The 2017 Tax Cuts and Jobs Act will bring significant changes to individual taxpayers, but states will also be affected by some of the law's provisions. The limitation on deductions for state and local taxes has grabbed the most headlines, because by definition, it affects taxpayers in states with high property values and high taxes – primarily "blue" states with Democratic voting bases.
However, there is a less-publicized change that benefits wealthier taxpayers while threatening the tax base of some states. A college-savings program, called a 529 plan after the corresponding section of the tax code, now allows families to use those funds toward elementary and high school costs at private schools – including those with religious affiliations.
Think of 529 plans as Roth IRAs for college. They allow you to contribute funds toward your child's education and accumulate tax-free growth on your contributions. As long as you use the funds for qualified educational purposes, the earnings are not taxed upon withdrawal. Deposits are limited to $14,000 per individual per year ($28,000 for couples) to maintain gift tax exclusion.
529 plans are administered by the states. You don't have to enroll in your state's plan – it's acceptable to live in one state, enroll in a 529 in another state, and use the funds to pay for college in a third state. As a result, many states offer tax deductions or credits to entice residents to use their state's plan (since a tax break doesn't help if you don't pay taxes in that state). Savingforcollege.com offers a state-by-state comparison of each state's deduction benefits.
The change to make K-12 tuition eligible for 529 funds is more targeted at tax savings than at building nest eggs. Traditionally, the concept of a 529 plan was to allow parents to start early and generate enough tax-free earnings to offset some of the skyrocketing costs of college. If funds are used for elementary and high school costs instead, contributions will have a shorter time to accumulate tax-free earnings and the tuition benefits are diminished.
However, by funneling K-12 tuition costs through a 529 program in their state, families can claim whatever tax break is available. Parents now have even greater incentive to use 529 programs, and the number of state residents claiming the tax break could expand rapidly without a proportionate benefit to state government.
States that offer tax incentives are understandably concerned about the corresponding loss of tax revenue. This last-minute change puts state legislatures in a budgetary bind. Meanwhile, states that don't have income taxes – such as Texas, the home of Sen. Ted Cruz, who inserted the 529 changes in the tax bill – don't see any decrease in tax revenues.
State legislatures have multiple ways they can deal with this issue. They can choose to raise taxes to make up for the shortfall, put limitations on the time between deposit and withdrawal of funds, apply caps, or come up with some clever variation that stays within 529 plan guidelines.
As a taxpayer, 529 plans offer a tempting offer to save on your state taxes – assuming you can afford to send your children to a private school and take advantage of it. Unfortunately, you may end up paying more taxes in the long run if your state chooses to raise taxes to make up for the lost tax revenue.
Along with tracking changes in your state tax laws, we suggest keeping up with any Congressional action over the next year. The federal tax laws may still be subject to future tweaking, and in an election year, representatives may want to retreat from programs that clearly benefit wealthier residents at the expense of lower-income residents.
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