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Retired Military Finances 201: Doing the 529 TwoStep Thumbnail

Retired Military Finances 201: Doing the 529 TwoStep

College Planning Taxes

I've heard of a dance called the Texas Two Step. According to Google, there is such a thing. There also appears to be a Texas Two Step Lotto game. The 529 Two Step is something completely different. In fact, the 529 Two Step is a name I made up. What I'm going to talk about is often called a Cycling Money Strategy. But since I like my name better, we're going to use the 529 Two Step name instead. Let's take a look

529 Tax Rules Reviewed

In general, at the Federal level, contributions to a 529 plan are not tax deductible. However, if used for qualified education expenses, earnings on those 529 contributions are tax free (kind of like a Roth IRA).

Things are different at the State level. Many states that have an income tax offer a current income tax deduction for contributions made to a 529 plan. So, at the state level there are both current deductions and potential tax-free growth.

Enter the 529 Two Step

Many of those states that offer the current income tax deduction also don't require that the funds stay in the 529 plan for any set amount of time.

In a perfect world you save up enough for college expenses well before Junior heads off to school. We don't live in a perfect world. If Junior is getting ready to go to school and you haven't saved up for college, you can get a little help from your State's Department of Revenue to pay for college. Let's look at an example:

I live in VA. VA allows you to take up to a $4,000 deduction for contributions to the VA 529 Plan (inVEST) per account. Contributions in excess of $4,000 carry forward until fully deducted ($4,000/year or reaching age 70 when the full amount is deductible). So, if you're married and have one child headed off to school, you and your spouse could contribute $4,000 each to a 529 account and take an $8,000 deduction on your VA Income Tax Return. You could literally deposit the funds one day and pay the college the next day. And by the way, that $8,000 deduction will reduce your VA taxes by $460. Not huge money...but every bit helps

The amount you can deduct will depend on the State you live in.

529 Two Step Gotcha's

Like any tax strategy, there are things you need to watch for. Here are the main ones:

  • Some States require that you contribute to their sponsored 529 plan. Some don't. You'll need to check on what your State requires
  • States don't automatically follow Federal tax law. For example, Federal law allows 529 funds to be used for K-12 education (with restrictions) and/or student loan payments (again with restrictions). Several States do not consider these payments qualified education expenses. If you take a distribution that your state doesn't recognize as a qualified education expense, you'll likely have to pay back the tax benefit you received when you took the deduction. You'll might also have to pay state taxes on the distribution.
  • A few States have taken action to prevent the 529 Two Step.
  • WI and MT require that the funds stay in the 529 plan for a specified period before they qualify as deductible
  • MN and MI require you to net contributions and distributions in a taxable year before calculating the deduction. So, if you put $1,000 in and take $1,000 out in the same year, you don't get the deduction.

Two Tax Systems

Judge Learned Hand, a prominent US Court of Appeals Judge said, "In America, there are two tax systems: one for the informed and one for the uninformed. Both are Legal." We'll keep working to keep you informed.

Military Finances are Different

Any American taxpayer can take advantage of the 529 Two Step. But as an Active or Retired Senior Military Officer or NCO, state taxes may not be in your cross-check. In that way you're different than your civilian counterpart. That's why we think military members should work with a financial planner and/or advisor that deals with your unique issues each and every day. If you'd like to find out how we work with clients just like you, use the button below to schedule a free initial consultation.

If you found this article useful, you might like the following blog posts:

Military Finances 301: Should You Buy a College Condo?


Military Finances 201: Getting Ready to Use US Savings Bonds to Pay for College? It Might Not Work Like You Think


Military Finances 201: Do GI Bill Benefits Affect Financial Aid and the FAFSA?


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