About Tax Deductions for Contributions to 529 Plans
Financial 529 plans are designed to help people save for college by giving them specific tax incentives. As of 2009, there are two types of 529 plans and each state offers at least one 529 plan. Prepaid tuition plans set the tuition rate for a future year by paying for it today, while college savings plans allow you to invest money that grows tax free and may grow faster than college expenses increase, but may also lose money.
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Federal Tax Benefits
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Contributions to 529 plans are not tax deductible on your federal income taxes, which means they do not decrease your taxable income. However, there are other federal tax benefits. While the money is in a 529 plan, it grows tax free, like an IRA or 401(k) would. When the money is withdrawn, as long as it is used for qualifying educational expenses, the contributions and all earnings are paid out tax free.
State Tax Benefits
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Thirty-three out of 43 states that have an income tax allow tax deductions for contributions to 529 plans to encourage residents to save for college. These deductions can come in the form of an above-the-line deduction or a credit. Above-the-line deductions reduce the amount of taxable income you have for the year and four states--Colorado, New Mexico, South Carolina and West Virginia--allow the entire amount to be deducted. For example, if you had an adjusted gross income of $40,000 and contributed $5,000 to a 529 plan, your taxable income would decrease to $35,000. A tax credit reduces the amount of tax owed. For example, Vermont offers a 10 percent tax credit for the first $2,500 for each beneficiary. If you contributed $2,500 to a 529 plan, your tax bill would decrease by $250.
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Qualifying Educational Expenses
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For the tax benefits to apply to withdrawals from 529 plans, the funds must be used for qualifying educational expenses. Qualifying educational experiences depend on what type of plan you purchase. If you purchase a prepaid plan, it usually only covers tuition and required fees, though some allow room and board to be purchased for an additional cost. College savings plans allow payouts to be used for tuition, required fees, books, and equipment that is required such as a laptop. If the beneficiary is enrolled at least half-time, room and board may also be covered as a qualified educational expense.
Who Can Participate?
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Unlike certain retirement plans like the Roth IRA, there are no income restrictions on who can participate in a 529 plan no matter what your income is. There are also no limits on who can use funds from a 529 plan, so if you attend school in the future you can become a beneficiary of your own 529 plan. The beneficiary of a 529 plan can also be changed without penalty. For example, if you had a 529 plan for your son, but he decided not to go to college, you can change the beneficiary to your daughter. As of 2009, the maximum amount you could prepay for college was $335,000.
Other Advantages
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In addition to the savings growing tax free, 529 plans are counted as assets in the holder's, rather than the beneficiary's name, which can translate into large savings when the estimated family contribution is taken into account. Assets that are credited to the student are counted 100 percent into the estimated family contribution. Assets that are credited to the parents are only credited 20 percent. For example, if you put $10,000 into your child's savings account for her to use for college, since the money was in your child's name, the estimated family contribution would be $10,000 more because of the account. However, if you put it into a 529 plan, the account would only increase the estimated family contribution by $2,000 because it is in your name.
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