Ocotober 2002

IRC Section 529 Plans: Deduction for New York Residents

By Leon M. Metzger, CPA

IRC section 529 provides an exemption from federal taxation for qualified tuition programs. As of January 1, 2002, the money withdrawn from such programs to pay for qualified higher education expenses is exempt from federal and New York State income taxes.

In addition, New York residents that contribute to one or more tuition savings accounts established under the New York State College Choice Tuition Program may receive state and city income tax deductions for contributions of up to $5,000 annually, provided that the contributions are neither otherwise deductible nor eligible for a federal income tax credit. Married couples may deduct up to $10,000 when filing jointly. Account owners can take advantage of the federal tax deferral of earnings on contributions, and contributions to all accounts, but a lifetime maximum of $100,000 applies to New York’s plan.

Federal gift tax rules exempt contributions of $11,000 per year from taxation. The rules also exempt gifts made in excess of that amount if the taxpayer does not make any other contributions to that beneficiary over the next five years. Thus, under IRC section 529(c)(2)(B), a taxpayer may apportion a lump sum of $55,000 over a five-year period.

New York’s program charges a management fee of 0.65%, which is comparatively low but not the lowest. Depending on the underlying investment, Utah’s fee can be as low as 0.31%. New York residents participating in an out-of-state 529 plan, however, cannot receive a New York tax deduction. Thus, the question is: If a New York taxpayer’s criteria for choosing between the New York and Utah plans are fees and state taxes, which should the taxpayer choose?

Unfortunately there is no clear-cut answer, but the factors to consider include:

Example 1. A married couple with a seven-year-old son expects that, wherever it invests, the annualized return on investment will be 8%. Each parent wants to contribute $10,000 one time only. Assuming the couple files a joint return, their maximum New York State and City tax savings are $1,044. After eliminating the federal tax benefit, that savings is only $644, in which case the Utah plan would be worth $906 more than the New York one. Are the higher fees worth saving $644 today? Most contributors would choose the New York plan because an after-tax rate of at least 2.92% on the $644 outweighs the extra fees.

Example 2. Assume the couple above also has a five-year-old daughter. The Utah plan is worth $1,812 more than the New York plan for the son (double the amount in example 1 because the $10,000 deduction is now allocated to two children) and $2,444 more for the daughter. In this case, the contributors would have to earn 15% after taxes on the $644 in order to make the New York plan more attractive.

Example 3. Assume each parent from example 2 invests $5,000 in the New York and Utah plans for the son and $10,000 in the Utah plan for the daughter. This strategy maximizes the New York deduction and incorporates the best results from examples 1 and 2. The downside is the extra paperwork and recordkeeping involved.

Example 4. Assume each parent from example 1 wants to contribute $50,000. In this scenario, the contributors save a combined $9,059 in fees if they opt for the Utah plan.

Example 5. Assume each parent from example 4 wants to contribute $5,000 per year for 10 years. While this maximizes the New York deduction—$6,530 in total—the values of the New York and Utah plans are $204,269 and $210,928, respectively. Of course, if each adult invests the entire $50,000 in the Utah plan in the first year, the value of that account will be $243,279.

Unfortunately, there is not one investment strategy that works best in all scenarios. From these examples, however, we can draw the following conclusions:

Do not assume that in-state plan deduction guarantees that this is the best program for New York State residents. Prospective contributors should also evaluate, on a risk-adjusted basis, which program’s investment manager is superior.

Leon M. Metzger, CPA, executive vice president of Paloma Partners Management Company, an investment management company, chairs the NYSSCPA Taxation of Financial Products and Institutions Committee.

Milton Miller, CPA

William Bregman, CFR, CPA/PFS

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