All About 529 Tax Deductions

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Stanley Tate

#1 Student Loan Lawyer

Updated on October 4, 2022

A 529 plan is an excellent option to start saving for your child’s college education early.

529 plan contributions aren’t typically tax-deductible, but they are exempt from federal and state taxes when used for qualified higher education expenses (tuition, room and board, textbooks, or other expenses related to secondary education enrollment).

Even though every state has a plan, they are not all the same. The best 529 plans have the lowest costs and a wider range of investment choices.

Keep reading to learn more about student loans and the benefits of having a 529 plan.

What is a 529 plan?

529 plan, which gets its name from Section 529 of the Internal Revenue Code, is a state-run tuition account often used for tax purposes. With a 529 plan, your family can set aside money for a specific beneficiary’s higher education, and that money won’t be taxed.

You can invest in a 529 plans in all 50 states and the District of Columbia.

529 plans are divided into two categories, both of which offer significant tax benefits.

Prepaid tuition plans

With a prepaid tuition plan, your family selects a qualifying institution of higher education. While the criteria differ by state, public universities are usually eligible.

The payments from your family go toward the beneficiary’s school’s tuition and fees.

Prepaid plans rarely allow families to pay for room and board in advance.

Because prepaid tuition plans are guaranteed to keep pace with college tuition, families can rest easy knowing that their money will be there when they need it.

Education savings plans

Families can use an education savings plan (also known as a college savings plan) to save for their children’s education.

Prepaid tuition plans can only be used to pay for tuition, whereas you can use funds in your education savings plan for tuition and living expenses.

Benefits of a 529 plan

1. Tax benefits

Investments in 529 plans grow tax-deferred, which means you don’t have to pay federal state taxes on the money you invest in them.

Distributions are also tax-free if used to pay for qualified education expenditures, including college tuition and fees, books and supplies, and some room and board costs.

You can even use tax-free distributions for up to $10,000 in K-12 tuition each year and up to $10,000 in student loan repayment per beneficiary and sibling.

In most states, eligible 529 plan distributions are not included in your taxable income, and many states offer a state income tax deduction or credit for donations to 529 plans. The only college savings plan with state tax benefits is the 529 plan.

You don’t have to use your home state’s college savings plan for tax benefits, even if your state has residence requirements.

The exception may be if your family has pre-paid their tuition.

Most states do not allow you to claim their tax benefits if you choose another state’s college savings plan. These seven tax parity states, however, let you claim benefits for a 529 plan based in any state:

  • Arizona

  • Arkansas

  • Kansas

  • Minnesota

  • Missouri

  • Montana

  • Pennsylvania

If you’re unsure of your own state’s rules or need further tax advice on the benefits of a 529 plan, please consult your tax advisor.

2. Low maintenance

Investing in a 529 plan requires very little work on the part of the account owner.

There are two ways to open a 529 plan account: online or through a financial counselor.

Families who prefer to “set it and forget it” might choose an automated investing plan tied to a bank account or payroll deduction plan. In these circumstances, a program manager is responsible for the day-to-day management of the 529 plan’s investments.

Plus, beneficiaries don’t have direct access to the account. As the donor/account owner, you can rest assured that the money goes only to what you intend — education.

Although there’s very little maintenance on your part, you can start off by choosing a portfolio that will grow with your child or grandchild’s age. Many 529 plans begin with riskier investment portfolios during the beneficiary’s early childhood and transition to steadier investments as the child ages.

3. High contribution limits

Like Roth IRAs and Coverdell Education Savings Accounts (ESA), 529 plans do not have yearly contribution limits or large aggregate limits. Depending on where your 529 plan is based, state-specific maximum aggregate limitations range from $235,000 to $529,000.

In terms of taxation, donations to a 529 plan are considered made to the chosen beneficiary, which means these contributions are only taxed if they exceed the federal gift tax exclusion. The annual gift tax exclusion will be $15,000 (for individuals) and $30,000 (for married filing jointly) in 2021.

There is also an option to contribute up to $75,000 in one tax year without paying taxes on the gift if the donation is treated as if it were spread over 5 years.

4. Only a minor impact on financial aid

A 529 plan owned by a dependent student’s parent or a dependent student is recorded as a parental asset and has a minor impact on financial aid eligibility.

On the FAFSA, distributions from parent and student-owned accounts for education expenses are not recorded as income.

5. Flexibility

Regardless of household income or contribution amount, all 529 plans provide the same benefits to all families. No matter where you reside or where your child will attend college, you can invest in practically any 529 plan.

You can change your 529 plan investment options 2 times within any given calendar year. With the same beneficiary, you can rollover funds from one 529 plan to another.

If you change the beneficiary, your 529 plan isn’t subject to those limits.

Are 529 plan contributions tax-deductible?

There are no federal tax deductions for 529 plans.

The tax advantages and rules of 529s differ from those of 401(k)s, although they are similar.

One significant distinction is that, unlike a 401(k), donations to this account are not eligible for federal tax deductions. While some 401(k) and Individual Retirement Accounts (IRAs) allow you to save pre-tax cash for retirement, there is no federal tax benefit for 529 accounts.

State 529 Tax Deductions

529 tax deductions are available in many states.

Although you cannot claim 529 tax benefits on your federal income tax return, you may be allowed to do so on your state tax return.

A 529 tax deduction or credit is available in more than 30 states, as well as the District of Columbia, allowing you to write off 529 payments and reduce your state income tax burden. That will enable you to save more money for your child’s education.

What states allow tax deductions for 529 contributions? These states offer tax deductions or tax credits for your 529 plan contributions (more details below):

  • Alabama

  • Arizona

  • Arkansas

  • Colorado

  • Connecticut

  • Washington, DC

  • Georgia

  • Idaho

  • Illinois

  • Indiana

  • Iowa

  • Kansas

  • Louisiana

  • Maryland

  • Massachusetts

  • Michigan

  • Minnesota

  • Mississippi

  • Missouri

  • Montana

  • Nebraska

  • New Mexico

  • New York

  • North Dakota

  • Ohio

  • Oklahoma

  • Oregon

  • Pennsylvania

  • Rhode Island

  • South Carolina

  • Utah

  • Vermont

  • Virginia

  • West Virginia

  • Wisconsin

How much of a 529 plan is tax-deductible? Tax deductions differ from state to state, and some are a lot more generous than the rest.

For instance, if you contribute $5,000 to a 529 plan in Indiana, you’ll get a 20% tax credit, which translates to a $1,000 credit. Each taxpayer can claim a maximum $250 credit for each beneficiary who contributes up to $2,500 in Vermont, with a 10% tax credit.

Are earnings from a 529 plan subject to taxes?

Although contributions aren’t tax-deductible, the earnings in a 529 account aren’t subject to tax treatment by the state or federal government when they’re used to pay for education.

The growth of your account isn’t taxed, either. If you invest $1,000 and earn 5% during a year, you’re not taxed on the $50 you earned.

529 account investments can also be sold and used to pay for eligible education-related expenses without incurring federal income tax if you use the money to pay for those fees.

How do I claim 529 contributions on my taxes?You don’t have to claim 529 contributions on your federal taxes because they’re exempt. If you received a form 1099-Q from a 529 plan distribution, you only have to report those earnings on your federal taxes if they were not spent on qualified education expenses (in other words, if they were non-qualified withdrawals).

You may be taxed on the earnings by your state if you use the funds for non-qualified expenses. There may also be other tax consequences, such as an additional 10% federal tax.

If you have 529 funds, you can use them on everything from tuition to internet access for a student. After the Secure Act was signed into law in 2019, the rules for using money in a 529 plan were further reduced.

Up to $10,000 can be used by the beneficiaries of 529 savings plans to pay down student loans. 529 plans can also be used to pay for homeschooling, apprenticeships, private elementary, and/or secondary education.

It doesn’t matter what the 529 money is used for; it’s a huge tax benefit to save for education in a 529 savings account.

Who is eligible for tax benefits from a 529 plan?

Anybody can open a 529 account. For the most part, parents or grandparents open these accounts on behalf of a beneficiary child or grandchild. State tax deductions may be available in some jurisdictions for the account holder.

The money in the account grows tax-deferred until it is withdrawn. As long as the money is used to pay for acceptable educational expenses as defined by the IRS, the withdrawals aren’t subject to state or federal taxes.

Students in grades K-12 are limited to $10,000 in tax-free withdrawals each year.

Should you have a 529 plan?

529 plans are an obvious choice for college savings for many families. Most plans have age-based investing options that automatically rebalance, taking more risk when your child is younger and less risk as they get older. You can open a 529 plan immediately on the website of your state’s plan.

Whatever option you choose for saving for a college education, getting started today is one of the most critical decisions you can make. You’ll allow your money time to compound if you start early, and that’s where a large portion of the value in your account will come from over time.

Wondering how to save for college?

A 529 plan is an excellent way to save for the future, but only if you’ve done your homework. As a student loan attorney, I’m well-versed in the ins and outs of saving for college and would love to help you select the best plan. Just schedule a free 10-minute consultation.

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