The Tax Cuts and Jobs Act passed by Congress back in December brings a lot of changes. One that caught the eye of many high-income earners is the change that occurred to 529 plans. Before the new tax bill passed, parents were only able to use a 529 plan to pay for college; however, it is now the case that 529 funds can also be used to pay for education as early as elementary school.
While that may sound great, it's important to look at the purpose of a 529 plan and analytically consider the good and bad of withdrawing funds now.
First, 529 plans are beneficial because the earnings in the account are tax-free when used to pay for qualifying education expenses. So, the primary benefit of using a 529 plan is that my money grows over time, giving me additional tax-free dollars beyond my own to pay for my kid’s college. If you contribute up to the allowable annual gift exclusion of $14,000 per child ($28,000 for married couples), then immediately withdraw those funds to pay for private school, the benefit of tax-free earnings is entirely eliminated for the simple fact that there were no earnings. The money was never invested. If the 529 plan is serving as a pass-through, the only benefit you’ll see is a small state income tax deduction.
The state income tax deduction can be of some value in states with state income tax but this deduction is not near what people expect it to be. The tax benefit reduces your taxable income as it relates to state income tax, which is helpful, but it does not reduce your taxable income as it relates to federal income tax. You’re able to deduct up to $10,000 on your state income tax return, which under the assumption you’re contributing $10,000 to a 529 plan, you would save $500 in taxes if you live in Mississippi and $700 if you’re in Arkansas. The deduction is not sparing you the 30% or 40% in taxes as would be the case with other deductions on your federal return. This is simply sparing you from paying the highest marginal state income tax rate, which as an example, would be 5% in Mississippi on up to $10,000 and 7% in Arkansas. This pales in comparison to the opportunity cost of not investing the money for several years. And remember, the earnings in a 529 plan avoid federal income and capital gains tax, not just state income tax.
IF YOU WANT TO USE YOUR 529 NOW
If you already have an established 529 plan that has had several years of growth and want to use some of the funds on your children's elementary or secondary education now, you might consider this approach: make small withdrawals from your 529 plan to help offset private school expenses now, and take advantage of the state income tax deduction. Then, immediately put what you spent back into the 529 plan so it doesn’t take away from what was initially saved for college. This strategy grants you the benefit of a small tax deduction while still allowing your 529 funds to grow for their long-term purpose: college. My fear is that many will take what they’ve been saving for college, use it now, and not replenish the 529 plan with what they normally pay out-of-pocket for school this year. By not replacing those funds, you're taking money away from future college savings, which will likely require many to pay for college out of cash flow with taxable dollars instead of tax-free dollars as initially intended.
Another fear would be that your annual gift exclusion is still limited to $14,000 per child ($28,000 for married couples), which means saving for one reduces what you can save for the other. Paying gift taxes is out of the question and would negate the benefits of the 529 plan altogether, so we need to contribute within these limits. The Tax Cuts and Jobs Act only permits a distribution of $10,000 per year for elementary and secondary schools. Assuming I’m a single parent, if I’m contributing $10,000 this year, which is what I would normally pay for my child’s schooling and withdraw the same amount to pay the actual bill, I’m now forced to save only 4,000 for my child’s future college expenses. What if the analysis shows I should be saving $8,000 per year for my child’s college? Is the goal just underfunded? If married, this is less of an issue because you would be able to save an additional $18,000 in that year for college, future elementary or secondary education expenses. You also have to consider that state 529 plans have lifetime contribution limits ranging from $235,000 - $500,000. Since a finite amount of money can be saved without incurring gift taxes or maxing out what the plan will hold, it’s critical to understand that college savings should continue to be the first priority. Here’s why: the contributions made to cover early education expenses today are merely benefiting from the state income tax deduction and not from the tax-free growth since the money is going in and out of the account before any meaningful growth can occur. However, the contributions made for college can benefit from both the tax-free growth, as well as the state income tax deduction.
529 plans have traditionally been about the future. While using them in the present is now possible, it limits the plan's inherent tax benefits and you may be unwinding what you prepared for college. With college tuition rising on an annual basis, we cannot afford to let the use of a 529 plan in the present replace what it was initially designed to do.