The Tax Law's Biggest Education Change Is on Hold in Several States

The recent tax rewrite gave one big boost to tax-free college savings plans: The federal tax code now allows you to use money in 529 plans to pay for tuition at K-12 schools.

But before you jump to withdraw from an account to pay for a private prep school, beware: You could wind up taking a significant financial hit by doing so. That's because several states first need to update their own tax codes in order to let account holders keep all the existing benefits of saving in a 529 account while using the money for K-12 education. If you live in certain states and you withdraw funds before that happens, you may risk having to repay a state tax deduction you've already received—or facing state tax on the investment gains in your account.

College savings accounts, named for Section 529 of the Internal Revenue Code, have been around for more than 20 years. Money invested in the accounts grows tax-free, and when you withdraw the money, you don’t pay any federal or state taxes, as long as the money is used for “qualified expenses.”

That’s where things get wonky: Qualified expenses used to be defined as higher education tuition, room and board, books, and more recently, computers and software. Now, however, the federal tax code says up to $10,000 a year in K-12 private school tuition is also a qualified expense.

Not all states automatically follow the federal definition for their 529 laws, however—and any gaps between federal and state laws could prove a minefield.

More than 30 states and the District of Columbia offer a benefit at the time money is put into the account: a state income tax deduction or credit for contributions to 529 accounts. Yet some states have language that specifically defines the accounts as being college savings—and that phrasing could prove troublesome unless state laws are amended, says Jared Walczak, a senior policy analyst at the nonpartisan Tax Foundation. Many states also have yet to clarify whether investment gains might become taxable in the event of a discrepancy between state and federal law.

Meanwhile, it's not at all certain that states will rush to match the federal definition.

While private school enrollment is comparatively small—about 10% of the school population nationally attends private schools, according to the National Center for Education Statistics—tax-free private school tuition could still cost states millions of dollars in revenue.

For example: The change could reduce New York state’s tax base by up to $3 billion, according to Nat Malkus, deputy director of education policy at the American Enterprise Institute. That would cost the state, which allows a $10,000 deduction per couple, as much as $200 million in tax revenue.

Other states that could take a big hit, Malkus says, include Indiana (which could lose $149 million in revenue) and Illinois ($90 million). All three of the states Malkus cites appear to conform to the federal 529 rules, however, meaning their state legislatures don’t need to act in order for families to get the benefits for K-12 spending.

On the other hand, the Omaha World-Herald reported that Nebraska State Treasure Don Sternberg may seek to postpone changing that state's law until 2020, because of the effects on the state budget.

What should families do if they'd like to use 529 savings for K-12 expenses?

First, call whatever plan you're invested in and ask about the potential consequences of a withdrawal, says Andrea Feirstein, a 529 plan consultant. The answer will be different depending on where you live and which plan you're invested in, she adds.

Michael Fitzgerald, the state treasurer in Iowa, for example, has already warned families not to use their accounts for K-12 expenses until the law is amended. If they do, the state could recapture any deduction they received in previous years for contributing to the account. Similar warnings have come from plan officials in Maine and Nebraska.

By contrast, Utah’s Educational Savings Plan is ready for K-12 withdrawals, says Executive Director Lynne Ward. She says her office has already received a variety of questions—although none about whether K-12 withdrawals are qualified expenses under Utah law. (Most of the questions are about what's considered a qualified expense, Ward says: For K-12 costs, it’s only tuition, whereas there’s a broader set of higher education costs allowed.)

How much money is at stake? Deductions or credits for 529 contributions are generally worth no more than a few hundred dollars a year to a family. The real power of 529s is in the tax elimination on investment gains, and the sooner money is deposited, the better for compounding those gains, says Norman Boone, a financial planner in San Francisco. That means families considering opening a 529 account strictly for K-12 expenses have to weigh the likelihood of changes in state tax law with the value of saving and investing earlier, Boone says.

But for parents with existing accounts looking to use money for K-12 expenses, financial planners recommend waiting to see whether their state's law will be updated to match the federal code.

Peg Creonte, senior vice president at Ascensus College Savings, which manages day-to-day operations for more than 30 plans in several states, says she hasn't seen definitive action from their state partners.

“It’s just too early,” she says, noting that the tax bill was signed less than three weeks ago.

Still, she expects most states will act quickly to address the issue as legislatures convene in the coming weeks. “It benefits everyone if there’s clarity around what benefits exist and what don’t.”

This story has been updated to clarify the potential tax hit to New York, Illinois and Indiana.