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529 tax plan confronted by conflicting definitions

ALBUQUERQUE, N.M. — Today I choose to address another new law topic. Again, it is complicated.

But I am actually going to try to explain it so the problem becomes clear to all of you. To be fair to me as I start this effort, people who try do not always succeed.

Section 529 of the tax law allows for contributions to state-established plans that can be used for qualifying education expenses (QHEE). There is no deduction for contributions, but funds in a plan grow tax-free.

If Section 529 plan funds are used for QHEE, the distributions are tax-free. This means the earnings escape tax forever.

New Mexico has a Section 529 plan. To encourage New Mexico residents to use the New Mexico plan, the state allows a tax deduction for contributions made to the plan.

The deduction is allowed for contributions made under the Education Trust Act. This act refers to post-secondary education expenses. Place a pin in that definition for now.

Let’s now use an illustration. Parents contribute $50,000 to the New Mexico 529 plan. No federal deduction is allowed. A $50,000 New Mexico tax deduction is allowed, saving $2,450 in state tax.

The contribution grows to $100,000 and is later distributed to pay for college costs of a child named as beneficiary. The distribution is not taxed for federal or state purposes.

So $50,000 of earnings is never taxed. And the state subsidizes the original contribution with the tax savings from the allowed New Mexico tax deduction.

What if the $100,000 is distributed for a reason other than education? Little Joey does not go to college. Mom and Dad take back the $100,000. They are then taxed on the $50,000 earnings.

New Mexico also has a say in this improper distribution. The state tax deduction was intended to subsidize higher-education costs. So when the distribution is made for the wrong reason, New Mexico causes the prior deduction to be recaptured as income.

The result is then $50,000 of federal income (only the earnings) and $100,000 of New Mexico income (clawback of the prior deduction also) for the year of the improper distribution.

The new federal tax law allows 529 plan distributions to be used for K-12 school expenses. Distributions for K-12 costs are federal tax-free limited to $10,000 each year.

But the New Mexico recapture rule says that income is recognized when 529 plan distributions are made for anything other than qualified higher education expenses as defined in Section 529 of federal tax law.

Well, Section 529 of federal law now has two definitions of QHEE. Remember the New Mexico Act refers to post-secondary education, just like federal law used to.

Section 529(c) of federal law defines distributions that are not taxed for federal purposes. The new law added a rule that “for purposes of this subsection” QHEE now includes K-12 education costs.

But Section 529(e), which contains general definitions and rules for purposes of Section 529, still says that QHEE includes only post-secondary education.

As currently drafted, federal law includes K-12 costs in QHEE only for purposes of determining the taxability of distributions. The language limits the definition by stating “for purposes of this subsection,” and that subsection is only for distribution tax treatment.

Section 529(e) is a definition of QHEE that applies for the entire section. And it does not include K-12 education.

This is no doubt a drafting error in a new tax bill that was rushed through the legislative process. The K-12 provision was controversial, as it was intended to provide a tax break to private-school education and even to home schooling.

The rush to pass the bill, and the late reintroduction of the K-12 provision, led to sloppy drafting. But New Mexico law requires a recapture of a deduction for distributions that are not QHEE under Section 529.

I believe the general definition of QHEE found in Section 529(e) is the reasonable interpretation of New Mexico’s recapture law. This makes distributions for K-12 education taxable because the prior contribution deduction is recaptured.

Federal law is unlikely to change. That means New Mexico needs to clarify its recapture provision. Until then, I think K-12 distributions create New Mexico deduction recapture.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

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