Tomorrow marks one year after the Tax Cuts and Jobs Act (TCJA) was signed into law and families can now use 529 savings plans for K-12 tuition state and federal tax-free in over 35 states and Washington, D.C. Our Educational Opportunity Policy Analyst, Tori Bell, takes a look at what changes have taken place over the past year. Learn more about 529 savings plans on our Opportunity Learning Hub.
A 529 savings plan is similar to a Roth IRA, as contributions are made to an investment account with after-tax dollars. It can be helpful to think of it this way: a Roth IRA is an investment account for retirement, and a 529 savings plan is an investment account for education.
The funds grow tax-deferred, and as long as the funds are used for qualified expenses, the withdrawals are tax- and penalty-free. The plans are sponsored by the state, and they differ state-by-state. For example, some states offer an income tax deduction or credit for contributions to a 529.
However, if the funds in a 529 are used for a non-qualified expense, the earnings portion of a distribution may be subject to state and federal taxes, tax penalties, and a recapture of state tax deductions or credits claimed.
Account holders can choose in invest in any state’s 529 plan (not just their home state’s plan), but state income tax treatment is determined by the state where the taxpayer files states income tax. Anyone (e.g. a grandparent, neighbor, mentor) can set up a 529 plan and name anyone (e.g. a relative, friend, themselves) as a beneficiary, per the IRS.
Historically, 529 savings plans could only be used for qualified higher education expenses like college tuition. The TCJA expanded the use of 529 plans to include K-12 tuition—up to $10,000 per year per beneficiary.
While federal taxes were automatically subjected to this change, state taxes were another matter. Since some state tax codes didn’t automatically conform to changes in the federal tax code, the state tax treatment of 529 plans used for K-12 tuition was not clear from the outset in those states.
In the majority of states, 529 savings plans can now be used for K-12 tuition free of both state and federal taxes. This majority of states can be broken down into two separate categories:
There are nearly a dozen states where a policy change is needed, or the issue is still under legal review, before residents can use 529s for K-12 tuition free of state tax penalties.
To be clear, I am not suggesting this expansion is an education policy panacea. A key benefit of 529s is their ability to grow tax-free over a long period of time. If funds are used earlier on, they have less of an opportunity to grow. There is a greater benefit if families can save money in a 529 early on for their child and don’t touch the funds for many years. Just like the funds in a Roth IRA, the funds in a 529 savings plan have more time to grow the longer they remain in the account.
Unfortunately, life doesn’t always work out how we plan, and given individual circumstances, some families may desire to access their 529 funds earlier to send their child to a different school during their K-12 years.
So, even though this is an admittedly limited policy change, it is also an important one that expands educational freedom to American families, and that’s a policy move in the right direction.
Disclaimer: Families should consult with a qualified financial professional before making any personal financial decisions.
