Tax reform changes the way parents can pay for school
The Tax Cuts and Jobs Act signed into law on Dec. 22 made a number of sweeping changes to the tax code. Included in the bill was a provision which allowed families to make tax-free withdrawals of up to $10,000 per year from a 529 plan to pay for children attending private schools.
A 529 college savings plan has long been an important tool for investors to set aside tax-free dollars to save for a child or grandchild's college education, so any changes in the law affects many people.
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If you're a parent with kids in private school, expanding the law to include private schools may sound like a big win at first glance. Unfortunately, like many provisions of the new "simplified" tax plan, the full implications of this provision remains to be seen as we wait for state governments and private schools to react.
Tax reform changed the benefits of a 529 plan on a federal level. From a federal perspective, there are a few key facts to know about 529 plans, before tax reform:
- 529 plans can be used by anyone without income limitations.
- Contributions are not tax deductible for federal income tax purposes.
- When funds are withdrawn to pay for qualified higher education expenses (like tuition, books, room and board, etc.), you will not have to pay federal capital gains tax on the investment gains.
Starting in 2018, all of the above remains true exceptthat 529 plans can now be used to pay up to $10,000 per year, per child, in qualified expenses for K-12 private school.
From a federal perspective, the changes are actually pretty straightforward. However, state governments and private schools may follow with changes of their own.
Changes to 529 plans may impact tax treatment at the state level. It is fairly easy to understand how 529 plans work at the federal level. However, plans are actually administered by the states themselves. Each state has different rules and benefits regarding 529 plans for its residents. Many states offer tax deductions or tax credits to residents who contribute to a 529 plan. Sometimes these benefits are limited to the in-state 529 plan but not always.
If more parents decide to use 529 plans or the number of years they make tax-deductible contributions is extended as a result of the new tax law, it may lead states to consider reducing or capping the tax benefits offered to limit the impact on their tax revenues. Further, the changes add extra incentive for parents to consider private school instead of public school. How would some communities be impacted by reduced headcount and potentially a corresponding reduction in state or federal funding? State governments may decide not to help subsidize a run on their school systems.
Although states could try to find a way to separate 529 plan dollars funding K-12 versus college, tracking and enforcement could become an administrative burden.
Private schools will incorporate 529 plans into their financial aid formulas. Previously, assets in 529 plans could not be used to pay tuition for private K-12 education. When a private school calculated a student's financial aid package, this was taken into account. However, what happens when a portion of those assets are technically available for private school tuition – particularly when a family intends to reserve 529 plan savings for college? It is not known how private schools plan to adjust their financial aid formula or what impact that may have on the families who are already on the cusp of being able to afford private school in the first place.
What parents should do next. If you have a child currently in private school or close to enrolling, the benefits of using a 529 plan to pay for private school will likely be minimal, if at all. Like most financial planning matters, what will ultimately benefit your family most will be unique to your specific situation. Work with your financial advisor to discuss your options as factors unique to your situation will impact your strategy.
For example, if you have an older child already in college who will not need all of the funds in his or her 529 plan, then (all else equal) it may make sense to use 529 plan funds. Keep in mind that unless you live in a state that offers a tax deduction or tax credit for contributions to a 529 plan, the only benefit is that you don't have to pay taxes on the investment gains. If your time horizon is only a couple of years from contribution to withdrawal, it may not be worth it as gains could be minimal and the funds are exposed to fluctuations in the market.
For parents with a funded 529 plan earmarked for college, there is also an opportunity cost to use those funds earlier for private school. By using the money earlier, you miss out on future years of tax-free growth. Depending on your cash flow situation, this may also impact your ability to reach your college funding goal down the line.
Parents with very young children may be best suited to continue saving early in a 529 plan, without going overboard. As we have just seen with the Tax Cuts and Jobs Act, sweeping changes to the tax code can happen at any time. Parents should be cautious not to over-fund 529 plans as the next administration could change this provision once again. With the penalty of non-qualified distributions at 10 percent, it's certainly possible to have too much of a good thing.
Copyright 2017 U.S. News & World Report