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I want to help pay for my granddaughter's preschool and primary education expenses and would like to get a deduction on my Arizona state taxes in the process. Arizona offers a state tax deduction for a 529 plan contribution. What's my best option?

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Here are the pertinent facts as far as I can tell:

  • Arizona hasn't conformed to the federal law that allows 529 plan withdrawals to be used for K-12 tuition.

  • Arizona has a deduction for 529 plan contributions that does not depend on which state's HSA plan you use (you're free to shop around):

    43-1022. Subtractions from Arizona gross income

    1. The amount contributed during the taxable year to college savings plans established pursuant to section 529 of the internal revenue code to the extent that the contributions were not deducted in computing federal adjusted gross income. The amount subtracted shall not exceed:

    (a) Two thousand dollars for a single individual or a head of household.

    (b) Four thousand dollars for a married couple filing a joint return. In the case of a husband and wife who file separate returns, the subtraction may be taken by either taxpayer or may be divided between them, but the total subtractions allowed both husband and wife shall not exceed four thousand dollars.

  • State income tax would be due, per instructions for Form 140 Line 17:

    J. Nonqualified Withdrawals from 529 College Savings Plans You must make an addition to income if both of the following apply to you:
    • You received a nonqualified withdrawal from a 529 college savings plan.
    • You did not include the amount of the withdrawal in your federal adjusted gross income.
    The amount that you must include on line 17 is the amount withdrawn, but no more than the difference between the amount of contributions subtracted in prior years and the amount added in any prior years.
    .....
    A qualified withdrawal is a withdrawal from an account to pay the qualified higher education expenses of the designated beneficiary of the account.

Typically with non-qualified withdrawals from a 529 plan the money goes to the beneficiary or the account holder and they pay the penalty/tax on the non-principal amount. The wording about the amount to include above sounds to me like it is intended to recapture any deductions made, but doesn't seem to account for the money going to the beneficiary rather than the account owner. So, potentially there could be tax savings by having the beneficiary report it as income.

Unless the beneficiary can take the income and not owe state income tax (and not create state income tax liability for her parents), then I don't think you can save on AZ income tax in years where you are both contributing and withdrawing, because any non-qualified withdrawal (in this case your granddaughter's K-12 tuition) will incur state income tax.

If there's a long enough time between contribution and withdrawal for K-12 tuition spending, then from a state tax perspective you could come out slightly ahead by virtue of today's dollars being worth more than tomorrow's dollars. A tax deduction today could earn interest until you have to pay income tax onto the withdrawal in a few years.

Alternatively, don't withdraw the money until such a time as they change the law to conform to federal law or your granddaughter is off to college and you get the full benefit of tax-free growth and the AZ deduction.

Edit: I Was going to delete after thinking about additional issues regarding beneficiary vs account owner claiming the income and lack of familiarity with the AZ income tax, but leaving for reference and may update further after have time to do more research.

  • Wouldn't the non-qualified withdrawal be counted against the granddaughter? – pboss3010 Apr 18 at 14:56
  • @pboss3010 Hadn't thought of that, unqualified withdrawals at the federal level can be taken by either the beneficiary or the account owner. If the tax liability were passed to the granddaughter then perhaps the tax could be nil or a lower rate. – Hart CO Apr 18 at 15:09

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