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I was setting up an Illinois 529 plan recently. Contributions to the plan are state income tax deductible up to $10,000 per tax payer per year. It got me thinking:

What is to stop someone with no need to spend money on educational expenses from creating a 529 plan for themself and every year contributing $10k and then withdrawing the money a month later?

The distribution would be non-qualified, but since basically none of the income would be "earnings", there would be almost no penalty or income tax due on the withdrawal. And, they would benefit from deducting the income from state income tax.

I can't be the first person to think of doing this, so I am wondering if anyone knows what the catch is? For the record, I am not looking for legal advice or am particularly interested in implementing this strategy—I'm simply curious about this idea.

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Nice idea, but you will have a potential problem. State lawmakers have already considered this option:

I looked at this site: Saving for college because it include info for on all the plans. For Illinois it discuses income tax recapture.

Effective January 1, 2007, rollovers from this plan to an out-of-state program are included in Illinois taxable income to the extent of prior Illinois deductions. Effective January 1, 2009, nonqualified distributions from this plan are included in Illinois taxable income to the extent of prior Illinois deductions.

Most of the states have similar wording. When looking up the law the key word is recapture.

The reason why there is no recapture provision at the federal level is that there is no tax deduction on contributions. The 10% penalty make it less likely that somebody would want to have nonqualified distributions.

If a state gives a tax deduction in the year of the contribution they want to demand that tax deduction back if the funds are not used for educational purposes. Generally there are of course provisions for scholarships, death, and disability.

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From a federal tax point of view, withdrawals from 529 plans are treated as taxable unless they are used on qualified expenses:

The part of a distribution representing the amount paid or contributed to a QTP does not have to be included in income. This is a return of the investment in the plan.

The designated beneficiary generally does not have to include in income any earnings distributed from a QTP if the total distribution is less than or equal to adjusted qualified education expenses (defined under Figuring the Taxable Portion of a Distribution , later).

[...]

To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses.

You'll have to include them in your income and pay normal income tax on them, and also in most cases pay an extra 10% penalty:

Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income.

You'd have to check on the situation from a state perspective but I'd imagine it's quite similar. The basic point is that non-qualified distributions are treated as earnings.

  • Having read @mhoran_msprep's answer I'm now not sure if this answer is correct/useful – GS - Apologise to Monica Apr 23 '15 at 12:43

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