January 17, 2018

529 Plan Changes – Should you use your 529 Savings Plan to pay for elementary or high school?

Families saving for future educational expenses were granted an unexpected gift from the Tax Cuts and Jobs Act: up to $10,000 of elementary or high school tuition and fees may now be paid (tax and penalty-free) from 529 savings accounts. (Previously, 529 plans were limited only to college expenses.) In this post, I will address how this change to the tax code affects residents of Oregon and Washington and will answer some of the questions we have been getting here at our office.

529 plans come in two varieties:

  1. Prepaid tuition plans allow you to buy tuition credits in today’s dollars that can be used when your child reaches college age, (allowing you to avoid inflation on those educational costs).
  2. 529 savings plans function more like retirement accounts, where investments grow and qualified withdrawals may be taken tax-free.

Oregon offers both varieties of 529 plans, while Washington offers a prepaid tuition program (called GET) and is in the process of developing a savings plan.

Parents may elect to open a 529 account in any state, regardless of residency. Many states, Oregon included, incentivize residents to use their state’s plan by offering an income tax deduction on contributions. Oregon residents may deduct contributions to the Oregon 529 plan of up to $4,660 (taxpayers filing jointly) or $2,330 (all others). Washington State has no income tax, so there is no state tax deduction for contributions to a Washington plan.

Note: Although the new tax bill allows tax-free withdrawals from 529 plans of up to $10,000/year for private K-12, it is unclear if the benefit will also apply to Oregon income tax. Legislators are advising families to hold off on paying private school expenses from 529 plans pending additional direction from the Oregon legislature. Contact us to learn more before making any K-12 withdrawals from your 529 plan.

It is unclear whether families with prepaid tuition plans will realize any new tax benefits under the Tax Cuts and Jobs Act. For residents of Oregon and Washington, if you are considering taking advantage of the new provision to take withdrawals from a 529 savings account to cover K-12 expenses, here are a few things to weigh:

  1. There is nothing more powerful in finance than compounding tax-free interest followed by tax-free withdrawals. The 529 has these features and is an ideal long-term savings account — it should be used as such first and foremost. If you are behind on college savings, the tax change will not be a silver bullet to solve your savings gap and allow you to afford private K-12. On the other hand, if you have sufficient funds set aside to cover college costs already, and/or if you have other funds earmarked for pre-college educational expenses, the provisions of this act may help you.
  2. If you are an Oregon resident, already have enough saved for college, and are considering adding to your plan in order to pay for K-12 tuition and fees, your analysis should be focused on the annual income tax ramifications.

Consider this example: If a sample Oregon family earns over $250,000 and deposits $10,000 into the Oregon College Savings Plan, the family will be able to exclude $4,660 from their Oregon income that year, saving them $461 in Oregon Income Taxes (9.9% of $4,660).

That year, the same family may withdraw $10,000 from the 529 savings plan tax-free for private school expenses. Withdrawals from 529 plans are taken on a pro rata basis, so the make-up of your specific 529 assets matters a great deal in figuring your tax benefit. If we assume our sample Oregonians have a 529 savings plan with a balance that is 75% principal and 25% earnings, the provisions of the Tax Cuts and Jobs Act should save that family about $500 in federal long-term capital gains tax ($2,500 earnings at 20% capital gains tax) and $247 in Oregon income tax ($2,500 earnings at 9.9% Oregon income tax) compared to the same family withdrawing $10,000 from a taxable brokerage (non-529) account.

Total Hypothetical Savings (Oregon): $1,208. Parents pursuing this avenue should be mindful of the $310,000 maximum account balance in the Oregon College Savings plan.

3. If you are a Washington resident, already have enough saved for college, and are considering adding to your 529 savings plan in order to pay for K-12 tuition and fees, the math is less compelling. Because Washington has no state income tax and no deduction for 529 contributions, the savings realized at withdrawal for our hypothetical family are limited to the federal long-term capital gain savings outlined above.

Total Hypothetical Savings (Washington): $500.

Utilizing 529 accounts to pay for K-12 expenses will affect each family differently, depending on the age of the child, the state you live in, and the growth rate you experience in your 529 accounts. It is clear that for high-income earning residents of Oregon (and the 30 other states that offer income tax deductions for 529 contributions), routing $10,000 of K-12 tuition and expenses through the 529 each year makes a lot of sense, as long as you are not doing so to the detriment of saving for college.