With federal changes to the way 529 plans work in Dec 2017, and MN changes to the way 529 plans work passed in summer 2017, now seems like the perfect time to take a deeper dive into a subject which many people have some awareness around, but perhaps don’t fully understand all the nuance.
What is a 529 Plan?
In general, 529 plans have been a good way to save for college. You make contributions with after tax money into the plan and the money can be invested. States run the 529 plans and most states have a 529 plan option, but they are generally available to residents of any state, not just local folks. Growing up in MN my parents had a 529 plan for me based out of New Hampshire. The money grows tax free inside the 529 plan, just like it would in a Roth IRA where you invested after tax money. If you know about Roth IRAs, think of the 529 plan as just a Roth IRA for education only.
When you get to college you can take out the money to pay for tuition plus room & board. As long as you take it out for those qualified education expenses the entire distribution is tax free so you permanently avoid taxes on the growth that occurred in the 529 plan, and that’s a pretty good deal. It’s a way for parents, grandparents, aunts and uncles to set aside money for a child’s college fund.
When you get money tax free out of the 529 plan you cannot also claim those expenses for the education credits, no double dipping of tax benefits on the same dollars. But the rules for 529 qualified expenses aren’t the same as the education tax credits since room and board is allowed for 529 plan distributions and you don’t need to reduce the tuition by the scholarship amount like you do on the education credits. Those calculations can get a little messy, but just be aware the rules are not the same for 529 plans and education credits and you want to be sure to maximize your tax benefits for both.
The new federal tax bill passed in December 2017 has a change for 529 plans. Now up to $10,000 per student per year can be withdrawn for elementary and secondary education, that means k-12 private school. It’s oddly a per student limitation, not based on the account owner so if you had two kids in private school each student could access $10,000 to cover tuition in a given year. This opens up even more possibilities and incentives for parents and grandparents to be contributing to the 529 plans knowing there is another avenue for utilizing the funds.
The definition of higher education expenses was also expanded to include more homeschool expenses, tutoring, online education materials, dual enrollment, and educational therapy for students with disabilities. All of these federal changes apply to 2018 tax years and forward, they are not effective for the 2017 year.
For MN starting in 2017 they allow for a tax credit or tax deduction for contributing to a 529 plan. For any MN resident the net contribution for the year (contributions less distributions) can generate a tax credit of $500 if you are a low income taxpayer. Just a $1,000 contribution to a 529 plan will generate a $500 tax credit which is a powerful incentive for folks to contribute. The income limitation on the tax credit is around $75k where it begins to phase out.
If you are a higher income taxpayer you won’t be able to get the tax credit, but instead you can get a MN tax deduction of up to $3,000 on a joint tax return or $1,500 for single. There is no income limit to the deduction so all taxpayers can be taking advantage of that part of the new tax bill for 2017 and future years.
While MN does offer a 529 plan option, you do not have to use the MN state plan in order to get the tax benefits on your MN income tax return. The contributions can be made to any state’s plan.
Those are some nice tax breaks and they don’t want people to unfairly game the system so they also added a recapture tax. If you take 529 plan funds out and don’t use them for qualified education costs the income is taxable on the federal return and now on the MN return you will have to pay back the credit or deduction that you claimed based on the contributions. Seems like a complicated measure to prevent a tiny amount of abuse, but it’s in there.
529 plans have always been used to save for college, but now they can be used for k-12 expenses too. For MN taxpayers a credit or deduction is available for everyone who makes a contribution to a 529 plan. With expanded uses for the money and state tax incentives for contributions I expect to see an uptick in the taxpayers taking advantage of these accounts as a way to pay for education costs and when they are properly utilized it can be a powerful tool.