Effective January 1, 2018, for the purposes of 529 plans, the definition of "qualified higher education expense" is expanded to include tuition at elementary or secondary schools – which means you can now take federal tax-free withdrawals (up to $10,000) to pay for K-12 tuition. However, not all states have conformed to the federal law. In some states, 529 plan distributions used to pay for K-12 tuition may be taxable at the state level, and any state income tax benefits claimed may be subject to recapture.
Prior to the Tax Cuts and Jobs Act, using a 529 plan to pay for elementary or high school would trigger a non-qualified withdrawal, subject to federal and state income tax and a 10% penalty on the earnings portion of the distribution. There are also additional consequences if you previously claimed a state tax deduction. In most states, non-qualified withdrawals are subject to recapture, meaning the principal portion will included in your state taxable income (to the extent of any prior tax deductions), eliminating any state tax benefit.
States that conform with the new tax law
Many states, including Missouri, Utah and Delaware, have conformed with the federal law and offer tax-free K-12 distributions at the state level. Residents of Missouri and Utah are also eligible to claim a state tax benefit for 529 contributions used to pay for K-12 tuition. Married couples in Missouri can claim a deduction for up to $16,000 of 529 plan contributions per year, and in Utah contributions of up to $3,920 by a married couple per year are eligible for a 5% state tax credit. Delaware does not offer a state income tax deduction or income tax credit.
States that have not conformed to the federal law
Other states weren't as quick to adopt the tax law changes and could face potential state tax revenue losses if they do. Take Illinois, for example. Contributions to an Illinois 529 plan of up to $20,000 per year by a married couple are deductible in computing state income tax. If every eligible family took advantage of this benefit, Illinois could lose about $90 million in state tax revenue, according to Nat Malkus, deputy director of education policy studies at the American Enterprise Institute, in an article from the St. Louis Post-Dispatch.
There were also concerns about potential tax revenue loss in Iowa, but an extensive Iowa state tax reform bill was signed in May 2018 that allows the same income tax deductions for K-12 distributions and certain rollovers at the state level that are allowed at the federal level.. State Treasurer Michael Fitzgerald expects the expanded state 529 plan benefits to cost between $3.7 and $4.5 million.
But perhaps being forced to wait for college to use a 529 plan isn't such a bad thing. 529 plans were designed to help families pay for higher education by offering tax-deferred investment growth and tax-free withdrawals. Because of the magic of compound interest, the longer funds are held in a 529 plan account, the greater the potential tax benefit. The total cost (tuition, fees, room and board) of attending a 4-year public university is currently around $122,000, yet according to Fidelity's 10th Annual College Savings Indicator study, on average, parents with children ages 0-18 reported having only around $41,500 saved for college. If parents are able to use their income to pay for K-12 tuition, it could make sense to save the 529 plan strictly for college expenses.
A note on Coverdell ESAs
If it turns out that you won't get any 529 state income tax benefits for K-12 withdrawals, you may consider using a Coverdell Education Savings Account to save for elementary, middle or high school. The original version of the Tax Cuts and Jobs Act, introduced in November 2017, proposed eliminating Coverdell ESAs, but the Senate Amendment and the final bill did not include this provision.
Although they do come with limitations ($2,000 maximum contribution per beneficiary per year, and only couples who earn less than $220,000 are eligible), Coverdell ESAs offer the same federal tax benefits as 529 plans, and they can be used to pay for K-12 or college expenses.
In some ways, Coverdell ESAs are more flexible than 529 plans. Coverdell ESAs offer self-directed investments, similar to an IRA, and right now have a broader definition of qualified expenses. According to IRS pub. 970, Coverdell ESAs can be used to pay for "Qualified Higher Education Expenses" and/or "Qualified Elementary and Secondary Education Expenses"- which includes K-12 tuition and fees, books supplies and equipment, academic tutoring, special needs services, and, expenses related to enrollment or attendance: room and board, uniforms, transportation and supplementary items and services (including extended day services). However, the language in the Tax Cuts and Jobs Act simply expands the definition of "qualified higher education expenses" to include private K-12 tuition.
We will continue to keep our readers up-to-date with any upcoming changes in regulation related to college savings. In the meantime, please consult with your specific 529 plan regarding the status of K-12 distributions.