By Jeremy Rodriguez, JD
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529 Educational Plans Should Be Gaining in Popularity
Now that the dust has settled and the tax code has been “reformed,” it’s time to unpack those changes and analyze how best they can help you and your clients. One of the changes was the expansion of 529 educational plans. Under the Tax Cuts and Jobs Act, eligible expenses include up to $10,000 per person per year for K-12 educational expenses. Given the popularity and rising costs of private education, and the state income tax breaks associated with many of these accounts, 529 educational plans should see a spike in popularity.
529 Plans – A Quick Overview
529 plans were created by Congress in the mid 1990s as way for families to save money for college education expenses, which at that time had just begun to skyrocket. There are two types of 529 plans: a prepaid plan and a savings plan. We will focus on the savings plans because they are most prevalent. If you understand how a Roth IRA works, you should have a pretty good idea of how a 529 savings plan works. A 529 plan is an investment account funded with after-tax money. The earnings grow tax-free and the withdrawals are tax and penalty free as long as they are qualified. Even better, some states provide state income tax deductions for contributions! Currently, 34 states offer some type of deduction or credit for 529 plan contributions.
The savings plan is run through a financial institution and operates like an IRA – contributions are invested in mutual funds or other investment instruments. While available plans vary by state, taxpayers can cross state lines and purchase 529 plans elsewhere. For example, you may live in Georgia but purchase a Michigan 529 plan. However, be aware that many of the state incentives (i.e. state income tax deductions or credits) require a contribution to that state’s 529 plan (either prepaid or savings) in order to qualify.
Again, just like IRAs, the contributing individual names a designated beneficiary for the account. However, it is the contributing individual, and not the beneficiary, that retains ownership and control of the 529 Plan. As stated above, distributions from the account are tax and penalty free if they are for qualified expenses. Under law, qualified expenses include tuition and fees to any accredited college, books, room and board if attending at least half-time (subject to state limits), special needs equipment necessary to attend school, and computer technology equipment. The last expense includes not only computers and tablets, but accessories, like printers and software programs, and even internet access.
If the distribution is not qualified, then the earnings will be subject to a penalty and the previous state tax deduction will be recaptured. The recapture rules vary by state.
529 Plans – What Changed?
Under the Tax Cuts and Jobs Act, a qualified distribution includes an annual distribution up to $10,000 to cover the cost of attendance at a public, private, or religious elementary or high school. The limit is applied on a per-student, per-year basis. The new change also includes certain expenses incurred in homeschooling such as curricular materials, books or instructional materials, online education materials, and tutoring expenses (as long as the tutor is not related to the student). Also included are dual enrollment costs for those students that are partially home schooled but also attend an institution of higher education. The changes were effective for distributions made after December 31, 2017.
How To Take Advantage
Obviously, if your state gives a deduction or credit for 529 plan contributions, you can use these accounts to save for future education costs while immediately lowering your state taxable income. What’s more is that Congress has now removed one of the major drawbacks with these accounts – that they could only be used for higher education expenses. Not all children continue their education after high school. Many find jobs or enroll in skilled apprenticeship programs. In either case, the tax advantages of the account would be lost. This uncertainty kept many parents from opening a 529 plan.
However, that uncertainty is largely gone. While you may not know if your child will enroll in college, you do know that they will attend elementary school and high school! You probably also have a good idea where that child will enroll. Is it a private/religious school or a public school outside of your district (which may include an additional out-of-pocket cost)? If so, you can begin investing now with a quicker timetable for reimbursement. This really makes sense for those with younger children.
Finally, if you already have a 529 plan established, check with the plan’s administrator before making a withdrawal. Because the law was passed near the end of December, states are currently scrambling to review their own tax code to determine if changes need to be made. For example, the state treasurer in Iowa recently warned families not to use 529 accounts for K-12 expenses until Iowa law is amended. The state treasurer in Nebraska issued a similar warning and added that he is considering postponing the change until 2020 due to effects on the state budget.
In conclusion, 529 plans can help lower your current state taxable income while saving for a necessary and foreseeable expense. However, be aware that there are many options available and that the investment choices and applicable fees will vary. Contact your financial advisor to learn more about these accounts.