What to Consider Before Using a '529' to Pay for K-12 Costs

This new rule has piqued the interest of many families with children in private school. At 529 plan adviser CollegeBacker, 54% of families who hold accounts are considering using their 529 funds for K-12 tuition, but more than half don’t know if that’s a good idea, says

Abby Chao,

co-founder and chief operating officer.

It isn’t.

“If you already have a 529 plan intended for college, then you should let it continue to grow until college to maximize the benefit of tax-free growth and withdrawals,” she says.

“Definitely not,” agrees Ric Edelman, who heads financial-planning firm Edelman Financial Services, and hosts a radio show on personal finance. Since the main benefit of a 529 is tax-free growth that compounds over time, you want to leave it in there for as long as possible. This is why investing 529 funds for a new baby makes sense, because the money won’t be needed for two decades until the baby goes to college. Taking out the money early and using it to pay for private school won’t do you much good, he says.

“The money won’t be in the account long enough for the compounding to do its job, rendering the exercise almost pointless,” Mr. Edelman says.

If you are not already maxing out your available state tax deductions, consider contributing up to the state tax deduction in a separate 529 account, Ms. Chao suggests.

“This allows you to choose an investment portfolio that matches the time horizon for K-12 withdrawals, whether it’s a year or a decade, while also capturing the state tax deduction,” she says.

You will be able to take better advantage of this new rule if you have younger children. In that case, you can set up a separate 529 for a young child—ideally a baby. “For a newborn, you have plenty of time to grow the account, even before elementary school,” she says.

Note that not all states are adopting the new K-12 rules when it comes to state tax deductions. In Illinois, for instance, residents don’t qualify for a state tax deduction for contributing to their 529s if the money is being used for K-12 tuition, Ms. Chao says.

“State tax penalties could be an unpleasant surprise if you try to claim a deduction for K-12 tuition without knowing the rules.”

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May I use distributions from my child’s 529 college savings account to pay for rooming expenses in a home that I own, and rent to my child, during college?

“A 529 plan can be used to cover the beneficiary’s room and board, regardless of whether the student lives on campus, off campus, or even at home with parents,” says Ms. Chao. Just make sure that the cost falls within the institution’s budget for room and board in its stated cost of attendance and that the student is enrolled at least half time, she says.

But Mr. Edelman thinks this strategy could earn you a call from the IRS.

“There’s a significant audit risk if you do that,” he says.

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What is the best way to transfer the funds from my nephew’s 529 in one state to my son’s 529 in another state without incurring taxes?

You’re permitted to switch beneficiaries in a 529 account, as long as the new beneficiary and the original beneficiary are close relatives. And you don’t have to use your own state’s plan, although certain states give tax benefits to residents who do so.

Most state plans allow you to move money this way, says Mr. Edelman. He recommends a two-step process: “Have child A in state A move the money into state B in the name of child A, and then change the beneficiary.” There may be a small fee to do so, he says.

Be aware of potential tax consequences, Ms. Chao says. “If you previously claimed a state income-tax deduction based on your contributions to your nephew’s 529 plan—and then you roll over to a different state—your nephew’s state may seek to recapture that deduction,” she says. To avoid this, you can stick with the original 529 plan and retitle it with your son as the beneficiary.

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Can we keep unused funds in my grown son’s 529 and use them for eventual grandchildren? Could we use these funds to pay qualified expenses for our daughter-in-law if the original beneficiary is our son, her husband? Is there an age limit on when a beneficiary can use the funds?

The rules are quite flexible when it comes to unused funds, Ms. Chao says. You can change the beneficiary to any member of the beneficiary’s family, including a child or spouse, without age limits or time limits.

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I’ve been contributing cash to our grandkids’ college 529 plans for the past couple of years. Can I deposit appreciated stock into their 529s instead?

No, you cannot contribute appreciated stock.

You can only deposit cash into a 529 plan, Ms. Chao says. That’s because each plan has a menu of investment options, often target-date funds, designed to grow in the early years and downshift to more conservative investments as the child approaches college. Plans don’t allow for self-directed investments like stock picking, says

Andrea Fierstein,

a 529 consultant to state plans who runs AKF Consulting.

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In 2013 I made a $70,000 contribution to my grandchild’s 529 plan as a five-year forward contribution ($14,000 x 5). I filed an estate-tax form. May I make a five-year forward contribution again in 2018?

Yes. Since five years have passed since your original contribution, you can contribute another $75,000 ($15,000 for each of the next five years) as another five-year forward contribution, Ms. Chao says.

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If a grandparent pays for qualified expenses directly out of a grandparent-owned 529, rather than giving the money to the student and having him or her pay the expense, does the student have to report this money on the Fafsa?

Yes, Mr. Edelman says. Any distributions from a grandparent-owned 529 for the student’s education would need to be reported on the Fafsa for the subsequent year, which would then be assessed as student income. To avoid this effect, grandparents can choose to contribute only during the last year of education, since the student will not file a Fafsa the following year, Ms. Chao says.

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Is it more beneficial for the grandparent to own the 529 when the child applies for financial aid, or should the parent own it?

It’s better for financial-aid purposes if parents own the account. When calculating “expected family contribution” for the Fafsa, a parent-owned 529 plan is considered a parental asset, which means the balance is assessed at a rate of up to 5.64% for every year the child is in school, Ms. Chao says. In contrast, a grandparent-owned 529 plan is not included in the financial aid formula until it is actually withdrawn for student. At that point, it is counted as student income for next year’s financial aid, which may be assessed at up to 50%, she says.

Ms. Schoenberger is a writer in New York. She can be reached at reports@wsj.com.