Many parents and grandparents are choosing 529 plans to ease the high price of college. Here’s a breakdown of the federal and state tax benefits and how to avoid issues with the IRS.

Tax strategies

Federal and State Tax Benefits of 529 College Savings Plans

  • 12/28/2015

Everyone knows that college is expensive. But not everyone knows how 529 plans can help you save for your child or grandchild’s education, while also delivering some attractive tax benefits. A 529 plan is an investment, and like every investment, there are risks as well as rewards. But on balance, many believe that 529s are one of the best ways to plan and save for college.

A 529 plan — named for the section of the Internal Revenue Code that governs it — can accumulate funds on a tax-deferred or perhaps even a tax-free basis, giving it clear advantages over taxable saving vehicles. There are typically state income tax benefits, too, and important estate and gift tax considerations. Whatever option you choose, you should look for the best combination of tax advantages, financial aid benefits, and flexibility.

College savings and prepaid tuition plans

There are two types of 529 plans: college savings and prepaid tuition plans. As a general rule, both offer the same tax results but have very different ways of going about it.

College savings plans are individual investment accounts.

  • Some plans let you enroll directly, while others require you to go through a financial advisor.
  • The details of college savings plans vary by state, but the basics are the same.

Prepaid tuition plans allow you to pay future tuition expenses at today’s prices.

  • They are operated either by your state or an individual educational institution.
  • State-run plans let you prepay tuition costs at one or more state colleges and universities.
  • College-run plans typically are limited to tuition at a specific school.

Instead of having an investment portfolio, prepaid tuition plans allow you to purchase tuition credits or units. Since the credits are purchased today for use in the future, you gain protection against inflation in tuition costs.

All 529 Plans
  • Contributions grow tax deferred and are tax free if the money is used to pay qualified education expenses.
  • Many states offer income tax incentives for state residents (like deductions for contributions).
  • Most 529 plans have high lifetime maximum contribution limits.
  • Anyone can open a 529 plan account regardless of income.
  • Both types of plans offer professional money management.
  • The account owner can change the beneficiary and roll over the money from one 529 plan to another.
  • There are estate-planning advantages to consider.
  • There are many plans to choose from.
College Savings Plans
  • You relinquish some control of your money.
  • Generally, returns aren't guaranteed so you roll the dice with the investment portfolios you've chosen, and your account may gain or lose money.
Prepaid Tuition Plans
  • The beneficiary is generally limited to attending in-state colleges, which limits choices.
  • If the beneficiary attends a different college, prepaid plans differ on how much money you'll get back.
  • Some prepaid plans have reduced benefits after enrollment since their investment returns have not kept pace with the plan's offered benefits.
Starting an account
College Savings Plans   Most college saving plans are open to residents of every state, which means you can shop around. A college savings plan can remain open indefinitely and can be opened at any time during the year.
Prepaid Tuition Plans   Most prepaid tuition plans are limited to residents. Once an account is opened, all tuition credits must be used by the time the beneficiary turns 30, and all withdrawals must be made within 10 years from when the beneficiary starts college. Also, before the beneficiary starts college the account owner is required to inform the plan administrator when the credits will be redeemed. Some prepaid tuition plans have specific enrollment periods.
Covered expenses
College Savings Plans   More flexibility in paying your beneficiary's education expenses since they can be used for:
  1. Tuition
  2. Books
  3. Equipment
  4. Fees
  5. Room and board
This assumes that the beneficiary is enrolled at least half time at any college accredited by the U.S. Department of Education. Withdrawals can be used at:
  • Undergraduate colleges
  • Graduate and professional schools
  • Two-year colleges
  • Technical and trade schools
  • Some foreign colleges and universities
Prepaid Tuition Plans   Typically designed to pay undergraduate tuition at in-state public colleges; expenses like room and board, books, and graduate school, may not be covered. Be sure you understand what education expenses are covered and the tuition equivalent you'll receive if your beneficiary attends a private or out-of-state college.

Federal income tax treatment

Neither type of 529 plan allows a federal income tax deduction. However, there is the opportunity to reduce the account owner’s taxable income by the amount of interest, dividends, and capital gains earned in the account.

Withdrawals that are used to pay the beneficiary’s qualified expenses are completely income tax free. Legislation passed late in 2015 allows tax-free disbursements for computers, software, and related technology — a provision that had previously been considered temporary. Any funds that are not used for qualified education expenses are considered “nonqualified.” The earnings portion of nonqualified withdrawals are subject to income taxes and a 10 percent penalty.

Tuition paid from a 529 plan that is later refunded can be recontributed to the 529 plan within 60 days, preventing any adverse tax treatment as a result of the refund.

You can avoid the 10 percent penalty if:

  • The beneficiary receives a scholarship and doesn’t need the funds
  • The beneficiary dies or becomes disabled
  • The student or the parent has claimed an American Opportunity or Lifetime Learning Credit for the qualifying expenses
  • The beneficiary attends the U.S. Military, Naval, Air Force, Coast Guard, or Merchant Marine Academies

Nonqualified withdrawals are taxable income

To determine the nontaxable portion of a nonqualified withdrawal, multiply the distribution by the ratio of total contributions over the account balance on the last day of the calendar year.

The person who receives the distribution will receive a Form 1099-Q with the earnings reported in Box 2. That person must report taxable earnings on Line 21 of his or her 1040 and use Form 5329 to calculate the penalty.

Other federal income tax considerations

Usually, a nonqualified withdrawal isn't possible with a prepaid tuition plan. To get money out, you have to cancel your contract. Upon cancellation, you may only get back your contributions, with no earnings. Some plans will refund a nominal amount of interest, which would be taxed and subject to the penalty.

If there is net loss once either type of account has been liquidated, the owner can claim the loss as a miscellaneous itemized deduction, subject to the 2 percent of adjusted gross income reduction.

Education credits

You can claim the American Opportunity or Lifetime Learning Credit in the same year you withdraw funds from a 529 plan, but you may not double-dip. If you or your beneficiary claims either credit, the qualified expenses must be reduced when determining the tax consequences of the distribution.

As a point of reference, the maximum amount of the American Opportunity Tax Credit is $2,500 and will consume $4,000 of qualified expenses, which results in a $4,000 reduction to your 529 expenses that are eligible for tax-free treatment. If you claim the Lifetime Learning Credit, the adjustment can be as high as $10,000.

To be safe, you should limit your 529 plan withdrawals to your beneficiary’s total qualified expenses, less the amount of expense that will be used when claiming the credit.

Here’s an example: Assume that the child’s total qualified expenses are $20,000 in 2015. Let’s further assume that the child’s parents withdraw $20,000 from a 529 plan as reimbursement for the expenses that they paid with a personal check. On their 2015 return, the parents claim a $2,500 American Opportunity Tax Credit, which utilizes $4,000 of qualified expenses. Therefore, only $16,000 of expense remains to be applied to the 529 plan withdrawal and the leftover $4,000 is considered a nonqualified withdrawal. The pro rata earnings would be taxed on the parents’ return, but there wouldn’t be a 10 percent penalty.

Avoid issues with 529 plan withdrawal timing

The account owner gets to decide when to withdraw funds from a 529 plan. Some plans have a waiting period before you can take a distribution. For instance, you can’t make a contribution on day one and then take a distribution on day two.

A logical assumption is that a 529 distribution must be requested when the college bill is received and then used to pay the balance due. In reality, a distribution can be taken at any time during the year, and it is tax-free as long as an amount equal to or greater than the qualifying expenses are paid during the year. In other words, the distribution doesn’t have to be traceable to the actual payment of expenses.

A problem occurs when you withdraw money from a 529 plan this year, and wait until next year before making the tuition payment; or, if you paid the expenses last year with a personal check and you reimburse yourself this year by taking a 529 plan withdrawal. By spanning two tax years, you are risking a mismatch that can result in tax and penalties.

The risk of a mismatch is especially high when the second semester tuition bills arrive in December but aren’t payable until January.

The tax code is actually silent as to whether distributions must be made in the same year as the expenses are paid. However, the IRS intends to issue proposed regulations, which will provide that earnings can be tax-free only if a distribution from a 529 plan during a calendar year is used to pay expenses during the same 12-month period or by March 31 of the following year. Until further clarification is provided, the best strategy is to match the withdrawals with the qualified expenses.

Selecting who will receive 529 distributions

Choosing the person to receive distributions when requesting a withdrawal (either the account owner or the beneficiary) can make a difference in the account owner’s and beneficiary’s combined tax liabilities. There are three options: Have a check made payable to the beneficiary, the school, or to yourself as the account owner.

The first two options will result in the 1099-Q being sent to the beneficiary. The earnings portion of nonqualified withdrawals would be reported on the beneficiary’s tax return, where presumably there would be lower (or zero) tax rates. If the account owner receives the distribution, the earnings are reported on the owner’s income tax return.

Parents sometimes decide that receiving the distribution makes it easier to pay the college bills. However, the IRS has been sending notices to account owners who receive a 1099-Q and do not report earnings on their tax returns. This does not seem to happen to the beneficiaries who receive a 1099-Q and report nothing on their tax returns.

Unless you want to respond to an IRS notice requiring the submission of additional documentation, it is recommended that you not receive distributions yourself. You can have funds sent to the beneficiary and work out the logistics of paying the college funds later.

Directing the distribution to the school has two advantages. First, the 1099-Q is sent by the plan to the beneficiary. Second, the timing mismatch is nearly impossible, since the distribution and expense payment occur on the same day.

The important thing to understand about direct distribution from the 529 to the school is that it could affect your child’s financial aid package. Policies can vary, with the worst-case scenario being that the school treats the payment like a scholarship, with a dollar-for-dollar reduction in aid.

State income tax treatment

Depending on where you live, you may be entitled to a state income tax deduction. Keep in mind that most states only allow a deduction for contributions to their own 529 plans. Some states will allow you to exempt the withdrawals and the earnings from your state income.

Most of the states that allow deductions have a cap, or some type of limitation, on the amount that you can deduct in a given year. For example, if you contribute $10,000 to your child’s 529 plan this year, your state might only allow a $4,000 deduction. However, some states allow you to carry over the excess contributions to subsequent years.

If your state allows you to deduct your contributions, you may be required to recapture nonqualified withdrawals.

How we can help

Investing in a child’s education has many benefits beyond tax considerations, but when all is said and done, a 529 plan can help lower the total price tag for a degree by reducing your tax burden. Your best approach is to consider the advantages of a 529 in light of a well-designed, goals-based financial plan. Take advantage of the incentives if they help you achieve your goals, but always consult your tax advisor to make sure the choices you make are in the best interest of you and your future student.