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The Short Answer

529 Accounts: Not Just for College Savings Anymore?

The proposed tax bill would allow 529 withdrawals for elementary and secondary school tuition; we consider some implications for investors.

The House and Senate are working to reconcile a proposed tax reform bill, which includes a section that would expand 529 allowable educational expenses to include K-12 tuition. 

Currently only qualified higher education expenses are eligible for penalty-free, tax-favored withdrawals; now, if the bill passes as is, up to $10,000 per year, per beneficiary could be used for tuition expenses "in connection with the enrollment or attendance of the beneficiary as an elementary or secondary school student at a public, private, or religious school." 

How Would It Work?
If this proposal becomes law, you could fund a 529 account with aftertax dollars when the child is an infant (or even before birth in the currently proposed version of the bill), and any earnings the investments enjoy wouldn't be taxed when you use the money to pay for private school, which translates into a big tax cut on private school tuition. If this bill were to become law and you decided you would like to use your 529 for these dual purposes--longer-term college savings as well as more intermediate-/short-term elementary school tuition--there are a few things to keep in mind.

First, from a practical standpoint, it would make sense to aggressively fund the account as early as possible so the investment earnings have more time to compound. Contributions of up to $14,000 qualify for the annual gift-tax exclusion (per person, so $28,000 per married couple) or up to $70,000 ($140,000 per married couple) with five-year election (read the IRS rules here). Some states offer a tax break on contributions as well.

The next consideration is how one would marry the goals of investing for elementary school and college in the same account. Currently, 529s are used for one goal: saving for college, which has a long time frame that makes a higher allocation to equities appropriate.

This proposal would change the way some people use 529s and necessitate more flexible investment options. Though it would not allow preschool tuition as a qualified expense, kindergarten would be allowable, meaning money invested in the 529 when the beneficiary is an infant would have at most a five- to six-year time frame. Plus, if you plan to send your child to private school for the duration of his elementary and secondary schooling, you will have an intermediate time frame of around seven to 17 years as well.

If you were to invest for that beneficiary's college expenses in the same 529 account, you would also have about an 18-year runway for a portion of the money. For this portion of the account, an age-based option that rebalances to become less aggressive (more bond-heavy) might be the best choice. But it probably won't make sense for the portion of the money earmarked for elementary education.

Even the most conservative age-based plan options are heavily allocated to equities for very young beneficiaries. For instance, Gold-rated  BrightStart Illinois 529 College Savings plan offers conservative, moderate, and aggressive age-based options, which vary in their allocation to equities. But the conservative 0-2 age-based portfolios begin with a 20% allocation to fixed income, so the investor is still taking on a lot of market risk.

Many 529s offer target portfolios that do not rebalance to be more bond-heavy over time. For instance, Illinois BrightStart offers a 60/40 equity/bond portfolio as well as 50/50 bond/money market portfolio. If this proposal becomes law, it would make sense for all 529 plan providers to offer some sort of option for intermediate savers with a 50/50, 60/40, or 70/30 allocation (the types of allocations that are available for 12- to 14-year-old college savers), alongside the more traditional equity-heavy age-based tracks that are intended for young college savers.

And for simplicity's sake, 529 plan administrators should allow multiple allocations within one account--currently some providers necessitate that you open separate accounts if you want to allocate the same beneficiary's assets to both an age-based option and a static option.

So Long, Coverdells
Another aspect of the proposed bill would cut off new contributions to Coverdell accounts. These accounts have been declining in use in recent years.

Coverdell accounts are similar to 529s in that they are funded with aftertax dollars. Money compounds on a tax-free basis, and withdrawals to pay for qualified educational expenses are tax-free, too. One aspect of these accounts that makes them challenging is their contribution limit of only $2,000 per beneficiary per year; any amount exceeding $2,000 per year per beneficiary is subject to a 6% excise tax penalty. That makes amassing enough money in the account to meaningfully save for college difficult.

Coverdells also have an income limit for the contributor: For 2017, single income tax filers with modified adjusted gross incomes of more than $110,000 and married couples filing jointly with incomes greater than $220,000 cannot make contributions to a Coverdell.

In addition, there are certain age limits. All contributions must be made by the time beneficiary is age 18, and the funds must be distributed from an account by the time the student reaches age 30 (though they could be rolled over into a Coverdell for another eligible family member). There is no requirement to liquidate the assets by a certain age in a 529 account.

The biggest advantage of Coverdells compared with 529s is their flexibility to be used for elementary and secondary education. In the likely event that the amended 529 distribution rules take effect, you would be able to use traditional 529 savings accounts for those expenses, too.

Though new contributions to Coverdells would not be allowed after Dec. 31, tax-free rollovers to 529s would be allowed.

ABLE Accounts
Another proposal would let families with a child with disabilities roll a traditional 529 account over into an ABLE account, which is a tax-favored way to save for the needs of a person with a disability. It is built on same the legal framework as 529 college savings plans, and it works in a similar way. Contributions are made with aftertax dollars to a plan with a preset menu of investment choices. Earnings compound on a tax-free basis, and withdrawals to pay for qualified expenses are tax-free, too.

ABLE account eligibility is limited to individuals with significant disabilities, the onset of which occurred before the individual turned 26 years old. ABLE accounts also have a broader set of qualified expenses including education, housing, healthcare, employment training and support, and legal fees.

Individuals' needs and circumstances change throughout their lifetimes, often in ways we can't anticipate. The proposed ABLE account rollover would provide families with additional flexibility in the event that a 529 account beneficiary is diagnosed with a disability or becomes disabled as a result of accident or injury.