Pros & Cons of 529 College Savings Plans

Soon after Derek and Lisa Stamper's daughter Ellie was born, the couple started planning for how they wanted to fund her future college tuition. Both physician assistants, the Columbus, Ga., couple had funded their own college educations through a combination of financial aid, private student loans, parental help, and income they earned from part-time and seasonal jobs during academic breaks. They knew how difficult that experience was and agreed they would take steps now to be able to offer their five-year-old daughter as much financial support as they could when the time comes for her to attend college.

“We started putting money in a 529 plan about four years ago. We did not put much into at the start, because we thought we were saving for college at the time," explains Derek.

Though his daughter has attended a part-time, private preschool program since 2016, the Stampers will face a much higher tuition bill when she begins kindergarten this fall at a private school near their home. “We intend to pay for her kindergarten from our 529 plan. This will save us some money come tax time — and every little bit counts," says Stamper.

The Stampers' plans for their 529 account funds have recently changed, thanks to a provision passed by Congress in December 2017 that expanded the Federal definition of “eligible expenses" for funds in 529 plans. As of January 2018, parents may be able to tap the money in a 529 plan to pay for up to $10,000 (per year, per beneficiary) of K-12 tuition at a private school. Though not all states allow funds in their 529 plans to be used for this purpose, Georgia — the Stampers' home state and 529 plan administrator — does.

“Now that we can use the 529 plan for her tuition, we have increased the amount we contribute to it. Her tuition is about $10,000 this year, so we will use all of the $7,000 balance we currently have in the plan to pay for it. Half of the tuition is due before school starts, and the second half is due after the first semester," says Derek.

If you're a parent with a child who plans to attend college, you may have heard of 529 savings plans, or already be a participant in one. As the Internal Revenue Service explains Opens in new window on its website, these plans were created in 1996 to help parents save for a child's future college with the help of tax-free growth on contributions, and tax-free withdrawals when funds are used to pay for costs the IRS deems “qualified education expenses." Opens in new window The plans are typically administered by a state or an educational institution and may offer state-level tax benefits based on each state's unique tax laws.

While the expanded definition of "eligible" 529 plan expenses broadens the potential uses for a 529 plan, this is one change where the proverbial "devil" really is in the details.

Consider these potential benefits and drawbacks if you're considering paying for your child's K-12 private school tuition with savings in a 529 plan, before you determine that it will be financially beneficial for your family.

What is a 529 Plan?

Parents may be eligible to deduct all or a portion of private school tuition expenses on their annual state tax return — but the parent must first ensure these important conditions are met:
 

• The expense must be considered “eligible." Tuition is the only qualifying K-12 expense; computers, software or other school-related costs are not.
• The parent (and child) must live in a state that offers a tax deduction Opens in new window or credit for contributions made to a state-level 529 savings plan, and one that allows funds to be used for K-12 tuition expenses.

Assuming these criteria are met, the expanded eligibility for 529 plans could provide significant tax benefits, especially for higher income households with a greater tax burden.

Tax Advantages of 529 Plans

The expanded 529 plan eligibility likely won't justify sending a child to private school if you otherwise wouldn't —but could provide some tax benefits for K-12 tuition expenses you'd have regardless. The higher your income (and potential tax burden at the state level) the more you could benefit. For example, a lower income family in their state's 2% tax bracket might save $200 each year in state taxes by investing $10,000 into a 529 plan and using those funds to pay for K-12 tuition expenses. Yet, a family in their state's 5.75% tax bracket could save $575 each year for that same investment. For taxpayers whose overall state tax bill results in a credit (but one that is not refunded), there is likely no tax benefit to using a 529 plan to fund K-12 expenses.

Using a 529 Plan to pay for Private School

Investing in a 529 plan carries a unique risk: You can't predict your child's future. If you've saved diligently, but your child decides she won't go to college, gets a full scholarship, or wants to attend a school that isn't 529 eligible Opens in new window, you could face a penalty for not using 529 plan funds to cover qualified education expenses. Parents in this scenario could use 529 plan funds to pay for private high school tuition, for example, as soon as they know they won't have the college expenses they expected.

Negatives of 529 Plans

While Alaska, Delaware, Georgia, Kentucky, Maryland, Mississippi, Missouri, Nevada, South Carolina, Tennessee, Utah, Virginia, West Virginia and Wisconsin do allow their plans to be used for qualified K-12 tuition expenses, many states specify that 529 funds can be applied to "college" expenses only.

Further, misunderstanding how 529 funds can be used in your state could result in a 10% penalty — and state taxes. Iowa, Maine and Nebraska have formally issued warnings that taxpayers who use 529 plan funds to pay for K-12 tuition could be required to pay state taxes for previous years when they took the 529 plan contribution deduction.

Investing in a 529 plan consistently (and early) in your child's life can help grow your investment over time, thanks to compounding interest. Using 529 plan funds to pay for K-12 private school tuition may benefit your current budget, but could reduce your potential for tax-free growth. Depending on your finances, that may mean you don't have the money you need to pay for college when your child is older.

Stephanie Taylor Christensen is a nationally syndicated freelance financial and business writer.

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