Parents dream of seeing their children graduate from college and go on to lead happy and successful lives. One of the things that can feel like an obstacle to the fulfillment of that dream is the high cost of college. As of 2023, the average cost of four years of college is $104,108 at a public school and $223,360 at a private school. Those numbers can seem daunting to parents who haven’t already started saving.
At CMP, we often work with parents to help them save for their kid’s college tuition and other expenses. One way we do that is by helping them understand the tax benefits of 529 accounts and maximize their 529 college savings plan tax deduction. In this post, we’ll explain how 529 college savings plan tax deductions work and what you can do to maximize your deduction.
What is a 529 Plan?
A 529 college savings plan is a tax-advantaged savings plan designed to encourage saving for future college costs. These plans are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.
The money you allocate to a 529 plan is contributed on a post-tax basis. While the money is in the 529 plan, it is typically invested in mutual funds, EFTs, and other assets, and investments grow tax-deferred. Withdrawals are not subject to income taxes if the money is used for qualified higher education expenses, including tuition, room & board, necessary supplies, and fees.
Types of 529 Plans
There are two types of 529 plans: prepaid tuition plans and college savings plans. Each state and the District of Columbia sponsors at least one type of 529 plan. See this link for a list of plans in your state. Here are some of the differences between the two types.
Education Savings Plans
Education savings plans are what most people imagine when they think of a 529 savings plan. These plans allow the saver to open an investment account, the proceeds of which may be used to pay for any qualified higher education expenses, including tuition, room & board, and mandatory fees. The funds can be used at any college or university in most cases and may also be used to pay up to $10,000 per year of tuition at any private, public, or religious elementary or secondary school.
Education savings plans are all sponsored by state governments, but unlike prepaid tuition plans, only a few have residency requirements. State governments don’t guarantee your investments in 529 plans and investments in ETFs, and mutual funds are not federally guaranteed, either.
Prepaid Tuition Plans
Prepaid tuition plans are typically sponsored by state governments, and there are limits on how you can use the funds you contribute. For example, most states have residency requirements since the money is often earmarked for use at a state school. As a result, the money may not be used to pay for room and board and other fees, and you may be limited in using what you’ve saved to pay for tuition at a non-participating college or university.
We should also note that the funds for a prepaid tuition plan may not be used to prepay for tuition at elementary or secondary schools. Prepaid tuition plans are not guaranteed by the federal government, although they may be guaranteed by the state government. We recommend reading the fine print because if you have a prepaid tuition plan that’s not guaranteed, you could lose your money if there’s a financial shortfall.
529 Plan Eligibility and Contributions
One of the things that’s appealing about 529 plans is that anybody can open one. Students who are over 18 may open one for themselves. Other people who may open 529 plans include the following:
- Parents
- Grandparents
- Aunts and uncles
- Other relatives
- Corporations (may open accounts on behalf of their employees)
- U.S. Savings Bond or UGMA/UTMA owners
Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors (UTMA) and U.S. Savings Bond owners may roll bonds and other assets into a 529 plan if they choose.
Multiple people may contribute to the same 529 plan. For example, a mother and father could each contribute to a plan on behalf of their child up to the state-imposed limit, which we’ll talk about in the next section.
529 Plan Contribution Limits and Restrictions
One of the biggest differences between a 529 plan and other types of savings and investment plans is that the Internal Revenue Service does not impose a limit on contributions. There are some things you should know that may impact your federal income taxes.
For 2023, the gift tax exemption is $17,000 per year. That means that if a mother and father wanted to make separate contributions to a 529 plan, they could each contribute $17,000 for a total of $34,000 in annual contributions while still claiming exemption from the gift tax. Each grandparent could do the same. Keep in mind that you have the option of contributing up to the gift limit for five years at once, but you would need to spread out the gift tax exemption over five years.
Aggregate Limits
Each state imposes an aggregate limit on 529 contributions per beneficiary. These limits are typically quite high. For example, in Utah, the aggregate limit is $525,000. Keep in mind that funds may be used for any qualified higher education expenses, including graduate school. We’ll get into more detail about state contribution limits below.
529 Plan Impact on Financial Aid
One question we’re often asked is about the impact of 529 plan holdings and withdrawals on financial aid. The formulas used to determine financial aid consider 20% of any assets held in a student’s name available to pay educational expenses. Since 529 plans are considered your asset and not your child’s, only 5.64% of the money in the fund is considered available for college expenses. Account assets won’t factor in at all if a grandparent or another family member owns the 529 plan.
We should note that withdrawals in support of a child may impact financial aid starting two years after the withdrawal. For example, if a grandparent makes a withdrawal in a grandchild’s freshman year in college, the student’s financial aid might be reduced in their junior year.
529 Plan Tax Benefits and Advantages
Some states offer an income tax deduction and other advantages for contributions to and distributions from 529 plans.
We have already mentioned that growth and distributions are tax-free, provided that they are used for qualified education expenses. That applies on both the federal and state levels.
Many states allow contributors to deduct their contributions. We’ll get into the details in the next section. You should check with your state or consult with a tax professional to make sure you take advantage of all available deductions.
529 Tax Deductions by State
As we mentioned above, 529 deductions vary from state to state. You’ll need to review your state’s laws regarding 529 college savings plan tax deduction limits before you file your taxes to make sure you claim the maximum allowable deduction.
Here are the details about a few states:
- Utah: There is a 5% tax credit on contributions up to $2,040 single/$4,080 joint beneficiary, with a maximum credit of $102 single/$204 joint beneficiary.
- Colorado: The full amount of contributions is tax-deductible.
- Nevada: There is no state income tax and no deduction.
You can find a full list of state tax deductions for 529 plans by clicking here.
529 Withdrawal Rules
As we have already noted, withdrawals from 529 plans are tax-free, provided that the proceeds are used for qualified higher education expenses. These include tuition, room and board, and other fees. Tuition savings fund proceeds may be used only for tuition.
How to Calculate Your 529 Distribution
If you want to maximize your tax advantages, you’ll need to make sure that you withdraw only what you need to pay qualified education expenses. If you don’t use the funds for qualified expenses, you’ll need to report them as income and pay a 10% penalty.
The formula to determine your qualified expenses is simple. Total college expenses, including tuition, fees, books, computers, and room and board, or K-12 tuition and fees up to $10,000 a year. Then, subtract any tax-free educational assistance the beneficiary has received, including tax-free scholarships, veteran’s educational assistance, or educational assistance from a qualifying employer program. Next, subtract any expenses used to justify the American Opportunity Tax Credit.
For example, a beneficiary who had $12,000 in qualified expenses, a $2,500 tax-free scholarship, and who claimed the maximum $2,500 AOTC could withdraw $5,500 from a 529 plan. $12,000 – $4,000 (used to qualify for the AOTC) – $2,500 (scholarship.)
We suggest consulting with a tax professional to be sure that you withdraw funds in such a way that you’re not penalized.
Considering a 529 Plan? Consult with Our Tax Pro!
Opening a 529 savings plan on behalf of your child, grandchild, or another relative can help you accumulate savings to pay for the child’s education. By keeping the gift exemption and other limits in mind, you’ll be able to maximize your 529 college savings plan tax deduction if your state allows one and minimize the risk of being taxed on withdrawals for non-qualified expenses.
Do you need assistance determining the best strategy for your 529 account contributions and distributions? CMP is here to help! Contact us to schedule a free consultation today.
