Cruz Amendment 529: Federal vs. State Tax Rules

A 529 plan is a tax-advantaged savings vehicle designed to help families set aside funds for future education costs. Traditionally, these plans, known as Qualified Tuition Programs, were used for post-secondary education expenses. The investment earnings in these accounts grow federally tax-deferred, and withdrawals are tax-free when used for qualified higher education costs. The Tax Cuts and Jobs Act of 2017 expanded the scope of 529 plans, altering how families can use these dedicated savings accounts.

Permitted K-12 Withdrawals

The federal rule change allows for up to $10,000 per year to be withdrawn from a 529 plan to pay for tuition at an elementary or secondary school. This annual limit is applied on a per-beneficiary basis, meaning a student with multiple 529 accounts is still held to the single $10,000 total withdrawal limit annually. The funds can be used for tuition at public, private, or religious schools.

The term “tuition” strictly covers the cost of enrollment or attendance. This means many common educational costs are not considered qualified expenses for K-12 distributions, including:

• Books
• School supplies
• Uniforms
• Transportation costs

Costs associated with a homeschool curriculum or materials are also not eligible for tax-free withdrawals.

Rollovers to Roth IRAs

Another expansion of 529 plan rules allows for unused funds to be rolled over to a Roth IRA for the plan’s beneficiary. These rollovers are free from federal income tax and penalties but are subject to several conditions. The 529 account must have been open for at least 15 years, and any contributions made in the last five years and their earnings are not eligible to be moved.

The amount rolled over in any given year cannot exceed the annual Roth IRA contribution limit, and the beneficiary must have earned income at least equal to the rollover amount. There is also a lifetime maximum of $35,000 per beneficiary that can be moved from a 529 plan to a Roth IRA. State tax laws may not conform to this federal rule, potentially creating state tax consequences.

Federal vs State Tax Treatment

While the federal government permits K-12 tuition withdrawals to be free from federal income tax, the treatment at the state level varies. The issue lies in whether a state has conformed its tax code to the changes made in the Tax Cuts and Jobs Act of 2017, as many have not.

In states that do not conform to the federal change, the earnings portion of a 529 withdrawal for K-12 tuition is treated as a non-qualified distribution. This means the account owner will owe state income tax on the earnings. Some states may also impose an additional penalty tax on those earnings, often around 10%.

An additional complication arises from state tax deductions for 529 plan contributions. Many states offer a tax deduction or credit for contributions made to their specific 529 plan. If a resident takes this deduction and later uses the funds for K-12 tuition in a non-conforming state, the state may “recapture” the prior tax benefit. This means the taxpayer would have to pay back the tax savings they previously received, effectively adding that amount to their state tax liability for the year of the withdrawal.

Making a Qualified K-12 Distribution

To proceed with a K-12 withdrawal, the process involves contacting the 529 plan administrator, usually through an online portal or by submitting a form. There are two payment options. The first is to have the payment sent directly from the 529 plan to the K-12 institution. The second option is for the account owner to pay the tuition bill and then request a reimbursement from the 529 plan.

Record-keeping is required when making any 529 plan withdrawal. Account owners must retain documentation that proves the funds were used for qualified tuition, such as tuition invoices, canceled checks, and bank or credit card statements. This documentation is necessary to substantiate the tax-free nature of the withdrawal in the event of an IRS or state tax agency audit.