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Included in the new tab bill were some changes to the tax treatment of 529 accounts and Coverdell IRA’s.  Traditionally, if you used the balance in the 529 account to pay for a “qualified expense”, the earnings portion of the account was tax and penalty free which is largest benefit to using a 529 account as a savings vehicle for college.

 

So what’s the change?  Prior to the Tax Cuts and Jobs Act (tax reform), qualified distributions were only allowed for certain expenses associated with the account beneficiary’s college education.  Starting in 2018, 529 plans can also be used to pay for qualified expenses for elementary, middle school, and high school.

 

Kindergarten – 12th Grade Expenses

 

Tax reform included a provision that will allow owners of 529 account to take tax-free distributions from 529 accounts for K – 12 expenses for the beneficiary named on the account.  This is new for 529 accounts.  Prior to this provision, 529 accounts could only be used for college expenses.  Now 529 account holders can distribute up to $10,000 per student per year for K – 12 qualified expenses.  Another important note, this is not limited to expenses associated with private schools. K – 12 qualified expense will be allowed for:

 

  • Private School
  • Public School
  • Religious Schools
  • Homeschooling

 

529 Accounts Will Largely Replace Coverdell IRA’s

 

Prior to this rule change, the only option that parents had to save and accumulate money tax-free to K – 12 expenses for their children were Coverdell IRA’s.  But Coverdell IRA’s had a lot of hang ups

 

  • Contributions were limited to $2,000 per year
  • You could only contribute to a Coverdell IRA if your income was below certain limits
  • You could not contribution to the Coverdell IRA after your child turned 18
  • Account balance had to be spend by the time the student was age 30

 

By contrast, 529 accounts offer a lot more flexibility and higher contributions limits.  For example, 529 accounts have no contribution limits.  The only limits that account owners need to be aware of are the “gifting limits” since contributions to 529 accounts are considered a “gift” to the beneficiary listed on the account.  In 2018, the annual gift exclusion will be $15,000.  However, 529 accounts have a provision that allow account owners to make a “5 year election”.  This election allows account owners to make an upfront contribution of up to 5 times the annual gift exclusion for each beneficiary without trigger the need to file a gift tax return.  In 2018, a married couple could contribution up to $150,000 for each child to a 529 account without trigger a gift tax return.

 

If I have a child in private school, they are in 6th grade, and I’m paying $20,000 in tuition each year, that means I have $140,000 that I’m going to spend in tuition between 6th grade – 12th grade and then I have college tuition to pile on top of that amount.  Instead of saving that money in an after-tax investment account which is not tax sheltered and I pay capital gains tax when I liquidate the account to pay those expenses, why not setup a 529 account and shelter that huge dollar amount from income tax?   It will probably saves me thousands, if not tens of thousands of dollars in taxes, in taxes over the long run.  Plus, if I live in a state that allows tax deductions for 529 contributions, I get that benefit as well.

 

Income Limits and Tax Deductions

 

Unlike Coverdell IRA’s, 529 accounts do not have income restrictions for making contributions.  Plus, some states have a state tax deduction for contributions to 529 account. In New York, a married couple filing joint, receive a state tax deduction for up to $10,000 for contribution to 529 account.  A quick note, that is $10,000 in aggregate, not $10,000 per child or per account.

 

Rollovers Count Toward State Tax Deductions

 

Here is a fun fact.  If you live in New York and you have a 529 account established in another state for your child, if you rollover the balance into a NYS 529 account, the rollover balance counts toward your $10,000 annual NYS state tax deduction.  Also, you can rollover balances in Coverdell IRA’s into 529 accounts and my guess is many people will elect to do so now that 529 account can be used for K – 12 expenses.

 

Contributions Beyond Age 18

 

Unlike Coverdell IRA’s which restrict contributions once the child reaches age 18, 529 accounts have no age restriction for contributions.  We will often encourage clients to continue to contribute their child’s 529 account while they are attending college for the sole purpose of continuing to capture the state tax deduction.  If you receive the tuition bill in the mail today for $10,000, you can send in a $10,000 check to your 529 account provider as a current year contribution, as soon as the check clears the account you can turn around and request a qualified withdrawal from the account for the tuition bill, and pay the bill with the cash that was distributed from the 529 account.  A little extra work but if you live in NYS and you are in a high tax bracket that $10,000 deduction could save you $600 – $700 in state taxes.

 

What Happens If There Is Money Left In The 529 Account?

 

If there is money left over in a 529 account after the child has graduated from college, there are a number of options available. For more on this, see our article “5 Options For Money Left Over In College 529 Plans”

 

Qualified Expenses

 

The most frequent question that I get is “what is considered a qualified expense for purposes of tax-free withdrawals from a 529 account?” Here is a list of the most common:

 

  • Tuition
  • Room & Board
  • Technology Items: Computers, Printers, Required Software
  • Supplies: Books, Notebooks, Pens, Etc.

 

Just as important, here are a list of expense that are NOT considered a “qualified expense” for purposes of tax free withdrawals from a 529 account:

 

  • Transportation & Travel: Expense of going back and forth from school / college
  • Student Loan Repayment
  • General Electronics and Cell Phone Plans
  • Sports and Fitness Club Memberships
  • Insurance

 

If there is ever a question as to where or not an expense is a qualified expense or not, I would recommend that you contact the provider of your 529 account before making the withdrawal form your 529 account.  If you take a withdrawal for an expense that is not a “qualified expenses” you will pay income taxes and a 10% penalty on the earnings portion of the withdrawal.

 

Do I Have To Close My Coverdell IRA?

 

While 529 accounts have a number of advantages compared to Coverdell IRA’s, current owners of Coverdell IRAs will not be required to close their accounts. They will continue to operate as they were intended.  Like 529 accounts, Coverdell IRA withdrawals will also qualify for the tax-free distributions for K – 12 expenses including the provision for expenses associated with homeschooling.

 

Michael Ruger

About Michael………

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

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Investment advisory services offered through Greenbush Financial Group, LLC. Greenbush Financial Group, LLC is a Registered Investment Advisor. Securities offered through American Portfolio Financial Services, Inc (APFS). Member FINRA/SIPC. Greenbush Financial Group, LLC is not affiliated with APFS. APFS is not affiliated with any other named business entity. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.