Tax Benefits of a 529 Plan
Key facts
- 529 contributions are subject to federal taxes but earnings grow federal tax-free.
- Plans vary from state to state, and some states offer state tax benefits as well.
- Distributions used for non-qualified expenses incur tax liability and may be subject to a 10% tax penalty.
There are many strategies for setting money aside to pay college expenses, and families often choose standard savings or investment accounts. In an effort to encourage increased college savings, the government offers a lesser-known option that comes with significant tax benefits. This option is a 529 plan. Opening a state-sponsored 529 plan can let your college savings grow in a tax-advantaged manner, increasing the total amount of funds you can withdraw from in the future.
Understanding the 529 College Savings Plan
States are tasked with creating their own 529 college savings programs, so the details can vary from one to the next. Fortunately, there is typically no residency requirement to participate in a state’s plan, so you can choose the option that best fits your needs.
Funds from a 529 college savings plan can be used for the beneficiary’s qualified education expenses, such as room and board, tuition, required fees and certain computer expenses at any institution of higher learning that meets basic eligibility requirements. Criteria include accreditation, degree options, and ability to participate in federal student aid programs. If these requirements are met, no federal taxes are assessed when funds are distributed to pay for qualified expenses. However, if funds are withdrawn from the account but not used as directed, there is tax liability and the possibility of a 10% tax penalty.
Maximizing the 529 Tax Benefits
While you will pay federal taxes on contributions to a 529 plan, your account’s earnings are exempt from federal taxes. Many states offer tax benefits as well, and in some cases, permit you to deduct the entire amount of your contributions from your total taxable income.
While it is often necessary to be a resident of the state in which the plan is sponsored in order to enjoy state tax benefits, some states take their support of 529 savings a step further. Known as “tax parity,” these states offer tax benefits for residents who contribute to any state’s 529 plan.
Contributions to a 529 plan fall under the heading of “completed gift” for tax purposes, and gift taxes can apply to contributions over a certain amount. The exemption is reviewed annually and adjusted as appropriate. It has stayed the same in recent years at $14,000 per person per beneficiary. For example, each parent can contribute $14,000 to each child’s 529 account, a total of $28,000 per account, while still avoiding gift taxes.
Those who wish to make a larger up-front contribution can take advantage of the 529 superfunding rules, which permit you to make up to five years of gifts to your beneficiary in advance without incurring gift taxes. For an individual, five years of contributions at the gift tax exemption limit is a total of up to $70,000. However, you will not be able to make additional contributions free of gift taxes for the entire period you elected to superfund.
Disclosure
Nothing in this article should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. This article is not intended as investment advice, and Wealthfront does not represent in any manner that the circumstances described herein will result in any particular outcome. Financial advisory services are only provided to investors who become Wealthfront clients.
This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.
For information on any 529 college savings plan contact the plan provider for details on the investment objectives, risks, charges, expenses, and other important information included in the Plan Description and Participation Agreement; read and consider it carefully before investing.
Please Note: Before investing in any 529 plan, you should consider whether you or the beneficiary’s home state offers a 529 plan that provides its taxpayers with favorable state tax and other benefits that are only available through investment in the home state’s 529 plan. You also should consult your financial, tax, or other advisor to learn more about how state-based benefits (or any limitations) would apply to your specific circumstances. You also may wish to contact directly your home state’s 529 plan(s), or any other 529 plan, to learn more about those plans’ features, benefits and limitations. Keep in mind that state-based benefits should be one of many appropriately weighted factors to be considered when making an investment decision.
Earnings on nonqualified withdrawals are subject to federal income tax and may be subject to a 10 percent federal tax penalty, as well as state and local income taxes. The availability of tax and other benefits may be contingent on meeting other requirements.