Should You Use a 529 for Private K-12?

A number of  impacts from the 2017 Tax Cuts and Jobs Act have attracted more press coverage than others, including the 529 plan expansion. Here, we’ll talk about that expansion and what you need to consider before making any withdrawals.

As you may already know, section 529 plans, usually referred to as simply 529s, offer parents federal (and often state) tax benefits to incentivize saving for college. These accounts grow tax-free and offer tax-free withdrawals to pay for education-related expenses.

Qualified withdrawals used to be related only to higher education expenses. But the new tax law expanded qualified expenses to include private K-12 educational expenses. Parents can now spend up to $10,000 per year from their 529s to cover K-12 private school tuition, without having to pay taxes or penalties on their account growth.

This seems like a pretty great idea for private school parents facing hefty tuition bills. But is it the right move for your family? Here, we’ll discuss some of the pros and cons to help you decide whether you actually should use your 529 to cover private K-12 expenses.

How it Works

First, you should know a few things about how a 529 works and what its basic benefits are.

A 529 plan is sort of like a Roth IRA, but it’s specifically for educational expenses. You put in after-tax money. There are now no limits to how much you can contribute, though your contributions could be subject to gift taxes. Then the money grows federal income tax free. This means more money stays invested over time, allowing your account to increase. Unlike Roth IRAs, though, 529 plans are mainly administered at the state level. And each state treats its plan a bit differently. The majority of states also allow your money to grow state income tax free, even if you invest in an out-of-state plan. However, taxpayers may still choose to invest in their state’s 529 in order to receive up-front tax benefits on contributions.

You can get more information about which states offer which benefits in this article. For now, it’s enough to know that each state has its own rules surrounding 529s and how they can be used.

We Don’t Know What All States Will Do

When the federal government opened up 529s to allow for up to $10,000 per year in spending on private K-12 tuition, not all states were wild about the move. Since 529s are a federal program, a state can’t prevent taxpayers from leveraging their savings for K-12 expenses. However, they can disallow these expenses at the state level.

What that means is that if your state doesn’t want to honor the federal rule, a withdrawal for private K-12 expenses could cost you state taxes, even if you don’t pay federal taxes or penalties. Also, some states are considering making taxpayers pay back some of the credits or deductions they received for spending 529 money on K-12 expenses.

We’re still waiting to see how many states will incorporate these new rules. If you live in one of the states with no personal income tax, the rules are irrelevant. But if your state incentivizes 529 contributions, you need to know the rules exactly before you make a withdrawal for K-12 expenses.

Powerful Benefits Over Time

Savings plans like the 529 may not seem to be a huge advantage, especially to taxpayers in low- to middle-income tax brackets. But over the course of years, the benefit will really pay off. This calculator can let you run some scenarios to figure out how much you could save by investing in a 529.

Let’s say you have an initial investment of $500, and you put in $2,000 per year from your child’s birth to their 18th birthday. We’ll assume a steady 8% rate of return.

If you’re in the 22% marginal tax bracket, your account could accumulate $82,891 in a 529 plan, versus $68,667 in a taxable account. That’s a savings of over $14,000.

And the savings are even bigger for those in a higher tax bracket. Let’s say you have the same savings scenario, but you’re in the 35% tax bracket. In this case, you’ll still end up with the $82,891. But you would have saved just $61,552 in a taxable savings account. So a 529 could save you more than $21,000 over 18 years!

Now, keep in mind that this calculator is very stripped down. You won’t receive a constant rate of return over the life of your 529, of course. And taxes on investments are more complicated, especially when you count on capital gains taxes and the like.

But with that said, it’s clear from these simple calculations that a 529 account can be a powerful tool to save for your child’s education. But the question remains: when, exactly, should you use that money?

More Time to Grow is Better

The bottom line here is that the most powerful investing factor isn’t how much you put in or even the growth rate. The most powerful factor for investors is time. That’s why it’s always best to start saving early and push your withdrawals as late as you can. This applies to retirement, and it also applies to saving for your child’s education.

Let’s say that instead of saving for 18 years in this tax-advantaged account. You put in $2,000 per year, but you only save for 13 years, until your child enters high school. Then you decide to withdraw $5,500 a year for private high school tuition.

What’s your balance when your kid starts high school? It’s only $32,370.

Then, if you withdraw $5,500 a year for the next four years to cover high school tuition, you’re left with well under $30,000 in the account–just in time for your child to start college.

That’s not a great situation to be in, when instead you could have ended up with over $80,000 in the account by waiting and contributing faithfully.

The principle that time is essential for investors should make you think twice before withdrawing that money to pay for anything other than college. With that said, there are some situations where using your 529 to pay for K-12 expenses could make sense, including:

You Have More Than Enough

If you’ve contributed a lot of money to your child’s 529 over time, you may find that you have more than enough to cover college and supplement K-12 expenses. If you get to your child’s freshman year of high school and see that they’re already set for college, you can justify taking some money out of the account to pay for private school tuition.

Again, though, be cautious here. If you’re not absolutely sure you have plenty to cover college expenses, you’re probably better off waiting it out.

Your Child Has Guaranteed College Tuition or Scholarships

What if you started saving a hefty amount for college but then took a job at a college that will now get your child free or heavily discounted tuition? Or maybe your child has already qualified for some major college scholarships that will cover the bulk of their tuition? In this case, using 529 funds for K-12 expenses could make sense. Just be sure that money is guaranteed and that your child will actually choose the scholarshipped school before you drain those funds.

Your Child Won’t Go to College

College isn’t for everyone. And if your child gets into high school and decides that he or she has other plans, use the money on something else if you need to. Just remember that you can always change the beneficiary on a 529 account. So if your older child goes into a trade but your younger child has his or her eyes on the Ivies, feel free to leave the money to grow but name a new beneficiary.

Talk to Your Tax Professional

At core, 529 decisions are very personal. What works well for one family may not work well for the next.

For the majority of families, waiting to withdraw from a 529 until college makes the most sense. This move gives your money the most power, as it grows over time. But for some, using a 529 to pay for some private K-12 expenses could also make sense. This is especially true in states with a hefty state tax benefit that adopt the federal rules.

Also, be sure to consult with a tax professional who understands the tax laws in your particular area. You’ll need to be sure how your state is treating K-12 529 withdrawals before making any major decision. This will keep you from getting penalized with unexpected fees and taxes while trying to do what’s best for your child.

Topics: Investing

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