Since 529 college savings plans were introduced in 1996, a growing number of parents and grandparents have taken advantage of the opportunity to salt away money for college and enjoy tax-free distributions. As of mid-2014, the amount invested in 529 plans totaled $244 billion, according to the College Savings Plans Network, a consortium of state-plan operators. Compare that with the end of 1999, when investments in 529 plans totaled $5.75 billion. The group says a key factor in that growth is an increasing number of families participating in college savings programs.
What is a 529 Savings Plan? A 529 plan lets an individual contribute after-tax dollars that are designated for qualified higher-education expenses. These expenses include tuition and fees, books, room and board, computers, and supplies. The distributions of these funds for qualified higher-education expenses are not subject to federal income tax. However, states may treat these disbursements differently. As a result, 529 plan investors need to understand the tax strategies that are available to them.
Many plans allow you to invest as little as $25 per month, provided they are making regular contributions. Most states offer residents an income-tax deduction for contributions to their 529 plan (if you live in a state with no income tax, there’s no deduction). But in some states that collect income taxes there are no deductions for residents’ 529 plan contributions.
A recent article in U.S. News & World Report, titled “The Tax Advantages of 529 Plans,” explains that the contributions to another state’s 529 plan usually are not tax deductible. A few states offer "tax parity"—account owners receive a deduction for 529 plan contributions to any state’s program. Some states (Colorado, New Mexico, South Carolina, and West Virginia) offer a tax deduction up to the full amount of the annual plan contribution.
Moving to Another State. It’s not uncommon for a person to start a 529 plan in one state and then move to a different state. This situation creates some tax implications, especially if it’s a “direct-sold” plan.
States with No Income Tax. Even residents in states without a state income tax should take advantage of 529 plans’ tax-free distributions, according to the original article. It’s a chance to invest in the market, grow your investment, and enjoy those earnings tax-free when you use them for qualified educational expenses.
Other Details. The tax-free distributions are still applicable if you have to change beneficiaries, like when the original beneficiary gets a scholarship and doesn’t need the money that you saved in the 529 account. Typically, in these situations, there are no taxes due when you change the plan beneficiary to another person in the family.
The original article suggests that grandparents should take special note of the estate planning benefits of 529 plan contributions. Since older generations often have a higher net worth than the generation with children still in school, they can enjoy some great benefits. These contributions let wealthier taxpayers take advantage of the gift-tax exclusion—money that may be annually gifted from one person to another with no federal gift tax. Be sure to ask your estate planning attorney about how this works.
Resource: U.S. News & World Report (December 22, 2014) “The Tax Advantages of 529 Plans”