You can now use a 529 to pay for K-12 tuition, but should you?
Among the changes in the tax overhaul passed by Congress in December was a provision allowing parents to use money saved in a 529 plan to pay for private school tuition for kindergarten through 12th grade.
Under the new law, starting with the 2018 tax year, you can withdraw $10,000 per student per year from a 529 plan to pay for primary or secondary education. Unlike funding for college, however, this money can be spent only on school tuition, not textbooks, computers, or other fees or activities. That means it applies only to the 10 percent of children who attend private school. If your kids go to public school, but you shell out for educational summer camps or other enrichment activities, the new law doesn't apply.
Still, it sounds great, right? But before you can put this gift to use, you have to determine whether the state where you started your 529 has agreed to the federal change.
"These states, a lot of them have not changed any of their rules," said Jill Schlesinger, a certified financial planner. "Some have banner ads on their websites saying, 'Don't be pulling your money out yet.'"
If you do take out money in one of those states, it could cost you.
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The federal government created 529s, but the 50 states plus the District of Columbia administer them. And not all jurisdictions have tweaked their rules to align with the new federal law. Some states' 529 laws say that you may withdraw funds tax-free only for "qualified college costs." In other words, if you prematurely withdraw 529 gains to pay for K-12 education, that money could be subject to income tax and a 10 percent penalty. You could even have to pay back any state tax deduction you received when you deposited the money. Ouch.
A handful of states have already announced that they will go along with the federal change and consider K-12 withdrawals a qualified 529 expense. They are Alaska, Delaware, Georgia, Kentucky, Maryland, Mississippi, Missouri, Nevada, South Carolina, Tennessee, Utah, Virginia, West Virginia and Wisconsin, according to Savingforcollege.com. The site says it will update this list as more states sign on, so check back. Other states may be aligned with the feds already simply because their laws are more vaguely worded and don't specify the word "college." However, additional states, such as Iowa, Maine and Nebraska have warned that they may have to introduce 529 legislation before residents can be assured of favorable tax treatment.
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Beyond the uncertainty of which states are going along with the federal change, there are other questions to consider in determining whether using 529 funds for K-12 education is a good idea.
• Do we -- or will we -- have enough for college? Most parents don't have sufficient money saved for college, so if they use some of those funds to pay for primary or secondary education, they could be robbing Princeton to pay Putney. When Fidelity surveyed parents about college savings, it found they had amassed only 29 percent of their goal by the time their kids reached college age.
• When will you need to withdraw from your 529? College savings plans work best when the investments have plenty of time to grow. The benefit is that you are not taxed on that growth when you withdraw the money. So if you take out money now, will yours have the years it needs to appreciate? "I would rather see people pay for private school out of cash flow and allow the money in the 529 plan to continue to accumulate and grow without any taxation," Schlesinger said. The new opportunity will work best for parents with young children who plan to use the money to pay for high school.
• Does your 529 plan have high-enough contribution limits? If you want to use your 529 to pay for both K-12 education and college, it will need to be substantial, and not all plans make that easy. For example, one of Michigan's 529 plans allows you to contribute only $88,000, whereas some of Virginia's plans allow you to put in as much as $500,000. If your existing 529 plan has low limits, you will need to open a second one or roll it over to one with a higher cap.
• Will $10,000 come close to covering my child's private school tuition? According to Private School Review, the average annual cost of private school tuition is $10,302, but parents in some metropolitan areas know it can cost much more. For example, a private education in the Washington area costs an average of $23,388 per year -- and often far more. The higher your child's tuition, the less the federal tax savings on $10,000 may mean to you. Is the rigmarole of starting and using a 529 worth it? It's a time vs. money analysis. As a separate matter, if you count on scholarships to pay some or all of your child's tuition, you should know that K-12 financial aid offices will now probably look at a family's 529 accounts when considering their overall ability to pay.
• Are my state 529 tax credits or deductions worthwhile? The real benefit of 529 plans is that they grow free of federal income tax, similar to a Roth IRA. But there are also 32 states that offer tax deductions or credits on top of that just for investing in a 529. If you withdraw money for K-12 education before those states have had a chance to sort out their new rules, you could miss out on those perks. Moreover, according to one analysis, a married couple making $100,000 a year and contributing $100 a month to each of their two children's 529 accounts would earn only $36 to $360 in state tax savings, depending where they live. So if you make modest 529 contributions, these perks can be negligible.
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After some soul-searching using the questions above, if you are still interested in using a 529 to pay for K-12 education, there are some steps and strategies to consider.
• Check with your state and your plan first. Because this is new territory, you will want to make sure your state is on board before you proceed. And if you started your 529 in another state • I've written before about how that can be smart -- you'll need to check that state's stance on 529s for K-12 education, too.
• Consider the shorter time horizon. Because you will need money for primary and/or secondary education sooner than for college, you may want to invest that money more conservatively. "It stands to reason that the sooner you need your money, the less risk you can assume," Schlesinger said. You can either start a separate, more careful 529 for K-12 costs, or you can change the asset allocation within your existing 529 plan -- you're allowed to do this once a year -- so that some of it is in very stable investments.
• If you park your money in a 529 briefly, do so with eyes open. If you have to set aside money for private school tuition anyway, one strategy is to briefly dump the maximum amount that will reap a tax credit or deduction into a 529 account. Then withdraw it and pay your tuition bill. If you want to try this, be sure to keep an eye on changing rules. States may opt to set minimum amounts of time that your money must stay invested in their 529s if too many people do this.
• Ponder front-loading if you can afford it. The big benefit of 529 plans is that they grow tax-free. That means that if you have the money, it could be lucrative to invest a couple hundred thousand dollars in a 529 plan now, so that it has as much time as possible to grow. Then you can withdraw $10,000 per child per year free of federal income tax to pay for private school tuition. You'll use the rest when your son or daughter goes to college. An online calculator shows that this strategy could net you five-figure tax savings over the years. Be sure to consult a financial adviser before taking the plunge.
All this talk about using 529s for K-12 education may be a moot point, given that only 41 percent of parents have a 529. That's why the real push should be to open a 529 account this year. Then you can wait until next year to use it for K-12 education. By then, the dust should have settled, and all should be clear.
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Leamy hosts the podcast "Easy Money." She is a 13-time Emmy winner and a 25-year consumer advocate for programs such as "Good Morning America." Connect with her at leamy.com and @ElisabethLeamy.