What If Your State Doesn't Allow 529 Withdrawals for K-12?

The passage of the Tax Cuts and Jobs Act ushered in significant changes to 529 accounts. Before that, 529 plans were strictly college savings vehicles: Only qualified higher education expenses were eligible for penalty-free, tax-favored withdrawals.

Now, however, up to $10,000 per year, per beneficiary can be used for tuition expenses "in connection with the enrollment or attendance of the beneficiary as an elementary or secondary school student at a public, private, or religious school."

Before you take a withdrawal from your plan, though, here are a few things to keep in mind.

Not All States Follow Federal Law This may seem strange--if it's the law of the land, how could state laws override that? But state and federal laws don't always agree. For example, marijuana is classified as a Schedule I drug and is illegal at the federal level. It's still illegal at the federal level in states that have decriminalized its use for medicinal reasons. Same-sex marriage is another example; some states allowed same-sex couples to be legally married long before the Supreme Court declared it legal in all 50 states in 2015.

Although federal law has expanded allowable 529 expenses, 529 plans are administered by states. Some states, such as Illinois, have decided not to follow the government's lead. What happens if you want to take advantage of the expansion but live in a state that disallows using the funds for elementary or secondary education?

According to James DiUlio, chair of the College Savings Plans Network, two things may be affected: The withdrawal could be considered a nonqualified distribution (and its gains portion subject to state tax), and/or a future adjustment could be required if you received state tax deductions or credits on prior contributions.

"There is no simple answer; plan participants should refer to their 529 plan's current website and disclosure materials or consult a tax professional to determine the tax implication for the transaction," DiUlio said.

Why Would States Decide to Go Their Own Way? The biggest reason that states would balk in the face of allowing 529 funds to be used for K-12 tuition is that it could result in lost state tax revenues. According to a report by the Brookings Institution, the cumulative state income tax liability resulting from the expansion of 529s to private K-12 schools could be over $900 million per year, with the biggest hits in New York, Indiana, Pennsylvania, and Illinois.

Some 529 investors are asking if states will follow the federal law eventually, perhaps when the impact to state budgets is better understood. According to DiUlio, it is hard to say what states will ultimately do.

"We know that some states are working to comply with the federal changes. Other states are working to allow postsecondary tax incentives for K-12 education," he said. "And other states are taking a wait and see approach as they determine how plan participants are using their benefits for K-12 expenses."

Decide Whether K-12 Tuition Is the Best Use of 529 Assets Even if you live in a state that allows 529s to be used for elementary and secondary education, it may not be the best idea. Essentially you're not fully maximizing the tax benefits of 529s. True, in certain states, investors can contribute $10,000 to the account and then turn around and use that money for private-school tuition, taking advantage of the state tax break for the 529 contribution. But if you use your 529 as a transactional account, you won't get the benefit of tax-free earnings.

For example, let's say you contributed $10,000 to a 529 account and left it in there for 17 years. You'd get the state tax break for the initial contribution. If that $10,000 compounded at a 6% annualized rate, you would have nearly $27,000 by the time the beneficiary is ready to begin college. Assuming you used the money to pay for qualified tuition, you wouldn't owe any taxes on the $17,000 in earnings.

Many families should use those tax benefits to their fullest advantage, because college comes with a steep price tag. According to data from Strategic Insight, the average 529 account balance as of the end of 2017 was around $29,000. The College Board says public in-state college tuition plus room and board costs about $20,000 per year (and more than $46,000 for private colleges) in today's dollars. Families should be saving as much as they can and giving their investments as long a runway as possible for compounding to lend a hand.

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