New tax laws regarding K-12 tuition payments and 529 plans
The Federal tax reform bill included an amendment modifying section 529 of The Internal Revenue code that may allow you to pay for your child’s K-12 private school expenses with distributions from a 529 plan. This is great news, particularly for South Carolina Future Scholars plan holders.
South Carolina is one of a handful of states that allows all annual contributions to the plan to be deducted from state income taxes. An annual contribution of $10,000 may save you $700!
For those unfamiliar with a 529 plan, the benefits include tax free growth on distributions when money is taken out for a qualified educational expense. Prior to the recent tax reform, those qualified educational expenses were limited to “higher education,” therefore excluding individuals from using 529s as a tool for K-12 tuition expenses. So, this is a big change and a great benefit for those parents currently paying tuition for K-12 schools or considering doing so.
However, there is one wrinkle, which is the disconnect between the Federal law and the state law—not a surprise. Many state laws specifically express that 529 distributions will only be tax free if used for higher education (e.g. college), thus excluding the tax benefit the federal law has enacted. For myself and my clients, I sought guidance from the S.C. State Treasurer’s Office, specific to the S.C. plan. Below is their response:
“The Treasurer’s Office has spoken with SC DOR (Department of Revenue) about state tax treatment regarding the changes. SC DOR advised us that they are telling individuals that until any state law changes are made related to the federal tax reform bill (and there may not be any changes made related to 529 plans), individuals are advised to move forward as the federal law allows.”
In addition, I called Future Scholars, the administrator of the S.C. 529 plan, and was told the very same thing. Both sets of guidance support the idea that S.C. residents should move forward as the federal law allows, that is, using 529 plan distributions towards K-12 tuition.
A few differences exist between how funds can be used for college and how funds can be used for K-12. Contributions to the state’s 529 plan are capped at a lifetime total amount of $426,000 for a single beneficiary. This hasn’t changed but may in the future. However, rules on distributions have changed. All qualified distributions and growth are tax free, while distribution amounts allowed for college are not limited, K-12 tuition is capped at $10,000 each year per beneficiary.
There are two strategies that have come about, most recently discussed in a December 21, 2017 New York Times article by Ron Lieber entitled “Yes, you really can pay for Private School with 529 plans now.” The first is “superfunding” 529 accounts with a pile of money upfront. Essentially front-loading tuition payments, then, pull out a $10,000 maximum each year to use for elementary and secondary school until the child starts college. In the Times article, Mr. Lieber had Vanguard run the numbers. If a family “superfunded” a 529 plan with $200,000, with an assumed growth rate of 6 percent annually, the family takes out $10,000 a year and ends up avoiding $2,380 in taxes annually. During elementary and secondary school years, it saves $30,940 in taxes and there would be over $370,000 left over for college, the Vanguard study explained.
If you are a South Carolina resident paying K-12 tuition, it makes good sense to use the 529 plan simply as a tool for tax free growth and for the 7 percent state tax deduction and this can be accomplished by the “funneling” strategy. If you pay monthly or annually, “funnel” the payment through the 529 to gain the state tax benefit. At the end of the day, the amount placed in a 529 account will incur a 7 percent savings on your state taxes. If you pay $10,000 then turn around and put that $700 savings in your 529, over a 10-year period with an assumed 7 percent growth rate, you could earn up to $10,000! That is one full year of tuition payments that you, without the tax change, would not have. Additionally, all contributions will grow tax free, eliminating taxes on dividends and interest as well as capital gains.
It truly is a win-win for you and your children. This change should not affect your college savings plan. We view it as a tool to make payments for K-12, realize the tax savings and re-invest the savings. A few good resources include:
Stephanie Mackara is a Daniel Island resident and is president of Charleston Investment Advisors, LLC. Diversification neither assures a profit nor guarantees against loss in a declining market. All investing involves risk. Principal loss is possible. Charleston Investment Advisors, LLC is part of The Wealth Management Alliance LLC, a registered investment adviser.