While tax reform merely tweaked some rules for retirement accounts, it significantly changed key rules for another type of tax-advantaged account: 529 plans.
Previously, 529 plans were a way to save money for a child’s higher education. Withdrawals, or distributions, from 529 plans were generally tax-free if they were spent on eligible higher-education expenses, such as college tuition.
Under the recent overhaul of the federal tax code, however, distributions can also be spent on “expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.” In other words, distributions can be spent on K-12 tuition.
This change became effective this year, applying to distributions made in 2018 and thereafter. So, the tax returns due in April 2019 will be the first you file under this new rule.
The good news
This change gives folks a new tax-advantaged way to save money for expenses related to children who attend a primary or secondary school that charges tuition.
A 529 plan is like a Roth IRA or Roth 401(k) account in that money contributed to a 529 plan is taxed only on the front end. So, contributions are not tax-deductible, but earnings grow tax-free, and no tax is due on qualified withdrawals.
As the Internal Revenue Service puts it:
“… the benefit of a 529 plan comes with the tax-free withdrawal of earnings that build up in the plan based on the contributions made.”
Of course, contributions and distributions are still subject to rules. For example, the same section of the overhauled tax code that allows distributions to be used for primary and secondary tuition also limits the total amount of distributions to $10,000 per beneficiary per year.
The bad news
Generally, 529 plans are sponsored by state governments. So, they are subject not just to IRS rules but also to state rules.
This means you cannot assume that the entity that sponsored a 529 plan is abiding by the new federal rules — including the rule that allows 529 distributions to be used on primary or secondary tuition.
Certified financial planner Jeff Jones of Longview Financial Advisors in Huntsville, Alabama, recently wrote for U.S. News & World Report:
“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.”
Before taking a distribution from a 529 plan, Jones recommends checking with a tax adviser to confirm that the state in which the plan is sponsored is abiding by the new federal rules.
Also, if you have yet to establish an education savings account, don’t assume that a 529 is the best option for you. Money Talks News founder Stacy Johnson details the pros and cons of 529 plans and various alternatives in “Ask Stacy — What’s the Best Way to Save for My Kid’s College?”
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