Are 529 plans smart for private school?

You can now use these tax-advantaged savings plans to pay for more than just college—but should you?

The cost of tuition for private K-12 schools can rival that at some colleges. So, the fact that parents and grandparents (thanks to changes implemented under the 2017 Tax Cuts and Jobs Act) now can put funds from a tax-advantaged 529 savings plan toward K-12 private school tuition—an expansion of the vehicle's original use for college expenses—sounds like good news.

If you have a child or loved one in private school and are considering using 529 funds to help cover those expenses, it's important to understand the pros and cons.

If you're not already familiar, a 529 plan is a state-sponsored account that lets you save for education expenses. Money in a 529 plan can be invested, and any earnings in the plan grow free of federal and state income tax (there may be exceptions, so check with your state). In some states, you may also receive a state income tax deduction or tax credit on the contributions you make.

These popular plans are soaring

According to Morningstar, a robust market and steady contributions helped 529 plans reach an all-time high in 2020.

Savings plan

Source Morningstar's "2021 529 Savings Plan Landscape"

What's new?

Previously, funds from a 529 plan were limited for use toward qualified higher education expenses, including college tuition, fees, books and other supplies. Now, funds can be used for K-12 private schools, although notably only K-12 tuition expenses are eligible, and only up to an annual limit of $10,000. (There is no limit on withdrawals for qualified college expenses.) Moreover, some states will tax 529 funds withdrawn for private school costs.

And although interest in homeschooling has risen due to the COVID-19 pandemic, you likely can't use 529 funds for homeschooling. There may be an exception for purchasing a curriculum, but check with your tax advisor first.

Losing out on long-term investments

One of the main benefits of saving for college in a 529 plan, especially if you start when the child is still young, is the tax-free compounding of your savings over years. You potentially lose out on many years of compounding if you pull the money out of the 529 plan only a few years after you contribute it.

Moreover, 529 plan funds are typically invested in age-based portfolios with college-age withdrawals in mind. If you tap your 529 plan for K-12 education, it may be at a time when the plan funds are being invested more aggressively (under a long-term strategy), making returns more uncertain.

With college costs being so high, you may be better served to find another source for private K-12 tuition while the funds in the 529 plan continue to grow.

The benefits go on

Don't let an expectation of college scholarship money take you off-course. Even for excellent students, competition for higher education scholarships can be stiff, says Shelly Eweka, Senior Director, Financial Planning Strategy at TIAA, and as such, may not cover the whole bill year after year. Even if you don't ultimately use all of the money accumulated in a 529 for undergraduate education, the funds have some flexibility.

"If your child goes on to graduate school, the money can be used for that," says Eweka. "And if that doesn't happen or there are still funds left over, you can pass them along to a sibling or other family member."

Take taxes into account

Using 529 funds for private K-12 education can be a good choice under some circumstances. Depending on your state, you may be able to contribute to a 529 plan to claim the deduction, then immediately use those funds to pay tuition. Or if you were considering selling an investment held in a taxable account to raise the funds for private school instead of tapping your 529 plan, you may face hefty capital gains taxes, says Rob Stevens, Financial Planning Strategist at TIAA. Talk with a tax professional to explore all your options.

Also, you can potentially accumulate considerable assets in a 529 plan. Because most 529 plans have set a high bar on contribution limits, you or a loved one can contribute up to five years' worth of the annual gift-giving limit to a 529 plan in one year and avoid gift-tax liability. That would total $75,000 for an individual or $150,000 for a couple that agrees to gift-splitting. If a family member such as a grandparent is looking to help defray schooling costs, contributing a large sum before the child reaches school age may help you accumulate enough to help cover K-12 and college tuition costs.

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