We have been longtime advocates of using a 529 savings plan as a way to pay for your children or grandchildren’s college tuition and other qualified expenses. That’s because, in addition to being a powerful way to save for college, there are many tax advantages with this type of plan, as long as you use it correctly.
First, let’s start with the number one question most people have: Are 529 contributions tax deductible?
Unfortunately, you can’t claim a federal income tax deduction for your contributions to a 529 plan. However, depending on where you live, you may qualify for a deduction on your state income tax return. A number of states now allow a deduction for contributions to a 529 plan.
Most of the states that provide a deduction for contributions impose a deduction cap, or limitation, on the amount of the deduction. For example, if you contribute $10,000 to your son’s 529 plan this year, your state might allow you to deduct only $4,000 on your state income tax return. Check the details of your 529 plan and the tax laws of your state to learn whether your state imposes a deduction cap.
Also, if you’re planning to claim a state income tax deduction for your contributions, you should learn whether your state applies income recapture rules to 529 plans. Income recapture means that deductions allowed in one year may be required to be reported as taxable income if you make a nonqualified withdrawal from the 529 plan in a later year. Again, check the laws of your state for details.
Benefits of a 529 plan
This brings us to one of the main benefits of a 529. Despite the fact that contributions are not tax deductible (in most cases), they are generally tax deferred both for federal and state purposes. This means you don’t pay income taxes on the plan’s earnings each year, allowing your investments to take advantage of the power of compound interest.
Then, if you take out money and use it to pay for qualified education expenses, the earnings portion of your withdrawal is free from federal, and perhaps, state income tax. This presents a significant opportunity to help you accumulate funds for college.
Qualified education expenses include tuition, fees and books for college and graduate school. Room-and-board expenses are also considered qualified if the beneficiary is attending college or graduate school on at least a half-time basis.
States differ in the 529 plan tax benefits they offer to their residents. For example, some states may offer no tax benefits, while others may exempt earnings on qualified withdrawals from state income tax and, as noted, offer a deduction for contributions. However, keep in mind that states may limit their tax benefits to individuals who participate in an in-state 529 plan.
529 plan withdrawal rules
You should look to your own state’s laws to determine the income tax treatment of withdrawals (and deductions). In general, you won’t be required to pay income taxes to another state simply because you opened a 529 account in your home state. But you’ll probably be taxed in your home state of residency on the earnings distributed by your 529 plan, whatever state sponsored it, unless your state grants a specific exemption. Also, make sure you understand your state’s definition of “qualified education expenses,” since it may differ from the federal definition.
If you make a nonqualified withdrawal (i.e., one not used for qualified education expenses), the earnings portion of the distribution will usually be taxable on your federal income tax return in the year of the distribution, and probably state return as well. The earnings are usually taxed at the ordinary income tax rate of the person who receives the distribution (known as the distributee). In most cases, the account owner will be the distributee. Some plans specify who the distributee is, while others may allow you (as the account owner) to determine the recipient of a nonqualified withdrawal.
You’ll also pay a federal 10% penalty on the taxable amount of the nonqualified withdrawal (usually, that means on the earnings). There are a couple of exceptions, though. The penalty is usually not charged if you terminate the 529 account because the beneficiary has died or become disabled, or if you withdraw funds not needed for college because the beneficiary has received a scholarship. A state penalty may also apply.
And just to clarify, these penalties only apply for nonqualified withdrawals. There isn’t really such a thing as an “early” withdrawal for a qualified expense, no matter if the account has been open 18 months or 18 years. And because of this, federal tax law allows you to use a 529 plan to pay for qualified K-12 expenses, up to $10,000 per year.
However, not all states are compliant with federal rules, so if you live in a noncompliant state and use 529 funds for K-12 expenses, you could be subject to a penalty. So make sure to check with your tax professional first.
At Edelman Financial Engines, our planners work with clients to help them achieve their financial goals. If you have questions about saving for your child or grandchild’s education, contact one of our planners today. They can help you determine if a 529 plan can be utilized as a part of your comprehensive financial plan.
Neither Edelman Financial Engines, a division of Financial Engines Advisors L.L.C., nor its affiliates offer tax or legal advice. Interested parties are strongly encouraged to seek advice from qualified tax and/or legal experts regarding the best options for your particular circumstances.