For many years, 529 college savings plans have offered a tax-favored way to save for higher education. These plans, officially called “qualified tuition programs,” take their nickname from the section of the Internal Revenue Code that authorizes them.
In brief, 529 plans are funded with aftertax dollars. In college savings plans, account owners choose from a menu of investments, and any earnings are untaxed. Distributions are also tax-free if they do not exceed the qualifying educational expenses of the account beneficiary. (“Qualifying educational expenses” include payments of tuition, fees, supplies, and certain housing expenses for the account beneficiary’s study at an eligible educational institution.) Before 2018, eligible educational institutions included only post-secondary institutions.
Under the new tax law, the benefits mentioned above remain as they were. Now, however, there are additional options. In tax years beginning after December 31, 2017, 529 plans are no longer limited to higher education at a post-secondary institution. They can now be used for elementary and secondary education, as well. That includes learning in public, private, and religious schools.
There is one caveat: Tax-free distributions for elementary and secondary education are capped at $10,000 per student per year. As before, there is no annual limit on qualified distributions from 529 plans for higher education.
Sooner rather than later
For some families, using 529 money for pre-college costs might not be an ideal strategy since the earlier money is withdrawn, the less time there will be for compounding earnings. Extending untaxed investment buildup, which eventually may come out as a tax-free distribution, is one of the biggest benefits of 529 plans.
Even so, the new law could prove beneficial in some situations. When cash is short and private school costs are high, a $10,000 tax-free distribution from a 529 plan may be welcome. If students are now attending an expensive high school but are expected to attend an inexpensive college, it may make sense to use the $10,000 529 distribution each year.
Moreover, even though the new 529 provision applies to federal tax, substantial benefits might come from state taxes. Nearly every state offers a 529 plan, and most of them provide state income tax credits or state tax deductions to residents who invest in the home state’s plan. (Some states have tax benefits for investing in any 529 plan.)
So far, states have differed on how they’ll treat 529 plan distributions for K-12 distributions. Assuming your state goes along with the new federal law, using $10,000 a year for pre-college costs may become especially attractive.
Our office can help you understand your state’s tax treatment of 529 contributions and how the state is dealing with the new rules on 529 distributions. Just contact our office, and we would be happy to schedule a consultation.