Ask a CPA Financial Planner: How did the new tax law affect how 529 plans are used for education?
I heard that there are new benefits to 529 plans after the Tax Cuts and Jobs Act of 2017. How does the recent tax reform change how 529 plans can be used for education expenses?
Section 529 plans are established by states and come in two flavors. The first is a prepaid tuition plan, and the second is an investment savings plan.
Before the recent tax reform, funds from 529 plans could only be used to pay for qualified higher education expenses for eligible colleges and universities. Under the new law, distributions can now be used to pay for qualified expenses for K-12 schooling as well.
So you're saying to yourself, “This is a great opportunity! I should use my 529 plan account to pay for my children’s K-12 private school tuition! Right?” Well as with most tax related questions, the answer is “It depends”.
A closer look at how 529 plans work
When you initially fund a 529 plan there are no immediate federal tax benefits. You do not receive a current year tax deduction like you would for a traditional IRA, 401(k) or HSA contribution. Instead, what you get is tax free growth on the money as long as you use it to pay for qualified education expenses. This means you would not pay any tax on interest, dividends and capital gains generated in the account.
Since there are no immediate federal tax benefits, the real beauty of the 529 plan is revealed when you have a long-term investment horizon. This takes advantage of compounding returns that will maximize your tax savings since the account will likely be made up mostly of untaxed income and gains.
Let’s look at a few examples:
You are a parent of two children, ages 15 and 17, and you currently do not have any 529 accounts setup for them. Both your children are currently enrolled in a private high school that you are paying tuition for. If you were to immediately fund a 529 account just to use the money within the next few months to pay their tuition the benefit would be minimal at best. There would be a very short time horizon to take advantage of the tax savings on the income in the account.
Consider the same situation as above, except in this new scenario you have been funding 529 plans for the last 15 years to pay your children’s future college expenses. After an analysis of the balance in the 529 plans and calculating the expected cost of college for your two children, you realize the plans may be a little overfunded. Since the plans have been invested for a long time and a large portion of the balance is made up of income, it may be a good idea to use some of the 529 plans for their private high school expenses.
Other Factors to Consider:
State Tax Implications
If you live in a state that has state income tax check to see if your state offers any income tax incentives for funding a 529 account. If so, the state income tax savings may be enough to warrant you funding a 529 account and using the funds in the short term.
However, many states do not currently have guidance regarding the treatment of these distributions for K-12 education. What can be especially tricky is if you decide to fund the 529 plan in the same year you will be paying education expenses. You will want to discuss the benefits with your CPA to see if this is a good option for you.
Dollar Limitations on K-12 Distributions
While there are no dollar limits for withdrawals for eligible higher education expenses, there is a dollar limitation on K-12 distributions of $10,000/year per student.
Your Personal Financial Picture
It can be easy to put the cart before the horse when planning around new tax savings ideas. You want to remember that you are planning for your entire financial future, which includes many intertwined and competing goals. You may want to ask yourself a few questions:
What was my purpose for funding the 529 in the first place?
Will I still be able to meet my college savings goals if I am taking money out early to pay for K-12 education expenses?
What lessons do I want to teach my children about paying for college and their education?
How do I plan on investing the money in the 529 plan and how does this affect my tax savings?
What other goals do I have that I need to work around/with such as retirement funding or paying down my own student loans?
While tax reform has brought about numerous planning opportunities for taxpayers and their financial planners it is always a good idea to consider your entire financial picture before making quick decisions.