One of the provisions in the Tax Cuts and Jobs Act of 2017 (TCJA) included the ability for an owner of a 529 education savings plan (such as Illinois’ Brightstart) to use the funds for K-12 private schooling just the same as for post high school expenses. This means that, at least at the federal level, owners of these plans will not pay tax on the growth of these funds if used for any private K-12 schooling. Previously this option was only available with a Coverdell savings plan, but TCJA extends this treatment to 529 plans.
In Illinois however, the state Treasurer and Department of Revenue have come forth to state that this usage will not be allowed by the state. This means that, if an owner of an Illinois Brightstart or Bright Directions 529 plan uses the funds from that account for K-12 tuition, the state of Illinois will tax the growth of the funds. The income will be included as ordinary income in Illinois, taxed at the standard 4.95% rate.
Not only that, but the state income deduction for contributions to either plan is effectively nullified if the money is not used for post-secondary expenses. So if a family contributed money over the years to a Brightstart plan and deducted those contributions from income for Illinois tax, and then they ultimately use those funds for K-12 expenses, the state requires a claw-back of the original deduction. This would effectively penalize the family for saving – for taking the tax reduction incentive and then using the funds in a manner not allowed by the state.
Behind this move is the assertion that the 529 plans were put in place to save toward college education expenses, not private K-12 schooling.
The Brighstart and Bright Directions plans’ disbursals for K-12 expenses would still have the federal tax break – which is non-inclusion of growth on the funds at the federal level. But the clawback inclusion of prior contributions and inclusion of growth as income at the state level will likely eliminate that federal tax benefit for most savers.
This does not eliminate the long-standing option of contributing funds to one of the Illinois plans (and thereby generating an income deduction) and then as quickly as the following day generating a distribution to pay for college expenses. Illinois’ Treasurer Michael Frerichs acknowledged this is still available, although likening the strategy to money laundering. I wouldn’t be surprised if this option receives more scrutiny in the near future.Other states?
There are 30+ states that provide similar tax breaks as Illinois’ for their residents saving in the state-sponsored 529 plans. Some states, including Missouri, Utah and Delaware, have come out to indicate that they will follow the federal tax-treatment of 529 distributions. Many other states are considering their options and proposing legislation for how to handle this new provision. Thus far, only Illinois has published their choice to not follow the feds.
Coverdell plans, originally slated to be eliminated with TCJA, are still available and still have the ability to be used without tax consequences for K-12 expenses as well. But Coverdell plans do not provide the tax reduction option for contributions that Illinois’ 529 plans do. Plus, Coverdell plans have a very limited contribution level: $2,000 per beneficiary (student) per year, and this contribution amount is only available for couples earning less than $220,000 in 2018.