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529 plans were originally designed to help prepare for future college costs by offering tax-free growth and tax-free withdrawals when the funds are used toward qualified higher education expenses. However, the recent change in tax code expanded the benefits of 529 plans to allow tax-free distributions for tuition expenses for private, public or religious schools of up to $10,000 per year.
Advisors can help clients take advantage of these new potential tax savings by developing an effective 529 funding strategy for K-12 education costs. With a relatively shorter time horizon and annual withdrawal limits, a different approach is recommended for 529 accounts that will be used to pay for pre-college expenses. Here are some things to consider when helping clients plan for private school:
How much will private elementary and/or high school cost?
Let’s first assume that your client is solely focused on saving for K-12 education, and already has a strategy in place for college. The first thing you’ll want to determine is their time horizon – how old is the child, and when will he or she begin attending private school? For example, parents with a two-year old child who are saving only for high school only will be able to accumulate more savings than someone with an older child, but they will also need to take inflation into consideration. Depending on where your client lives, this could make a big difference in future costs. In 2016, Manhattan private schools in New York city saw a 23% increase in tuition and fees over the previous five years, the Wall Street Journal reported.
But remember, the amount of your client’s future tuition costs may not equal their total 529 plan savings goal. Tax-free distributions for private elementary and high school expenses are limited to $10,000 per year, and anything beyond that amount will trigger a non-qualified distribution – subject to income tax and a 10% penalty on the earnings. Qualified withdrawals are also limited to tuition expenses, which does not include room and board, uniforms or transportation.
Selecting a 529 plan and investment options
When deciding which plan to use for private school education funding, your client will want to start by exploring their home state’s plan. Over 30 states offer a tax credit or deduction for 529 plan contributions, but non-qualified withdrawals can be subject to state tax recapture. Currently, only a small number of states have conformed to the federal law, but clients who live in these states may be able to deduct all or a portion of their private school tuition expenses from their state taxable income.
At this time, there are no specific 529 portfolios designed for private K-12 education funding, but that doesn’t mean you can’t find suitable investments for your client. With less time to recover from a market downturn, you want to explore conservative options such as a money market or stable value portfolio.
How much to save
To create an effective 529 funding strategy for your client, you’ll need to determine how much is needed to fund the lesser of the total tuition liability, or the maximum allowable withdrawal amounts, so that you will end up with a $0 account balance after paying the final year of private school tuition. This could be achieved with an initial lump sum deposit, monthly contributions or a combination of both.
For many clients, annual expenses will exceed the $10,000 tax-free withdrawal limit. For the 2017-18 school year, private school tuition costs ranged from $2,562 – $14,338 for elementary school and $5,262 – $31,567 for high school, according to the Private School Review. Any cost gaps – amounts that won’t be covered by 529 plan savings, will have to be paid with current income, scholarships, financial aid or other sources.
To help you calculate how much to save in a 529 plan, we’ve developed the 529 Savings Calculator for Private K-12 Tuition . Example: A client wants to use a 529 plan to pay for his two-year old child to attend private school from 1st through 8th grade. Annual tuition is currently $5,000, but has been increasing at 5.5% each year. The client has $20,000 to deposit today, and wants to know how much more he’ll have to contribute each month.
Using a 529 plan to pay for private school tuition
Source: Savingforcollege.com Calculator
As illustrated in the chart above, with a $20,000 initial deposit, your client would need to start making monthly contributions of $276 to effectively fund his future tuition costs. With this strategy in place, he would only need to come up with additional $580 to pay for the child’s junior year high school tuition, and $1,162 for senior year. With no account balance remaining, you would avoid the possibility of a non-qualified withdrawal and incurring taxes and penalties.
This example doesn’t take state tax benefits into consideration, but if your client lives Missouri, for example, they may qualify for a tax deduction. Contributions to any state’s 529 plan of up to $16,000 by a married couple are deductible in computing Missouri taxable income, so your client would be able to claim a deduction for the entire $3,312 ($276 per month) in contributions each year. To calculate the value of a client’s state tax benefit, try the State Tax Calculator.
Funding a private K-12 education with a 529 plan is an evolving space, and if you have alternative ideas or strategies that have worked well for your clients, we’d love to feature your story in an upcoming article for financial professionals.
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