Colorado parents and families should not face state tax penalties for using 529 college savings accounts for K-12 tuition as allowed by federal law. We have introduced common-sense legislation, House Bill 1123, that will prevent this nightmare scenario by addressing a misalignment between Colorado law and federal law governing 529 accounts. Unless the state legislature acts now, Colorado will enter a new era where the state punishes instead of encourages investment in students’ educational futures.
Created by the federal government, 529 savings accounts allow families to save money for a child’s education in a tax-advantaged environment. Colorado generously offers a state tax deduction for contributions made to the state’s 351,000 active 529 accounts each year. And just last year, a bipartisan group of lawmakers passed a bill to offer state tax credits to employers who contribute to their employees’ 529 accounts.
In 2017, Congress expanded the uses of 529 savings to include K-12 tuition. Parents can now use their funds to pay for tuition at a public school — a common expense for those who choose full-day public kindergarten in our state — or at a private school of their choice. This new flexibility acknowledges the fact that many parents find themselves needing to address educational challenges before college.
The fact that more than one-third of Colorado students require remedial classes once they enter college makes clear that families need the flexibility to access the K-12 environment best suited to their unique children. But academics are not the only reason parents might be looking for a new school. Students may be bullied, they may lack access to advanced or career programs, or changes in employment or housing arrangements could necessitate a change.
Twenty-eight other states already have already adopted 529 laws in alignment with federal statute. In Colorado, however, the state’s outdated law still considers withdrawals for K-12 expenses to be “unqualified.” The result is that parents in our state will be exposed to potentially severe state tax penalties if they access their own savings for more immediate educational needs.
Under the current misalignment, the Colorado Department of Revenue (CDOR) will “recapture” any deductions taken for 529 contributions that are later used for K-12 expenses. The same will likely be true for tax credits taken by employers contributing to their employees’ 529 accounts. CDOR will also have to enforce penalties against any tax-free earnings on funds prior to withdrawal.
This enforcement regime could leave Colorado families facing potentially devastating additional tax bills amounting to hundreds of dollars. The Federal Reserve found in a recent study that nearly half of American households would face significant hardship if confronted with an unexpected expense of $400, so these penalties could result in debt, missed payments on rent or utilities, or other sacrifices.
Worse, the penalties will be nearly unenforceable without the construction of intrusive state data and audit systems, unprecedented of levels of financial monitoring, and small armies of full-time bureaucrats whose sole job is to police families’ use of their own money. Without these tools, which do not yet exist, the state lacks any realistic means of knowing which contributors’ money was included in an “unqualified” withdrawal, and therefore whose deduction or credit to recapture. The end result: Parents themselves will have to bear the full cost of any assessed penalties.
Consider this hypothetical situation: Two parents open a 529 college savings account for their child when she is one year old. They contribute to the account both together and separately following a divorce. Others also contribute–an uncle, an aunt, grandparents, and various friends and relatives. Each takes a state deduction for their contributions. Similarly, one or both of the parents’ employers contribute to the account and receive a state tax credit of up to $500 each year.
After years of contributions to the account from multiple sources, the child is bullied at school and her parents decide to enroll her in a nearby private school. They use their existing 529 savings to cover the unexpected tuition costs as allowed by federal law. In the process, they also inadvertently trigger a cascade of state tax penalties that sees them being forced to repay the state deductions and credits taken by others over the course of many years.
No Colorado family should have to face this scenario. We hope you will join us in encouraging Colorado lawmakers to protect parents and students by passing HB 1123.
Rep. Colin Larson represents Colorado House District 22 in Jefferson County and Sen. Jim Smallwood represents Colorado Senate District 4 in Douglas County.