By now, you’ve heard of the Trump tax cuts passed late in 2017, which was the biggest effort to reform the tax code in decades. While the consequences of the Tax Cut and Jobs Act (TCJA) will be borne out in the coming years, we can begin to analyze the different sections and how each might apply to individual circumstances.
Specifically, a number of these changes impact saving and investing in 529 plans, which are tax-advantaged accounts intended to encourage parent's saving for their children’s education, and careful attention should be paid to these changes.
The distinguishing feature of 529 plans is the tax advantage afforded to the earnings on contributions. These contributions can be invested to grow the principal in mutual-fund type investments offered by each state (and D.C) in which the accounts are subject to market and other risks. Although the contributions an investor makes to a 529 plan are not themselves tax deductible when filing federal income taxes, any earnings on them grow tax free and are not taxed when withdrawn for a qualifying expense.
These non-taxed earnings include:
- capital gains,
- and dividends.
All else held equal, not having to pay taxes on the growing capital will allow the invested funds to grow faster, providing more resources to pay for tuition, books, fees, and other expenses.
Though not federally deductible, contributions may be deductible on state income tax returns in a majority of states. A list of the thirty four states that provide for contribution deductions is available here: http://www.finaid.org/savings/state529deductions.phtml.
As mentioned above, the tax-free investment growth is the primary benefit of the 529 accounts, but if you’re a resident of a high-tax state like California, New York, or Illinois, the state income tax deduction can be a very useful and lucrative tool for tax-planning.
You’ve saved money in a 529 account, now what?
Because 529 plans are designed for education savings, the special tax status of investment earnings in the plans is only available for withdrawals made to pay what are known as “qualifying expenses.” Qualifying expenses include tuition, various college fees, textbooks, and room and board. The IRS publishes a list of qualifying expenses and it can be viewed here: https://www.irs.gov/newsroom/529-plans-questions-and-answers.
If, however, the funds are withdrawn for expenses not on the qualified list, those withdrawals could be subject to taxes and even penalties. So, for example, if you withdrew $5,000 to pay for a semester of tuition, that withdrawal would not be taxed. But if you withdrew $5,000 to buy your child a car to commute to school, the withdrawal could be taxed as though it was income and also subject to a 10% penalty. Ouch.
The account owner has a measure of flexibility on naming beneficiaries on 529 plans. Any family member, including one’s own self, can be named as beneficiary and have contributions made to his/her account. Also, beneficiaries can be changed at any time by the account owner. So in the event the child does not pursue higher education, the beneficiary can be changed to a sibling or other family member.
State and Local Taxes (SALT) and 529 Plans
The TCJA imposed a limit of $10,000 on the amount of state and local income taxes that can be deducted when filing federal personal income tax returns. Aside from its obvious effects, this new limit might move you to rethink the way you plan contributions to a 529. If you pay more than $10,000 in state and local income taxes (SALT), for example, you could use 529 contributions to offset the reduction in the SALT deduction. Careful planning could maximize the impact of such contributions when done correctly. Before you make plans such as these, it’s wise to get the advice from your tax professional to avoid costly errors.
The Trump Tax Cuts (TCJA) and 529 Plans
The new tax law also made a key change to the nature of qualifying expenses which can have a big impact on education planning. The tuition, fees, and other educational costs that counted as qualifying expenses have previously been those associated with attendance at a post-secondary, or college-level institution.
With the updates under the TCJA, however, qualifying expenses include costs arising from nearly any level of education. This means that private school tuition for elementary, middle, are high school can be funded from a 529 account. These schools could be parochial, charter, or prep - all will qualify. Even homeschooling costs are now counted as qualifying expenses. Distributions from a 529 plan for these elementary, secondary, and homeschooling costs can be as high as $10,000 a year.
Education Planning and the TCJA
There are, however, a number of things to think about for parents who are interested in taking advantage of the new elementary, secondary, and homeschool provisions of 529 plans.
First, and most obvious, be aware that any funds withdrawn from 529 plans for K-12 education won’t be available for college expenses. It may be tempting to access the funds you have set aside for college, but those withdrawals can dramatically impact your long-term savings plans.
The second consideration stems from the first, is less obvious, and perhaps more impactful. Making withdrawals earlier in the education plan reduces the power of compounding returns which is the greatest potential benefit of 529 plans. This is the concept that investment returns continuously generate returns on themselves. It is this mechanism that can grow a modest periodic contribution to an account into a significant sum over five, ten, or twenty years.
Simply put, any dollar you spend for K-12 education could be two or three dollars you may not have for college because the withdrawals will decrease the compounded growth of the investment’s principal.
If you have made your calculations using the effect of compounding returns, making earlier-than-planned withdrawals will change that trajectory and require a new contribution schedule to make up for the reduced principle. This new schedule would certainly require increased contributions, with the degree of increase dependent on how much was withdrawn from the account. Critically, parents must also understand that any investment earnings will not only be subject to federal income tax, but also to a 10% penalty if a withdrawal is made for non-qualified expenses.
There are some circumstances where the 10% penalty can be avoided and one of those is in the case that the child earns a scholarship. In this scenario, the parent can make a withdrawal up to the amount of the scholarship award and avoid the penalty, although income taxes on the investment return will still be owed. It is interesting to ponder whether spending 529 money on a high-quality secondary school would increase the likelihood of a child earning a scholarship and thus perhaps reducing the overall amount needed from the 529 plan.
If saving and investing for retirement is the greatest personal finance challenge of our lives, saving for our children’s education is certainly a close second. The tax advantages of the education-centered 529 plans make them a compelling vehicle for working towards this goal. As with any financial topic, though, parents must stay on top of changes in the law that governs 529 plans. The new tax law made a great number of changes to a huge variety of issues in our taxes and these included 529 accounts, as we’ve reviewed above. Despite the need to remain informed and plan carefully, any parent should give serious consideration to using a 529 plan to fund their children’s education. Planning and saving now will make paying future expenses that much easier.