529 Accounts – K-12 Distributions Bandwagon

Take-Away: While the 2017 Tax Act liberalized the use of IRC 529 Higher Education Accounts to permit distributions to pay for tuition for elementary and secondary schools, up to $10,000 a year, not all states have jumped on that bandwagon.

Background: An IRC 529 account is an investment account that is created by a donor in the name of a designated beneficiary for the purpose of paying the beneficiary’s qualified higher education expenses. Each state sets its own limits for IRC 529 account contributions. The funds invested in the IRC 529 account will accumulate and grow federal income tax-free, and if the funds are used for qualified education expenses, like tuition, room, board, fees, books, supplies and related educational equipment, they are exempt from income taxes.

2017 Tax Act Change: Prior to 2018, a 529 account could be used solely for the purpose of paying for qualified higher education expenses, i.e. college and graduate school. But as a result of the 2017 Tax Act a 529 account can now be used to pay for tuition for elementary and secondary schools for federal income tax purposes, up to $10,000 per year. [IRC 529(3)(a)(ii).]

Michigan’s Blaine Amendment: While Michigan has both its MESP tuition program, and 529 plan legislation, along with advisor 529 plans, as of this writing it does not appear that Michigan has amended its 529 account legislation to authorize distributions from a 529 account for K-12 tuition expenses as tax deductible for state income tax reporting purposes. One reason may be that Article VIII, Section 2 of the Michigan Constitution prohibits the use of public funds or tax credits to support a student’s attendance at a private elementary or secondary school, often referred to as the Blaine Amendment. After the passage of the 2017 Tax Act and its liberalizing distributions that permit a 529 account to pay for K-12 tuition, the Governor asked for a binding opinion from the Michigan Attorney General with regard to the implications of the Blaine Amendment on distributions from state-sponsored or authorized 529 accounts for private school tuition. The Attorney General declined to provide such an opinion [probably because he was running for Governor at the time.] Hopefully with a new Governor and a new Attorney General we might get some clarification if a Michigan 529 account can be used to pay for a child’s private K-12 tuition.

Other State Reactions:  Not all states will characterize IRC plan distributions for K-12-year tuition as qualified distributions for state income tax reporting purposes. Some states that do characterize the IRC 529 distributions for K-12-year tuition as qualified distributions might actually cause those distributions to be recaptured, which would eliminate any prior state income tax benefits that were previously enjoyed. Other states have, or intend to, conform their tax laws to align with the federal tax code and will likely automatically include tuition payments for K-12 education from a 529 account as a qualified expense. Examples follow where some states have jumped on the K-12 bandwagon while other states have responded ‘not so fast.’

• On the ‘Bandwagon:’ There is legislation to allow for K-12 withdrawals from 529 accounts to be state-tax free in several states. States in this category, each with their own set of rules and limitations, include: Alabama, Arkansas, DC, Georgia, Idaho, Indiana, Iowa, Kansas, Maine Maryland, Massachusetts, Mississippi, Missouri, North Dakota, Ohio, Oklahoma, Pennsylvania, Rhode Island, South Carolina, Utah, Virginia, West Virginia, and Wisconsin.  There is currently pending legislation to allow for K-12 529 withdrawals to be free from state tax in
• Sort-of-on-the Bandwagon: No State Income Tax Deductions or Credits, but Distributions State-Tax Free: These states do not offer state income tax deductions or tax credits for K-12 tuition distributions, but distributions from 529 accounts for K-12 tuition are state tax free: Delaware, Kentucky, New Hampshire, North Carolina and
• No State Income Tax: 529 account distributions for K-12 tuition distributions in the following states are not subject to state income tax because there is no state income tax whatsoever: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and
• Louisiana: This is the only state currently with a separate 529-type of account that is specifically designed to save and pay for K-12 tuition. It is called the START K12 program. There is a one-time $10,000 deductible contribution to this account, but future contributions to the account are not eligible for a state income tax deduction.
• “Not on the K-12 Bandwagon:” California: It’s Franchise Tax Board has issued a report that indicates that California’s statute does not conform to IRC 529 account funding for elementary and secondary education or to the new federal rules that relate to the maximum distribution amount, which implies that a distribution from a 529 account for K-12 tuition will be subject to state income taxation. Colorado: There is a pending bill that would provide that a ‘subtraction is not allowed under this subsection if the payment or contribution that is made during the taxable year is intended for elementary or secondary school expenses.’ New Jersey: There is a pending bill that would not permit distributions from IRC 529 accounts for K-12 tuition by ‘excluding expenses for tuition in connection with enrollment or attendance at an elementary or secondary school.’  New York: The New York Department of Taxation and Finance issued a report concluding that ‘distributions for K-12 tuition expenses would not be considered qualified distributions under New York’s statutes that implement 529 accounts and thus, such distributions for those purposes would trigger a recapture of any tax benefits that had accrued on those contributions.’ Oregon: It formally passed legislation to decouple from the federal law with regard to distributions from 529 accounts. It provides that ‘withdrawals from Section 529 plans to pay expenses in connection with enrollment or attendance at an elementary or secondary school are added back for state income tax purposes.’ Vermont: It’s statute defines eligible education as ‘postsecondary programs.’ As a result, distributions from a Vermont 529 account to pay for K-12 tuition expenses would not qualify for tax-free state income tax treatment. In addition, the Vermont Tax Department has issued a Guidance that implies that amounts withdrawn from 529 accounts for K-12 tuition purposes would be subject to a 10% recapture penalty, and also imposition of a tax on gains realized with respect to such withdrawals.

Conclusion: Perhaps with a new Executive branch in Lansing we will get more direction on if K-12 distributions from an existing 529 account will be tax deductible for Michigan income tax reporting purposes. Until then, 529 account owners who are thinking about distributions from a 529 account to pay for K-12 tuition need to proceed with caution.