Should you use a 529 plan to pay for private school? The recent tax reform legislation included sweeping changes to our tax code. One of the lesser-known provisions could benefit parents who plan to send their children to private school. The Tax Cuts and Jobs Act included a provision to allow families to use funds from a 529 plan to help pay for private school in grades K-12. However, parents are encouraged to use caution before making any financial decisions as state governments and private schools may soon decide to weigh in with changes of their own.

How have 529 plans changed?

The tax legislation in 2018 changed the federal tax treatment of 529 plans. However, keep in mind that 529 plans are actually run and administered by the states themselves. States often have different rules and benefits of 529 plan participation for in-state residents; many even offer tax credits or tax deductions to its residents for contributions in a 529 plan.

529 plans are popular because participation is not phased out with income. Although contributions are not tax deductible for federal income tax purposes, previously, when funds were used to pay for qualified college expenses, they could be withdrawn capital gains tax-free. Starting in 2018, parents will now be able to withdraw funds to pay for qualified expenses in K-12 private school too, up to $10,000 per year, per child.

How will state governments react?

Recall that it is actually the states who administer 529 plans. The changes at a federal level may trigger states to reconsider the benefits they offer parents and grandparents contributing to 529 plans in their state. Why?

States that offer tax credits and deductions to residents may grow concerned that increased 529 plan participation may hurt their tax revenues. As a result, states who offer these benefits may consider imposing a cap on the benefits families can receive.

States may also consider whether these changes could have a detrimental and lasting impact on the schools in local communities. By making private school a bit more affordable, more parents may choose to send their children to private school instead of attending the public school in their city or town. Could this reduced headcount impact state and federal funding programs? It may not be in the states’ best interest to maintain their current 529 plan tax benefits, which in some states are quite generous.

How will this impact financial aid at private schools?

Since assets in 529 plans previously were not available before college, parents weren’t penalized when applying for financial aid. However, now that a portion of 529 plan funds are technically available for private school tuition, how may that impact a family’s aid package?

Since the availability of 529 plans funds for private education is so recent, many families have likely earmarked those accounts to pay for college. Will the financial aid formula adjust going forward for families who do not intend to tap their 529 plan for private school? The answers remain to be seen.

How should parents use 529 plans going forward?

Like many of the provisions to the new tax code, further analysis and guidance is required before recommendations can be made. For parents with children currently private school, using 529 plan funds may provide limited benefits and could actually hurt your education goals, depending on your specific situation. Why?

Recall the benefits of using 529 plans. Unless you live in a state that offers a tax deduction or credit for additions to a 529 plan, the only benefit is avoiding capital gains taxes on investment gains. If your time horizon is only a couple of years from contribution to withdrawal, the risk/reward may not be justified.

There’s also an opportunity cost to use funds earlier for private school, and you’ll miss out on future years of tax-free growth. Depending on your cash flow situation, this may also impact your ability to reach your college funding goal down the line.

For parents with very young children, it may be advisable to stay the course for now while we all wait for states and private schools to react. While these changes have now become law at a federal level, which could all change with the next administration, so it is important to stay focused on your goals and what is within your control. Remember, there’s a 10% penalty for non-qualified distributions, so work with your financial advisor on a savings strategy to help ensure you’re not over-funding your 529 plan.

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