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For many years, 529 college savings plans have offered a tax-favored way to save for higher education. These plans, officially called qualified tuition programs, are funded with after-tax dollars. Account owners choose from a menu of investments, and any earnings are untaxed. Distributions are also tax-free if they do not exceed the qualifying educational expenses of the account beneficiary: payments of tuition, fees, supplies, and certain housing expenses for the student’s study at an eligible educational institution. Before 2018, eligible education institutions included only post-secondary institutions.
For tax years beginning after December 31, 2017, 529 plans are no longer limited to higher education at a post-secondary institution (colleges, universities, etc.). Now they can be used for elementary and secondary education, as well. That includes learning in public, private, and religious schools.
There is one caveat: Tax-free distributions for elementary and secondary education are capped at $10,000 per student per year. As before, there is no annual limit on qualified distributions from 529 plans for higher education.
Frank and Danielle open a 529 account for their newborn son, Charles. Over the years, they invest thousands of dollars there. When Charles is 10 years old, he goes to a private elementary school where the tuition is $15,000. They take $10,000 from Charles’ 529 account to pay part of his tuition with a tax-free distribution. A larger distribution could lead to an income tax obligation and possibly an additional 10% tax on the amount of the taxable distribution.
Using 529 money for pre-college costs may not always be an ideal strategy. The earlier money is withdrawn, the less time there will be for compounding earnings. Extending untaxed investment buildup, which eventually may come out as a tax-free distribution, is the prime benefit of 529 plans.
Even so, the new law can prove beneficial in some situations. When cash is short and private school costs are high, a $10,000 tax-free distribution from a 529 plan may be welcome. If students are now attending an expensive high school but are expected to attend an inexpensive college, it may make sense to use the $10,000 529 distribution each year.
Moreover, even though the new 529 provision applies to federal tax, substantial benefits might come from state taxes. Nearly every state offers a 529 plan, and most of them provide state income tax credits or state tax deductions to residents who invest in the home state’s plan.
Rob and Brooke live in a state that offers a 10% tax credit for 529 contributions. They invest $10,000 in their state’s plan this year, getting a $1,000 state tax credit. Then, they use that $10,000 to pay part of their daughter Becky’s private high school tuition. With the $1,000 state tax saving, they effectively reduce Becky’s school cost by $1,000 by streaming their cash through their state’s 529 plan.
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