Traditionally, state-sponsored qualified tuition programs, or 529 accounts, have been used by parents to save money for college expenses. The funds in the account can grow tax deferred until a future date and, assuming the funds are used for qualifying college expenses, they can be withdrawn tax free. As of 2018, private school tuition is also included in the list of qualifying expenses.

TCJA

At the end of last year, the House and Senate ratified the Tax Cuts and Jobs Act of 2017. The legislature has resulted in major tax reform for businesses but also includes some small changes to individual tax code. Despite the Presidents’ aim for simpler tax law, these changes will arguably create more complexity and planning opportunities for filers.

Part of the reform introduced language that would potentially allow qualified tuition program money to be spent on private school (Section 11032 of TCJA). From IRC Section 529:

“Any reference in this subsection to the term ‘qualified higher education expense’ shall include a reference to expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.”

This is, of course, language at the Federal level and qualified tuition programs are maintained by individual states.

Qualified Tuition Programs

State-run college savings programs, typically referred to as 529 accounts, offer a number of benefits. Primarily, they allow funds to be invested in the market, through an intermediary, in order to grow tax deferred. Providing that the beneficiary uses the funds for qualified expenses, they can be withdrawn tax free. Additionally, when a saver utilizes the 529 plan of their state of residence, they can deduct their contributions on their state tax return. For example, as a Michigan resident, I am free to use the 529 program in any state, but I can only deduct contributions to the Michigan 529. If I prefer Vanguard (Vanguard manages the Iowa 529 plan) over TIAA-CREF (TIF manages the Michigan plan) I am free to use the Vanguard plan, but I cannot deduct my savings. However, the funds still grow tax deferred and can be used for qualified expenses without paying income tax, regardless of the plan used.

The maximum amount that can be deducted in a single year is $10,000 per family. Meaning, as a father of 5 children, I cannot deduct $50,000, I can only deduct $10,000. Hence, the most tax savings that can be realized in a single year is $425 (a state tax rate of 4.25%). Clearly, the true benefit of the 529 is the tax deferred growth and tax-free withdrawal.

Michigan Tax Law

Unfortunately, when people talk about using 529 accounts to pay for private school, they often forget to talk about individual state tax law. Specifically, for people saving in their state’s 529 account, local tax treatment is paramount. Remember, 529 plans are administered at the state level, and savers can receive a state income tax deduction.

Currently, there is no case precedent to rely on, but the Michigan constitution is clear: 

“No payment, credit, tax benefit, exemption or deductions, tuition voucher, subsidy, grant or loan of public monies or property shall be provided, directly or indirectly, to support the attendance of any student or the employment of any person at any such nonpublic school or at any location or institution where instruction is offered in whole or in part to such nonpublic school students.”

The simplest interpretation of that language suggests that when utilizing a 529 plan for private school tuition, a filer should not claim a tax deduction. Thirty-seven states in the U.S. have similar language in their constitutions. For Michigan residents, it would be prudent to forgo claiming a state tax deduction if they are intending to pay private school tuition from the account.

Strategies

That being said, there are still several strategies to maximize the tax savings of a 529 plan while paying for private school.

At its most basic, a 529 plan could be used to pay current year private school tuition, up to $10,000. Of course, this strategy is only beneficial if you deduct your contributions. Assuming that one is comfortable taking that risk, the most one would save is $425 each year, possibly less! For a family with a few elementary age students these savings could add up over time as $425 saved over 13 years adds up to $7,650. This is, of course, the total amount saved, not per child.

As I stated earlier, though, the real power is the compound interest and tax-free distribution. The best, most efficient, use of the 529 account related to private school tuition would be to prepay high school tuition for elementary aged students. Meaning, saving into a 529 account while concurrently paying tuition would allow parents to utilize market growth to help prepay future private school expenses while subsequently reducing their taxable investments.

For example, assuming savings started when a child entered kindergarten and continued until the end of middle school, parents would need to save $4,500 each year, or $375 each month to completely pay for the last 4 years of high school. As private school tuition tends to increase at a rate of around 4%, this strategy helps parents “keep up” with the rising cost of school. If tuition costs around $10,000 annually now, it could be $14,000 or higher by the time an elementary school-aged child is a freshman. This strategy would “cost” $40,500 in savings but would yield $60,440.42 in proceeds (a 6% rate of return), resulting in total savings of $19,940.42. Currently, 529 distributions are limited to $10,000 per student for private school, but it’s reasonable to assume the limit will increase over time.

This strategy can become even more impactful for parents with a lot of money saved in taxable investment accounts or with high incomes. As Michigan residents are not limited to the $10,000 deductible contribution (because they shouldn’t be deducting their contributions at all!) more money can be saved early on. However, it would still be advisable to limit savings to the annual gift taxing limits ($15,000 in 2018). Saving $15,000 in years one and two and $3,500 in year three covers all 4 years of high school. That’s $33,500 of contributions paying the same $60,440.42 of tuition costs, resulting in $26,940.42 of savings; in only 3 years!

Likewise, saving $15,000 in a child’s 529 over a longer period allows for additional growth and tax savings. In order to hypothetically save for both private high school and college, parents would need to save $15,000 for around 8 years for a total of $120,000 in order to cover $214,035.36 of education expenses (high school and college). The growth of the investment covers an additional $94,035.36 of costs!

This assumes that just one parent hits the gift limit, as a married couple could save $30,000 into each child’s 529 ($15,000 each, annually). Saving $30,000 for 3 years covers 85% of high school and college expenses!

Obviously, while this strategy is powerful, it has very limited applicability. For most people, the new tax law hasn’t changed the way they pay for private school. At least, not in Michigan. Also, these are extreme examples to illustrate a concept; each person’s individual circumstances will be unique. Always consult with a qualified financial planner and tax professional before engaging in any of the strategies discussed.

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