In a nutshell:
- Federal tax reform expands 529 college savings plans to include private K-12 tuition
- Michigan’s state constitution prohibits public aid to private schools
- Michigan families will not receive state tax breaks for saving for private K-12 tuition
The recently-enacted federal Tax Cuts and Jobs Act (TCJA) includes an expansion of tax-advantaged college savings program to allow account holders to use their savings for K-12 education expenses. The addition of this provision to the TCJA was intended to facilitate greater school choice by allowing families to use the savings programs for K-12 expenses like private school tuition. However, a long-standing constitutional provision will prevent Michigan families from taking advantage of the state tax benefits tied to the expansion of college savings programs when they use their Michigan savings for private school tuition.
A bit of history and the basics
Many attribute the origins of Section 529 college savings plans to the State of Michigan’s efforts, in the 1980s, to establish tax-exempt college savings accounts. (Section 529 refers to the section of the United States Internal Revenue Code authorizing them). Following a 1994 federal court ruling that declared the Michigan Education Trust (MET), Michigan’s pre-paid college saving plan established in 1986, exempt from federal taxation, the ruling was codified in the Internal Revenue Code in 1996. The modern 529 plan was born. These plans quickly spread across the country and became one of the most popular ways for parents to save for the fast-rising cost of higher education for their children.
Section 529 authorizes two basic types of plans: prepaid and savings plans. Prepaid plans, like Michigan’s MET, work by allowing people to purchase tomorrow’s college credits at today’s prices.
State-sponsored savings plans, like Michigan’s Education Savings Plan (MESP), work similar to 401K or Individual Retirement Accounts (IRA); contributions are invested in mutual funds or other investments and allowed to grow federal tax-free until they are withdrawn to be used for “qualified higher education expenses.” Over the years, the definition of what constitutes an eligible expense has been expanded, in 2015 to include computers and most recently in 2017 to include expenses related to K-12 education.
Specifically, under the new federal tax law (Section 11032 of TCJA), beginning in 2018, “qualified higher education expenses” include up to $10,000 in 529 distributions for tuition at public, private or religious elementary or secondary school. This provision opens 529 plans to K-12 education – extending the federal tax benefits to a new purpose.
For states that provide similar state tax treatment, 529 account holders could gain both federal and state tax benefits. More than 30 states offer a tax deduction or credit for 529 plan contributions.
Currently, Michigan tax law provides two benefits to 529 account holders and contributors. First, investment earnings on contributions that are subsequently used for eligible expenses are tax-free. This is similar to federal income tax treatment. This means withdrawals from Michigan 529 accounts used for eligible expenses are deductible in computing Michigan taxable income. This benefit effectively lowers the state income tax base.
Second, taxpayers are eligible for an income tax deduction on contributions to Michigan 529 accounts ($10,000 for married couples filing jointly or $5,000 for individuals filing single). This tax benefit is available to anybody making a contribution to a Michigan 529 account, but it is not available if the contribution is made to a 529 plan sponsored by another state. This tax deduction is designed to encourage Michigan residents to save for college. For a married couple contributing $10,000 to their child’s college fund, this amounts to a $425 income tax break. Statewide, the deduction reduces income tax revenue by over $14 million annually.
Michigan’s prohibition on public aid to private schools
But here’s where it gets tricky. Michigan, like 37 other states, prohibits direct government aid to religious schools. Commonly referred to as Blaine Amendment provisions, they were enacted to prevent states from funding parochial schools, often Catholic schools. Michigan’s prohibition, found in Article VIII, Section 2 of the 1963 Constitution, is broader than other states’ limitations because it forbids aid to any nonpublic school, not just religious schools. It was adopted in 1970 and specifically prohibits:
- the use of public funds to aid any nonpublic elementary or secondary school;
- the use of public funds, except for transportation, to support the attendance of any students or the employment of any person at nonpublic schools or at any other location or institution where instruction is offered in whole or in part to nonpublic school students; and
- any payment, credit, tax benefit, exemption or deduction, tuition voucher, subsidy, grant or loan of public monies or property, directly or indirectly, for the purposes identified here.
Here’s what it boils down to: While changes to the federal tax code will provide Michigan 529 account holders with new federal tax benefits if the funds are used to finance private K-12 education expenses, Michigan’s Constitution will prevent taxpayers from enjoying the current state tax benefits (associated with college savings) if 529 accounts are used for private K-12 education expenses.
This likely means that Michigan’s income tax receipts will not be affected as much as states with similar tax benefits but without Michigan’s constitutional prohibition. In those states, the federal change will provide a new opportunity for taxpayers to lower their taxable income for state income tax purposes via their 529 plans. These states may have a hard time making up the lost revenue. Michigan, on the other hand, won’t face this problem. The trade-off? Michigan families will not have access to these state tax advantages to pay for private K-12 education expenses.
Note: This post is intended for informational purposes only and not tax advice. Individuals should consult a tax professional before making a 529 plan investment.