Federal Tax Reform Update

Arizona Taxpayers: On December 22, 2017, the federal tax reform bill H.R. 1 was signed into law. Sections of this new law made changes to existing 529 internal revenue code which now permits withdrawals from a 529 college savings account up to $10,000 each year, per beneficiary, for tuition expenses in connection with enrollment and attendance at an elementary or secondary public, private or religious school (“K-12 tuition”). While we wait for the Arizona Department of Revenue and the Arizona State Legislature to respond to the new U.S. tax law, please note the following:

  • Arizona taxpayers should consult their tax advisors before making a withdrawal for K-12 tuition and/or before making a contribution which they intend to ultimately withdraw for K-12 tuition. It will require action by the Arizona State Legislature to extend favorable Arizona state tax treatment to withdrawals for K-12 tuition taken from an Arizona Family College Savings (529) Plan account. 

  • Account owners can withdraw assets to pay K-12 tuition and treat the withdrawals as qualified expenses for federal tax purposes.

  • Funds in 529 Plan accounts can be rolled over to ABLE Plan accounts without federal tax consequences, up to the annual $15,000 contribution limit. It may require action by the Arizona State Legislature to extend favorable Arizona state tax treatment to rollovers from an Arizona 529 Plan account to an ABLE Plan account.

The Commission will provide more information as additional details are released regarding how Arizona state tax law will conform to the new federal tax law. In the meantime, we encourage AZ 529 investors to consult a qualified tax advisor regarding their personal circumstances.

Montana Taxpayers: Withdrawals from Montana 529 Plans to Pay for K-12 Tuition may be Taxable in Montana 
Despite changes made to IRC 529 in the “Tax Cuts and Jobs Act”, a withdrawal from a Montana 529 Plan to pay for K-12 tuition continues to be a nonqualified withdrawal under the Montana Family Education Savings Act. Funds used to pay for K-12 tuition may subject the account owner to recapture tax on contributions previously deducted and require the beneficiary to include the earnings in their gross income.  

The change made to IRC 529 at the end of December 2017 exempts expenses for tuition in connection with enrollment or attendance at elementary or secondary schools, up to $10,000, from being included in the gross income of the beneficiary. This provision is effective beginning with tax year 2018. 

As stated in Part 1 of the “Family Education Savings Act”, the intent of the Montana legislature was to make postsecondary education more affordable. For this reason, the statute is clearly written to provide that a withdrawal from a 529 Plan must be used to pay for higher education expenses, such as tuitions for colleges, in order to be entirely exempt for Montana tax purposes.  

Montana taxpayers may face two consequences if they withdraw funds from a 529 Plan to pay K-12 tuition. The account owner may have to recapture tax on part of the withdrawal, and the beneficiary must report the portion of earnings included in the withdrawal on his/her tax return.  

The account owner must report and recapture tax on any portion of the payment that reduced the Montana adjusted gross income (AGI) of the contributor, even if the contributor is not the account owner. The recapture tax equals the recapturable amount times the highest marginal tax rate in effect and must be reported on the account owner’s individual income tax return. 

Contributions that did not reduce Montana AGI are allocated to a non-qualified withdrawal first. Taxpayers must be aware, however, that all contributions made by Montana residents are deemed to have reduced Montana AGI unless the contributor provides evidence that the contributions were not previously deducted. 

Any nonqualified withdrawal includes a portion of earnings. These earnings are taxable to the beneficiary for Montana tax purposes. Beneficiaries must use the principles described in IRC 72 relating to annuity contracts to calculate the amount of earnings included in the withdrawal. See current IRS Pub 970, Tax Benefit for Education, page 52. For most beneficiaries, however, the amount of earnings alone will not create a filing requirement.  

Example: A Montana resident opened a 529 Plan and deducted from Montana AGI all but $1,000 of the contributions made to the account. In 2018, the account holder withdraws $10,000 to pay for K-12 tuition of their son, the beneficiary of the account. Of this amount, $2,000 represents earnings on the account. 

For Montana tax purposes:  

  1. The beneficiary of the account includes the $2,000 of earnings as a Montana addition on the Montana tax return. However, if it is the only income received by this taxpayer, there is no filing requirement because the amount is below the filing threshold. 
  2. The account holder reports and pays a recapture tax on the $7,000 of contributions that reduced Montana AGI. ($10,000 – $1,000 – $2,000 = $7,000).