The Tax Cuts and Jobs Act of December 2017 changed the tax code for most Americans. For parents with younger children, one of the new opportunities is the added flexibility to use traditional 529 college saving plans to help pay for K–12 tuition expenses.
Although the money may come from multiple 529 accounts, only $10,000 total can be spent each year per beneficiary on elementary, middle, or high school tuition. For amounts greater than $10,000 that are withdrawn to pay for K–12 tuition, the earnings will be subject to income tax and a 10% federal penalty. State income taxes may vary. Contact your tax advisor for details.
"The new legislation makes adding to your 529 savings more attractive because it provides additional flexibility for parents and families who value education," says Melissa Ridolfi, vice president, retirement and college leadership at Fidelity Investments. "But with these opportunities come additional considerations and potentially, some tough trade-offs."
Given the fact that college tuition, room and board, and related expenses can be some of parents' biggest liabilities, does it make sense for you to tap into your 529 to pay for elementary or high school tuitions—or wait until your kids are heading off to university?
A family looks at 2 options for their 529 savings plan
529 plans are tax-advantaged savings accounts designed to help parents and students benefit from potential growth in the market over time. In addition to certain tax advantages like the avoidance of paying capital gains taxes, the power of compounding (where 529 accounts' earnings from both capital gains and interest are reinvested to help generate additional earnings over time) make it an attractive savings vehicle for many parents and grandparents.
There are different ways to fund current and future K–12 tuition and college expenses. Let's look at 2 hypothetical scenarios for a family.
The family plans to send their daughter to a private high school next year. They have been diligent savers since she was born and they have saved approximately $100,000 in her 529 savings account. They have estimated they will pay about $32,000 for the first year of college—an amount that is likely to grow at 5% every year.
In scenario 1, (see chart) they are considering withdrawing $10,000 per year from their 529 to help pay for 4 years of private high school. With this strategy, they would lose out on potential tax-deferred compounding benefits and they would deplete their 529 account balance halfway through the 3rd year of college. The net result would be total out of pocket costs of $53,000 for their daughter’s education expenses across high school and college.
In scenario 2, the family plans to fund $10,000 in annual tuition expenses for 4 years of private high school through savings, scholarships, and other means. By not tapping into their 529 savings account until college, they are able to see the power of compounding at work over a longer time horizon. Their $100,000 in the 529 account could have the potential to continue to grow and fund the entire cost of their daughter's college education. As a result, they would have paid a total out of pocket cost of $40,000 for their daughter's educational expenses across high school and college (see chart).
By keeping more money in their 529 account for a longer period of time, the family could save approximately $13,000 ($53,000 vs. $40,000) in total out of pocket educational expenses for their daughter’s high school and college education—and avoid taking out college loans to finance Year 3 and Year 4 of college for their daughter, which with interest, would further increase the total costs of college.
"Although the 529 does give you added flexibility to meet short-term needs like K–12 tuition bills, you may pay more in the long term due to the potential loss of the tax advantaged and compounding benefits of a 529," advises Ridolfi. "It's important to have every dollar available earning a return if you want to maximize your college savings."
A popular choice in Fidelity-managed 529 plans includes age-based investment options that potentially help you stay on track with the goal you choose at the onset. These investment options are designed to automatically shift your investment mix from more aggressive (more stocks) to more conservative (fewer stocks) as your child approaches college age so withdrawing assets from the account before maturity can impact the effectiveness of the age-based strategy."
Tip: We understand that there may be family emergencies or other times when it may be necessary to tap into a 529 account prior to the college years. However, if you do, the key would be to contribute back those amounts annually (from other sources of personal savings) to help keep your college savings efforts on track.
Keeping your college savings on track
While many families have found a variety of ways to pay for ongoing educational expenses, it's important not to lose sight of the college savings goal for each child. To that end, we've come up with a simple rule of thumb to check whether your college savings are on track. We call it the "college savings 2K rule of thumb." Simply multiply your child's current age by $2,000. This amount can show you whether your college savings to date are generally on track to cover 50% of the cost of attending a 4-year public college.
Another way to check your progress is to use Fidelity's college savings calculator, which allows you to change several key assumptions and then see how the outcome is affected. The results will show you approximately how much you should have saved to date, assuming this steady savings rate continues into the future. If you are behind in your savings efforts, the calculator gives you the ability to adjust your monthly savings amount and see what the impact would be in closing the savings gap.
Not on track? You're not alone. According to the 2016 Fidelity College Savings Indicator,1 parents across the US want to save close to 70% of expected college costs—yet they are only on track for about 30% as a whole.
Can you boost your savings even more? Many parents believe they can—and should—be saving more for college in their kids' 529 plans. Thinking back over the past 10 years, 52% of parents with children in 10th grade or older say that they could have saved more each month, with a median incremental amount of $200 per month.
Tip: Increase your savings by applying for a Fidelity Investments 529 College Rewards® Visa Signature® Card.2
Putting college savings into perspective
"Although the new tax laws provide greater flexibility to use 529s to pay for K–12 expenses, many families will be faced with tough choices. Parents can work with a financial advisor to figure out and decide what’s right for their unique situation, in order to stay on track with their long-term education goals," says Ridolfi. "A 529 is one of best ways for parents and grandparents to save because the combination of tax advantages and the power of compounding can help parents save more over the long haul."
Tip: Savings can truly be a family affair. Fidelity offers a 529 Online Gifting Service, which lets owners of Fidelity's retail 529 college savings accounts use social media and email to encourage friends and family to help them save for college.
Next steps to consider
Open a flexible, tax-advantaged 529 college savings plan.
Confirm you're on track with our college savings calculator.
Learn how college savings plans work, including tax savings.