Tax season has come to a close, and many Americans are still wondering how the tax reform changes in the Tax Cuts and Jobs Act of 2017 will affect them.
With most of the changes taking effect in tax year 2018 and beyond, the best time to begin tax planning was Jan. 1. The second-best time is now and reviewing education savings investment strategies is no exception.
One of the most commonly used savings vehicles when planning for education expenses is the 529 college savings plan. What initially started as a pre-paid tuition program was made official in 1996 by the Small Business and Job Protection Act. When the IRS issued guidelines for tuition plans in 1998, they did so under Code Section 529, and the name, 529 college savings plan, stuck.
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Jump forward to 2018 and 529 plans still come in two flavors, a pre-paid tuition program and an investment savings plan, and these plans now total hundreds of billions of dollars in assets.
The 529 savings account was set up as a tax-advantaged investment account which allow families to invest and save for their children’s higher education expenses. Most of these plans are sponsored by states and state agencies, however educational institutions can also sponsor a 529 plan.
Any monies, including investment growth, used for qualifying expenses for the named beneficiary is distributed tax-free. Qualified expenses include tuition, fees, books, required supplies to include computers. The 529 plans can even cover limited room and board costs.
Under the old federal tax rules, 529 plans could only be used for eligible colleges and universities. With the Tax Cut and Jobs Act of 2017, federal rules allow 529 plans to cover qualifying expenses for private, public, and religious kindergarten through 12th grade, and that’s changing the way some financial advisors are assisting their clients with planning for education expenses.
“A lot of clients were forced to pay for private high schools out of their taxable investments,” says Ryan Bayonnet, a certified financial planner with Hyland Financial Planning.
Under the new rules, monies can be used tax-free on qualifying expenses for K-12 private and religious schools.
“For clients that would like their children to attend private high schools, we have begun funding 529 Savings Plans,” Bayonnet says.
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Investors should beware of the following gotchas that accompany the new rules for 529 plans.
Limit on withdrawals. Using 529s to cover qualifying expenses for private, public, and religious kindergarten-through-12 expenses comes with a catch. The new rules apply a $10,000 per year per child limit on withdrawals. Overdraw the limit and taxpayers will face a 10 percent penalty in addition to taxes on the amount of investment growth distributed.
Adoption of rules. While the federal rules are allowing for kindergarten through 12 qualifying expenses, that doesn’t mean the state or educational institution sponsoring a specific 529 plan has adopted those same federal rules. So far, less than half of the states in the U.S. have confirmed they will conform to the new federal rules.
Be sure to check with a tax advisor to confirm if the state in which the 529 plan is sponsored is in line with the new federal rules before taking a distribution.
Tax break uncertainty. Furthermore, for those states that offer a tax deduction on state tax returns for making 529 plan contributions, it’s unclear how states will treat a tax-deductible contribution and tax-free distribution that is made in the same tax year.
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Even with the limitations, the new federal tax laws are opening up an entirely new planning strategy when planning for education expenses. Investors need to proceed with caution to ensure they don’t end up on the wrong side of an IRS rule.
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How Tax Reform Is Changing 529 Plans originally appeared on usnews.com
