Happy 529 day! While many may be more familiar with other May days such as Memorial Day, Cinco de Mayo and Star Wars Day (May the Fourth be with you), parents and grandparents with children in their early years should be more aware of a lesser known May day, also known as 529 day (Section 529 plans).
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs.
Earnings in a 529 plan grow federal tax-free and will not be taxed when the money is taken out to pay for qualified educational expenses of the designated beneficiary.
Although contributions into a 529 plan are not deductible for federal purposes, many states do allow contributions to be deductible or provide tax credits (California offers neither). All contributions to 529 plans must be used with after-tax money.
Starting January 1, 2018, the Tax Cuts and Jobs Act has widened the usage of how funds can be spent without being taxed. Elementary, middle school, and high school tuition costs (K-12), up to $10,000 per year, can now be paid with 529 plan funds and not be taxable.
While this change enables more flexibility to how non-taxable funds may be spent, the benefits of compounding growth in the plan may not be as significant. With funds being used up sooner for K-12, there are less years for contributions to grow as opposed to waiting until a child goes to college.
STATE RESPONSES TO FEDERAL CHANGES
With federal changes coming into effect as of January 1, 2018 many states are left scrambling on how they will react to the sweeping changes. While some states have set up their plans to conform to federal changes automatically, states without this “piggybacking” must decide whether they allow the same tax breaks for K-12 tuition, or if they will not conform to Federal law and continue treating these tuitions as taxable with penalties.
California, unfortunately, is a state that does not conform to Federal law with regards to K-12 tuition. As such, the state has decided the earnings portion of any distribution towards K-12 tuition is subject to California income tax and an additional 2.5% California tax. The link to this decision is below.
Opening up a 529 plan continues to be one of the most effective ways for parents looking to save money for their kids’ education. To open an account, visit the state page at the link below.
By: Brett Bradbury, CPA