When qualified state tuition programs (QSTPs) were first introduced in 1996 and Section 529 was added to the Internal Revenue Code, the intent of Congress was to create a create a tax-friendly way for families to save for college costs. At that time, the law provided that any earnings in a QSTP would be tax deferred if eventually used for qualified educational expenses. Over the past two decades, Congress has expanded the benefits and flexibility of these tuition programs, now commonly referred to as 529 college savings plans. Earnings used for education expenses were made to be tax-exempt rather than merely tax-deferred, the list of qualified educational expenses has been expanded on several occasions, and many states have jumped in with the added benefit of state tax deductions for money contributed to a 529 plan.
It has become increasingly clear that both federal and state lawmakers seek to encourage families to save for college. In spite of the continued improvements to 529 plans and the expanded advantages and flexibility, it is estimated that only 2.5% of all US households have a 529 savings account.
Congress took another shot at expanding the adoption of 529 plans by again broadening the definition of qualified expenses in the December 2017 Tax Cuts and Jobs Act. Specifically, the new law now permits that $10,000 per student, per year from a 529 plan can be used to pay for elementary and secondary school expenses. No longer should we collectively refer to these accounts as 529 college savings plans – they are now more aptly called 529 education savings plans. And the recent tax change raises the question – now that families can use 529 plan accounts to pay for some K-12 costs without taxes or penalties, should they?
The Case for Not Using 529 Plan Accounts for K-12 Expenses
There is a simple mathematical truism of tax free growth – the more the investments grow, the larger is the advantage of the tax-free growth. Conversely, limited investment growth means limited benefit of tax-free accounts.
The best way to exploit the advantage of tax-free growth is increasing the time variable. Ideally, investments are left to grow in a tax-free account for as long as possible so as to best exploit the compounding impact of tax-free growth.
The optimal usage of 529 plans, consequently, is to fund them aggressively when children are infants and then to wait as long as possible to use the funds. The earlier these accounts are funded, the more time there is for the benefits of tax free growth to be realized. Moreover, for parents who have limited assets in a 529 plan account when a child is headed to college, it generally makes sense to wait until the final year of college to use such funds – just to exploit the benefit of the tax-free growth.
With all this said, the idea of using 529 accounts to pay for pre-college expenses contradicts the real benefit of these accounts. From a pure economic standpoint, using 529 accounts for pre-college expenses tends to be a bad idea.
What If 529 Funds Are Needed to Cover K-12 Private School Costs?
The implicit assumption in asking this question is that family cash flow is insufficient to cover private elementary or secondary school expenses. As a result, parents must tap into a 529 plan account to make up the difference for up to $10,000 per year.
There may be unique circumstances when such a strategy could be defensible. For parents experiencing a cash flow shortfall because of a recent job loss or high and unexpected medical expenses, the temporary use of a 529 account to keep children in K-12 private school may be prudent.
Yet for parents who simply don’t have the income to regularly cover private K-12 costs without using 529 savings to help supplement expenses, the question of whether private school can really be afforded in the first place has to be raised. Depleting 529 plan funds that were intended to help cover college costs to instead pay for private K-12 expenses often just exacerbates the challenge of paying for college. Parents who consistently need to use 529 savings to help meet K-12 expenses need to evaluate their ability to afford private school as the sacrifice might be an inability to pay for college.
When Might It Make Sense to Use 529 Accounts to Pay for K-12 Costs?
There are two cases where it generally makes sense to use 529 accounts to pay for private K-12 expenses: parents who appear to have overfunded 529 accounts and parents who live in states that offer a tax deduction for 529 contributions used to pay for K-12 education expenses. Examples below should help to illustrate both situations.
Example 1: Roger and Michelle aggressively funded a 529 plan account for their only child, Sam, when he was young. The investments in the 529 account have done very well and now the total value is $200,000.
Sam is beginning his sophomore year at a private high school and expects to attend college at a state school that will likely cost between $20,000 – $30,000 per year. Based on this reasonable expectation of the future, Roger and Michelle anticipate that they likely have more than they need in the 529 account to cover every dollar of college expenses for Sam. Sensing that they may wind up with excess funds in Sam’s 529 account after college expenses have been paid, Roger and Michelle elect to withdraw $10,000 per year to pay for Sam’s sophomore, junior, and senior years of high school.
By taking advantage of these tax-free and penalty-free distributions permitted under the new tax law, Roger and Michelle are able to reduce the size of the 529 account so as to reduce the amount of excess funds that might be left after paying all of Sam’s college expenses. Such “excess funds” would be subject to taxes and fees if not used for qualified education expenses so they are wisely planning to minimize any future fees and taxes (however, as described in this Astute Angle post and this one, these fees and taxes can be minimized with smart planning).
Importantly, such a strategy to use 529 funds to pay for Sam’s high school costs might not be as wise if Sam had younger brothers and sisters that could use the excess funds or if it seemed very likely that Sam would pursue graduate studies.
Example 2: Bryan and Elizabeth live in South Carolina and have three young children in grades 3, 5, and 9 at a private school. They pay $18,000 per year for each child to attend this school (total of $54,000/year).
When the children were younger, Bryan and Elizabeth aggressively funded 529 education savings accounts with the intent of using these assets to pay for college expenses. They feel good about having adequate funds in these accounts to pay for most or all college expenses for all three children without making additional contributions.
After the Tax Cuts and Jobs Act passed, they recognized a new opportunity to save on taxes. South Carolina, like 33 other states provides a state tax deduction for contributions to its 529 plan. Moreover, South Carolina conforms with the federal tax code and treats K-12 tuition as a qualified education expense.
In prior years, Bryan and Elizabeth wrote three $18,000 checks for each child’s tuition at the private school. In 2018, they have $54,000 set aside in their checking account for these tuition payments but before writing those checks, they electronically move $10,000 to each child’s South Carolina 529 account ($30,000 total). The following day, they seamlessly move the $10,000 from each 529 account back to their checking account. They then write and send three $18,000 checks to the school.
The $10,000 for each child that they contributed to the 529 plan qualifies for a state tax deduction and the $10,000 that they subsequently withdrew from each account to pay for K-12 private school expenses counts as a qualified educational expense. The minimal effort of transferring funds to and from their 529 accounts over a 24 hour period provides them with a $30,000 state tax deduction that they would have missed had they simply written the checks.
The utility of this strategy will depend on the state of domicile and on whether parents are already contributing to a 529 account to prepare for college expenses. In many states, the strategy will only work well for parents like Bryan and Elizabeth who have already saved sufficient funds for college expenses. At the time of this writing, the following states allow for some version of this strategy to be utilized: Arkansas, Georgia, Idaho, Kansas, Maryland, Massachusetts, Mississippi, Missouri, North Dakota, Ohio, Oklahoma, Pennsylvania, Rhode Island, Utah, Virginia, West Virginia, and Wisconsin.
Even though the new tax law permits 529 accounts to be used for private elementary and secondary school costs, we generally think this is a bad idea. First, it sets a bad precedent of using savings that were earmarked for tomorrow to cover today’s discretionary expenses. Second, using 529 accounts for K-12 expenses destroys much of the benefit of tax-free growth by shortening the time period during which dollars are in a 529 account.
There are occasions when it can make sense to take advantage of the new 529 allowance for K-12 expenses but these occasions generally apply to the prudent savers who have already aggressively funded their 529 accounts or to parents in the midst of a temporary financial emergency.
Have questions about this topic or your unique situation? Disagree with the advice above? Use the comments section below, call us at 770-671-9500, or click here to send an email.