or whether you are free to use an other state's plan and still get the tax benefits can be found here. Note that any state without an income tax will not have this benefit (because there’s no tax to deduct off of). To determine whether your state has a tax benefit for contributions to a 529 plan, visit this site.
Important: Check the fine print or call the state’s 529 Plan to ask whether you can deduct the gross contribution or the net contribution on your taxes. Two states, Michigan and Minnesota, block the loophole by basing the state income tax deduction or tax credit on annual contributions net of distributions. If the state limits to the net contribution, this strategy is useless because you’ll contribute and pull the money out in the same year, so your net contribution will be zero. Also most states do not have a waiting period on withdrawals. However, Wisconsin and Montana block this loophole by imposing a time limit.
Step 2: The person should contribute up to the tax deduction or credit limit for that state (or any amount they want up to that deduction limit, but obviously maxing it out gets maximum benefits). As soon as the money clears, have a check cut to the school and pull it out with a check to yourself and use it for qualified education expenses that you can substantiate. You may be asked for documentation later.
Important: The person must use the money for qualified higher educational expenses. Otherwise, you will be subject to penalties. This is why this tax trick works during your MBA because you have earned income AND tuition to pay in the same year.
What can 529 funds be used for?
Tuition and fees
Room and board (up to the amount it would cost to live on campus)
Required textbooks and supplies
Technology including a new computer - this is new! "The technology, equipment or services qualify if they are used by the beneficiary of the plan and the beneficiary's family during any of the years the beneficiary is enrolled at an eligible educational institution"
What can 529 funds NOT be used for?
What happens if you do a withdrawal that is not for qualified higher education expenses?
Bad stuff. 10% penalty on any investment gains plus you have to pay income taxes on the gains.
How do I get the money out to pay for tuition or expenses?
The 529 plan can pay the school directly or you can take the money out yourself and pay the school. Be sure to keep good records.
What are the steps at tax time?
Be sure to alert your accountant that you made a 529 contribution and be ready to substantiate the qualified higher education expenses. If you’re using something like Turbo Tax, they will ask about 529 contributions and distributions in the state tax section.
What’s the difference between a credit and a deduction?
A credit means the government gives you the money back on your taxes dollar-for-dollar. A $1000 credit means $1000 savings on your taxes. Credits are awesome!
A deduction reduces your taxable income. If your taxable income is $25,000, a $10,000 reduction reduces your taxable income to $15,000. You only pay taxes on the $15,000 instead of the $25,000. Note that the 529 deduction is a state tax deduction, so it only applies to your state taxes, not your federal taxes. This means that the federal government will still tax your income as if you made $25,000 but the state government will tax your income as if you made $15,000. The federal government and the state government tax your income differently and at different rates. That’s why you have to do multiple tax returns (one for the federal government, one for the state, maybe even one for your local municipality).
What’s a carryforward?
A tax carryforward is a rule that allows a taxpayer to save an un-used deduction, credit, or loss for a later year.
What’s an above the line deduction?
An above-the-line deduction is a deduction that allows a taxpayer to subtract from his or her gross income in arriving at "adjusted gross income" for the taxable year. Above the line deductions are better than below the line deductions because they reduce your AGI. Reducing your AGI is important because there are lots of tax benefits that get phased out based on your AGI. In general, you want your AGI to be as low as possible.
How much could I save?
An MBA student who works at a management consulting firm in New York City over the summer and earns $35,000 could flow $5000 through his or her 529 plan, withdraw the money to pay 2nd year tuition, and thus only report $30,000 in New York State income, thus dropping his or her New York State tax bill from $1,393 to $1,071 for a savings of $322. This can be much higher for students in states that allow a higher deduction.
If every Wharton student, for example, made $35,000 over the summer and worked in New York City and used this loophole, the Class of 2019 (~860 people) would collectively save $276,920 on New York State taxes.
This site has a map that shows the tax benefits you could receive from contributing to a 529 plan in each state.
What else should I consider?
Sometimes using a 529 to pay for qualified higher education expenses can negate your ability take other education related tax credits. The Lifetime Learning Credit gives a tax credit of 20% of up to $10,000 of tuition. The IRS restricts double dipping so you can’t use the same $10,000 of tuition and books to justify the Lifetime Learning Credit and your tax-free 529 distribution. This doesn’t really apply to many full-time MBAs who have tuition expenses out the wazoo, so plenty to go around across all the deductions. Also many MBAs are disqualified from the Lifetime Learning Credit because it has an income cap. It might be a factor in your in-between year when you only have summer internship income. The LLC starts to phase out for single tax filers with modified adjusted gross income of $55,000 and completely disappears at $65,000.
Are there age limits?
There are age limits for 529 beneficiaries for a small minority of states and their plans, particularly for some tuition prepayment plans. You can see the limitations here.
Do the states know about this? What if they close the loophole?
They do know but it’s not a very popular loophole, so they haven’t bothered to close it.
Need Tax Help?
We recommend TurboTax. They have an awesome portal dedicated entirely to students and education tax credits.
The owner of this site is not an investment advisor, financial planner, nor legal or tax professional and articles here are an opinion. Consult a tax professional for your tax planning needs. The content on this site is intended to be educational and used for general informational purposes only. It is not intended to provide specific advice or recommendations for any individual. The owner of this sites assumes no liability for information provided above. The information may not be correct when applied to your specific situation.