A 529 Plan is a way to save
for college that provides special tax advantages not
available through regular savings. These plans are named
after Section 529 of the Internal Revenue Code which governs them.1
There are two types of 529 Plans:
529 Prepaid Tuition
Plans, and
529 College Savings Plans.
529 Plans are administered
by states, state agencies, and educational institutions.
You participate in the plans through a state. To contribute money to the 529 Plan, you may pay a state agency that
runs the plan, or the state may delegate the administration of
the plan to a private investment firm. In that case, you would
make contributions
to the 529 through the brokerage firm.2
Each state determines which
type of plan it will have. However, if you do not
like the plan available in your state of residence, you may be able to
participate in another state's plan. Check with the specific state for details on residency
and participation requirements.
This article deals with the
federal tax rules regarding 529 Plans. State rules tend to mirror
the federal rules, but usually at least one state has
a variation to each rule. Check with the state your plan is with
for clarification of their tax treatment of 529 Plans.
What is the difference between
a 529 Prepaid Tuition Plan and a 529 College Savings Plan?
With Prepaid Tuition Plans, you buy “credits"
at the current price of tuition that cover a certain portion of tuition.
Some plans also allow the purchase of additional “room and board credits".
When a family member goes to college, the “credits"
can be redeemed to pay for the same portion of tuition and fees, no matter how the price may have fluctuated.3
For example, Susan's parents
bought one year's worth of tuition credits to State University in
1999 at the 1999 price of $5,000. Susan will attend
State University beginning in the fall of 2008 and redeem these credits to pay for her 2008 tuition. Since
her parents bought enough credits to cover one year of tuition, Susan
will not owe any additional money for her 2008 tuition even though the price of tuition in 2008 is $8,000. The credits
purchased in 1999 will cover the total 2008 price.
Prepaid plans are advantageous
because the price of tuition is tied to the year when the credits are
purchased. Disadvantages are that
some states have residency requirements to participate, and there is
a small window of time each year to enroll.4
529 College Savings Plans are quite
different from prepaid tuition plans. 529 College Savings Plans are set up on behalf of a beneficiary.
529 College Savings Plan money is invested, and earnings on the 529 College Savings Plan grow tax-deferred. Generally, as long as money from the 529 College Savings Plan is withdrawn to cover “qualified education expenses",
no federal taxes are owed on the amount withdrawn. 529 College Savings Plans usually have no age limit, unlike the prepaid tuition
plans.5
What is considered a qualified education
expense for 529 College Savings Plans?
For 529 College Savings Plans, qualified
education expenses include tuition, fees, room,
board, books, supplies, and equipment. As long as money is taken
from the 529 College Savings Plan to pay for those expenses, no federal income tax will be
owed. 6
Who is eligible to participate
in 529 College Savings Plans?
It depends on the rules of
the state, but generally 529 College Savings Plans allow anyone to set up
an account for a beneficiary regardless of the beneficiary's age.
Unlike 529 College Savings Plans, Prepaid Tuition Plans tend to have stricter rules
with age limits and time requirements.7
Who is a designated beneficiary for a 529 College Savings Plan?
The beneficiary of the 529 College Savings Plan is the future college student.8
What type of colleges will
be considered eligible for 529 purposes?
For 529 College Savings Plans, generally
any college, university, vocational school, or other postsecondary educational
institution that participates in Department of Education student aid programs is an eligible institution.
Distributions from 529 College Savings Plans are tax-free if used to pay for qualified expenses at such institutions.9
Prepaid tuition plans tend
to limit the colleges available since the tuition credits are usually
purchased for certain colleges in that state.10
Are there any limitations on contributions to a 529 College Savings Plan?
While there are no income limitations
that reduce or eliminate the amount you can contribute to a 529 College Savings Plan,11
contributions to a 529 College Savings Plan are considered a gift to the beneficiary,
so the federal gift tax exclusion of $12,000 per person per year applies to 529 College Savings Plans.12
This means that up to $12,000 can be deposited in a child's
529 College Savings Plan without the child owing gift taxes. Parents can
still contribute more to the 529 College Savings Plan, but the amount contributed over $12,000 will
be subject to the federal gift tax.
For example, Susan's mom
deposits $13,000 in her 529 College Savings Plan in 2007. Susan will owe
federal gift tax on $1,000 of her mom's contribution to her 529 College Savings Plan.
States rules for contributions to 529 College Savings Plans
vary, so check with your specific state's plan for details about any limitations on contributing to 529 College Savings Plans.
When can I withdraw my money
tax-free from a 529 College Savings Plan?
For 529 College Savings Plans, distributions
that pay for qualified education expenses are not
taxed. As long as the money from the 529 College Savings Plan is used for tuition, fees, room, board, books, supplies, and equipment, no federal income tax will be owed on the money withdrawn from the 529 College Savings Plan.13
What
happens if I take a distribution from a 529 College Savings Plan that is not for qualified education
expenses?
If the 529 College Savings Plan distribution is not
used for qualified education expenses, you will owe federal
income tax on it and additional 10%
tax penalty on the amount, unless the 529 College Savings Plan distribution:
is paid because
the designated beneficiary of the 529 College Savings Plan dies,
is paid because
the designated beneficiary of the 529 College Savings Plan has become disabled,
is included in income
because the designated beneficiary of the 529 College Savings Plan received a scholarship, veterans
educational assistance, employer-provided educational assistance, or
other tax-free gift received to pay for education,
is made to a designated
beneficiary of the 529 College Savings Plan attending a U.S. military academy, or
is included in income
because the expenses were used to calculate the Lifetime Learning and
Hope Tax Credits.14
How do you maintain a
529?
One of the aspects to consider
when choosing a 529 are the maintenance costs. Some states' fees are minimal while others charge extensive fees for maintaining a 529. Again, check with your
specific state, but in general, prepaid tuition plans incur enrollment fees and administrative fees for maintaining the plan.
529 College Savings Plans can have enrollment, maintenance, and asset management
fees. If a brokerage firm administers a state's 529 College Savings Plan, they
will normally charge fees as well.15
How does a
529 affect my federal income tax?
In the year you make contributions
to a 529, there is no tax deduction. You will owe taxes on the money you contribute. If you buy $3,000 of prepaid tuition credits in 2007, include the $3,000
in your income on your tax return. The same is true for 529 College Savings Plans. If
you contribute $4,000 to your child's 529 College Savings Plan, include the
$4,000 as income on your tax return.
The big tax pay-off comes in
the years when money is taken out of the 529 to pay for college expenses.
If distributions are received for qualified education expenses, you
will not owe federal income tax when the distribution is made.
Because distributions can be tax-free, the earnings of a 529 College Savings Plan are not
taxable. Even though you paid taxes on the 529 College Savings Plan contributions in the
year you made them, you will not owe taxes on money withdrawn from the 529 College Savings Plan later
to pay for college expenses.16
For example, Susan's parents
contributed $5,000 to her 529 College Savings Plan in 1999. They were
not able to deduct the $5,000 from their income in 1999, so they paid
federal income tax on it. In 2008, they take $6,000 out of the 529 College Savings Plan to pay for Susan's tuition, fees, room, board, and books to State
University. Since they used the money from the 529 College Savings Plan to pay for qualified education expenses, neither Susan nor her parents owe any federal income tax on the $6,000 withdrawn from the 529 College Savings Plan.
Do I have to withdraw money
at a certain age from a 529 College Savings Plan?
Generally, money does not
have to be withdrawn by a certain age or date if the plan is a 529 College Savings Plan. Prepaid tuition plans can have age restrictions,
so check with your state for details.17
What happens to
a 529 College Savings Plan if the designated beneficiary dies?
The beneficiary of the designated beneficiary can receive money
from the 529 College Savings Plan without owing the additional 10% tax. However, the
money will be subject to regular income tax. There can also be a rollover
of the 529 College Savings Plan to another eligible relative of the designated beneficiary.18
For example, Susan's parents
set up a 529 College Savings Plan for her and also one for their son James.
Susan passes away before she attends college. Her parents can
rollover the money from Susan's 529 College Savings Plan to James's 529 College Savings Plan. No 10%
tax penalty will be owed.
What is a rollover?
Any amount of money distributed
from one 529 College Savings Plan can be transferred or rolled over into another 529 College Savings Plan tax-free
if the new 529 is for the same designated beneficiary or one of the
following nine relatives of the designated beneficiary:
Child or descendant
of a child.
Brother, sister,
stepbrother, or stepsister.
Father or mother
or ancestor of either.
Stepfather or stepmother.
Son or daughter
of a brother or sister.
Brother or sister
of father or mother.
Son-in-law, daughter-in-law,
father-in-law, mother-in-law, brother-in-law, or sister-in-law.
The spouse of any
individual listed above.
First cousin.19
What are the
advantages of participating in a 529 College Savings Plan? Why not invest that
money in mutual funds?
The main advantage is the tax treatment.
The money invested in the 529 College Savings Plan grows tax-free, and as long as the money
is used for qualified education expenses, no taxes will
be owed on distributions from the 529 College Savings Plan. If the money were invested
in mutual funds without going through a 529 College Savings Plan, earnings on the mutual
fund are subject to income tax.
This article has introduced
you to the basics of 529 plans. Each state has different rules, so this is not meant to be a comprehensive
guide. For more information about a specific state's plan, contact
that state or visit the following links.
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