Colorado Lawmakers Move to Formalize Penalties for K-12 529 Withdrawals

Our Colorado partner schools and families will remember hearing about HB 1123 by Rep. Colin Larson earlier this year. The bill would have aligned state law and federal law so that Colorado parents utilizing 529 college-savings accounts for K-12 tuition would not be subject to state penalties. Unfortunately, it died in its first committee hearing at the Colorado Capitol.

See below for a quick recap of the current legal situation surrounding 529 accounts.

Issue Recap

In 2017, Congress expanded the acceptable uses of 529 savings to include K-12 tuition expenses at public and private schools. That new flexibility acknowledged the fact that many families need to access their savings to meet educational needs long before their students go to college. For instance, a student might:

  • Need a more rigorous academic environment
  • Want access to a specialized program or field of study
  • Need a school closer to their parents’ home or work
  • Need a safer environment free from bullying or other issues

The main advantage of 529 accounts has always been that they allow money to grow in a tax-advantaged environment. Colorado has taken those advantages a step further by providing state tax deductions and credits for 529 contributions made individuals and corporations, respectively. Those extra state tax advantages are designed to incentivize increased saving for students’ educational futures.

Here’s where it gets complicated. While federal law now recognizes K-12 tuition as an acceptable withdrawal from 529 accounts, Colorado law has not been brought up to date. As a result, state law considers withdrawals for K-12 tuition to be “unqualified”—a designation that can carry all sorts of consequences for who ignore it.

In practice, this misalignment between state and federal law means that parents who try to utilize 529 funds in accordance with federal law could still be subject to hefty state tax penalties. These penalties will most often take the form of “recaptures,” in which the state forces parents to repay any credits or deductions taken for relevant contributions to the account.

SB 257

While Rep. Larson’s HB 1123 was designed to correct the misalignment of Colorado law and federal law on 529 account usage, SB 257 does exactly the opposite. It actually makes this misalignment permanent by writing into state law that parents cannot take advantage of the new federal flexibility.

In practice, the bill says that any parent who attempts to follow federal law and use 529 savings funds for K-12 tuition will face potentially severe state tax penalties for doing so. What a way to close out the 2019 legislative session, right?

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