Author’s Note 5/16/2024: It is our understanding that the information below regarding Nebraska’s 529 plan is still current, and state legislation has not changed. However, rules can change. Please reach out to us if you are ever unsure of how the rules might apply to your situation.
One of the most common goals our clients have is to save for their children’s college expenses. Their specific goals, however, vary widely. Some parents want to provide just enough seed money to get their scholars off to a good start. They might save enough to cover tuition at a two-year community college. Other parents anticipate covering the full cost of tuition and housing at a four-year, in-state university. Still others want to pay for both undergraduate and graduate degrees at whatever school the student chooses. Regardless of how much they want to save, many parents utilize a 529 plan because of the tax benefits.
Federal Law Expanded “Qualified Expenses” to Include K-12 Tuition
As part of the 2018 Tax Cuts and Jobs Act, the federal government decided to allow 529 Savings Plans (aka College Savings Accounts) to be used for K-12 expenses. For people who currently send (or plan to send) their kids to private school, this was good news. And for families paying K-12 tuition now — while knowing their students will receive scholarships to pay for college later — the change was especially positive.
Prior to the change, K-12 tuition was considered an “unqualified” expense, and using money from a 529 plan to pay for it came with multiple penalties. First, the growth on the account was taxed as income at the federal level and possibly the state level for account owners whose states have income tax. Second, there was a 10% federal tax penalty. Third, if account owners received a state tax deduction, they had to pay back those deductions. Fourth and finally, some states imposed another penalty on top of the 10% federal penalty.
State Rules Complicate the Tax Treatment
You’d think that now that the federal government considers K-12 expenses to be “qualified” expenses, you could use funds from a 529 plan to pay that tuition bill without any fear of penalties, right? Unfortunately, as with most tax questions, it’s not that simple. It’s complicated because individual states have to adopt the federal view that K-12 expenses are qualified expenses. Case in point: Nebraska. Nebraska has NOT yet adopted the federal government’s definition of a qualified expense. Nebraska says you still have to use a 529 account for college and that K-12 expenses are unqualified expenses. Many of our clients live in Nebraska, so let’s take a closer look at how saving for college as a Nebraska resident might affect your taxes.
There are three scenarios in which someone might be saving using a 529 account that has some sort of connection to Nebraska. First, let me describe a situation that has nothing to do with Nebraska’s rules or Nebraska’s college savings plan: a parent lives in Kansas, they use Illinois’s state-sponsored plan, and their child is going to school at the University of Nebraska-Lincoln. All of the rules around 529 plans have to do with the state where the account owner (likely the parent or grandparent) lives and the state that sponsors the plan. The state where the child attends college typically doesn’t matter when it comes to 529 plan rules.
Knowing that, let’s look at the scenarios that DO involve Nebraska.
Scenario 1: The account owner lives in Nebraska and contributed to its state-sponsored 529 plan (the NEST 529 plan)
This describes most Nebraska residents who are using a 529 plan. If you’re living in Nebraska and contribute to the NEST 529 plan, you might qualify for a state tax deduction up to $10,000 that you contribute to NEST plans. So the NEST plan is a popular choice with Nebraska parents and grandparents.
What happens if you fall in this group and you decide to use your NEST account to pay tuition at your child’s private high school? The federal government views this as a qualified expense, so you probably won’t have to pay federal income tax on the earnings, and you’ll probably avoid the 10% federal penalty. However, Nebraska doesn’t view this as a qualified expense. So you’ll probably have to pay income taxes on the gains. Thankfully Nebraska doesn’t have its own state-specific penalty for unqualified expenses, so you don’t have to pay that. But you do have to repay any state tax deductions that you received in the past when you contributed to the NEST plan. Bottom line for the likely scenario: you’ll pay state income tax on the earnings, and you’ll pay back the deductions.
Scenario 2: The account owner lives in Nebraska but contributed to a different state’s 529 plan
Some Nebraska residents don’t use the NEST plan. For a variety of reasons, they might choose to contribute to a different state’s 529 plan.
What if you’re in this group, and you decide to use your 529 plan to pay tuition at your child’s private high school? Again, the federal government views this as a qualified expense, so you won’t pay federal income tax on the earnings, nor will you pay the 10% federal penalty. You never received a state tax deduction when you contributed to that plan, because it wasn’t the state-sponsored NEST plan. That means you won’t have to pay that back. However, you will likely be required to pay state income tax on the earnings. You live in Nebraska, and you’re subject to Nebraska’s income tax laws regardless of where that 529 plan is held.
Scenario 3: The account owner lives in a different state but contributed to the NEST 529 plan
Just as in the previous scenario, some people use a 529 plan sponsored by a state outside their state of residence. For example, someone who lives in Colorado and contributes to the NEST 529 plan would be in this group.
What if you’re in this group, and you decide use your NEST 529 plan to pay tuition at your child’s private high school? You might have picked up by now, but again, you won’t pay federal income tax or a federal tax penalty. You’re subject to the laws of your state of residence, so it depends on whether your state has adopted the federal definition of qualified 529 plan expenses. The fact that you contributed to Nebraska’s 529 plan doesn’t mean you’re subject to Nebraska’s definition of a qualified expense.
If your state views K-12 expenses as a qualified expense, you’re in the clear. But if your state is like Nebraska and views K-12 expenses as unqualified, you might have to pay state income tax (if your state has income tax) and a state-specific penalty (again, if your state has one).
More Changes May Be Coming
There have been multiple attempts by the Nebraska State Legislature to bring the Nebraska definition of a qualified expense in line with the federal definition. Most recently, a bill was proposed (LB165) in March 2023, but as of April 2024, discussion on the bill has been indefinitely postponed. If you have an opinion on whether K-12 expenses should be qualified expenses for 529 plans, I encourage you to contact your state senator.
In the meantime, Nebraska residents who use a 529 plan for K-12 expenses have to carefully navigate the differences between the state and federal definitions. If you’re in a situation where you are considering using a 529 plan for K-12 expenses, or if you already have, you need to work with a qualified tax advisor. Don’t view the information in this article to be sufficient enough to make a clear conclusion of how it affects you; everyone’s situation is unique. This article is for educational purposes only and is not meant to provide legal or tax advice. For help with your specific situation, consider clicking here to schedule a meeting with us. We routinely help clients with college savings questions. We’d love to help guide you on the right path so you can feel confident about your financial decisions.
