One of the more confusing provisions of the new federal tax code centers on how 529-plan savings account money can be used. It has long been the case that earnings in such accounts are tax-free if used for qualified higher education expenses, such as tuition and room and board. In addition, more than 30 states allow state income tax deductions or credits for contributions.
But the federal Tax Cuts and Jobs Act, which President Trump signed into law at the end of 2017, made such money available for qualified private K-12 education costs as well — up to $10,000 per student per year starting this year.
Almost immediately, some parents of private school kids in states that allow deductions or credits for contributions saw an opportunity. They could deposit money into a 529-plan account and just as quickly withdraw money to pay their kids’ tuition and other allowable expenses. Voila — their private school expenses would suddenly become tax-advantaged.
Just as quickly, some state officials cried foul. Concerned over a sudden drop of millions of dollars in tax revenue, Illinois, Iowa, Louisiana, Nebraska, and New York were among states telling 529 plan participants, “Not so fast.”
In about 20 states, legislation governing their 529 plans explicitly states that money in such plans may be used only for higher education expenses. If parents in such states use 529-plan money to pay private K-12 expenses, they will have to repay any contribution-related tax savings, the officials warned. Even if parents use money they previously contributed to a 529 plan, they will have to pay state taxes on the earnings, and possibly a penalty.
Some of these states may eventually change their legislation to comply with the new federal rules, but they’re buying time to adjust their budgets accordingly. Others may keep their rules as they are, thereby disallowing state tax benefits for 529-plan money used to pay private K-12 expenses.
If you’re considering using 529-plan money to pay private K-12 expenses, it appears safe to assume that no federal income taxes will be due on earnings on such money. As for state taxes, including taxes on earnings and any contribution-related tax savings, check with your tax advisor.