By Michael Howell
In recent months, you may have read articles highlighting some new and improved benefits to the popular 529 college savings program as a result of the passage of the Tax Cuts and Jobs Act.
Specifically, the new tax law has expanded the use of 529 plans, allowing for up to $10,000 per year to be used to pay for tuition at elementary or secondary private and religious schools.
At first glance, this expanded flexibility is welcome news. After all, more versatility in most cases is a good thing. Except upon deeper inspection of the changes, the updates are of less value than most people think, especially for those of us living in California (keep reading).
A Quick Primer on 529 Plans
As a quick primer (or reminder) of how 529 plans work, the core benefit of the program is it allows owners to invest money using after-tax dollars toward future education expenses and capture tax-deferred growth. Fast forward to when education expenses come due, and withdrawals are tax-free so long as they're used to pay for qualified education expenses as per the IRS.
In other words, you can avoid paying tax on the growth portion of your 529, meaning less money going to Uncle Sam and more money going toward helping your student pay for education expenses.
Why the Change Matters
Prior to the new tax law, 529 assets could only be used to pay for college and higher education expenses. In my interactions with parents and grandparents planning for the future, this restricted usage of 529 assets is often one of the primary deterrents to a would-be 529 investor utilizing the program to save for college expenses. In these case, the driving concern is usually over the potential of a student deciding to skip college altogether and the money becoming subject to taxes and penalties.
So on the whole, expanding the flexibility of the program by allowing withdrawals to pay for K-12 expenses is undoubtedly an improvement, if ever so slight.
The bigger question is whether you should use 529 assets to pay for K-12 expenses?
A few words of caution…
The Funds Can Only Be Used to Pay for K-12 Tuition
You'll notice in the above primer on 529 plans that I mentioned 529 withdrawals are tax-free so long as they're used to pay for qualified education expenses.
Per the federal guidelines, the definition of a qualified education expense now depends on whether your 529 funds are used to pay for college or private K-12 expenditures. If the withdrawal is made to pay for a college bill, qualified expenses include tuition, room and board, books/supplies, and specific technology items like computers. In contrast, withdrawals related to K-12 costs are only applicable toward tuition.
As small as this difference may seem, it's significant enough to get someone in trouble. That means no using 529 assets to pay for your high school student's computer, books, or charging them rent for the privilege of living under your roof (as tempting as that may be)!
In This World, Nothing is Certain but Death & California State Taxes
Remember how I mentioned that 529 withdrawals are tax-free if they're considered qualified education expenses? Well, they're only tax-free if we're talking about federal tax and if the state you reside in follows the same federal guidelines.
Unfortunately for Californians, if a parent withdraws money out of a 529 plan to pay for K-12 expenses, it will be considered a non-qualified distribution for California tax purposes. Without getting too technical here, this means that a portion of any 529 distributions used to pay for K-12 expenses would still be tax-free for federal tax purposes, but would be considered "taxable earnings" for California state tax purposes. Also, the taxable portion of any non-qualified 529 distributions would be subject to a premature 2.5% withdrawal penalty in California.
When the purpose of putting money away in a 529 in the first place is for the tax-advantaged growth potential, this should be a deal breaker for most Californians, at least for now. Should Sacramento decide to update and adopt the federal guidelines at a later date, this would make the benefit worth considering.
Consider the Trade-Off
Lastly, consider the trade-off of using 529 assets to pay for secondary or high school expenses. At its most practical level, dollars used to pay for private K-12 schooling will mean fewer dollars available to help pay for college expenses. Not to mention, dollars withdrawn early from a 529 are no longer invested and compounding over time, which means less money for college and a lower tax benefit.
Remember the primary tax benefit of a 529 plan is tax-free growth. A 529 plan with an investment held for 3-5 years has far less growth potential than an investment held for 15-20 years. So any tax benefit that would come from using 529 funds to cover private K-12 expenses would be negligible at best because the investments just aren't given as much time to compound and grow.
This is why investing early in a 529 plan when a child is a baby makes so much sense. An investment timeline spanning nearly two decades can allow for a more aggressive investment plan. The longer the assets remain in the plan, the higher the growth potential and tax benefit over time.
So in this advisor's opinion – if paying for private school is important to you, you're better off utilizing your cash flow and other means to pay for tuition expenses.
If you're using a 529 plan to save for college—my advice is to save early, save often, and hear the whispered words of wisdom in Paul McCartney and "Let it Be!"
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.