Q: Tax Playa, how does a 529 college savings plan work?
Lou, Arlington VA
A: A 529 plan is like a Roth IRA for college. Money goes in after-tax, and distributions (including earnings) are tax-free if used for higher education. It is one of many tax benefits available to families for education, and a particularly-good one...
For more information on 529 plans, please check out the excellent website www.savingforcollege.com, or look up IRS Publication 970, "Tax Benefits for Education."
A 529 plan is legally known as a "qualified tuition program" because they started out as mechanisms to pre-pay for a specific college's tuition. They were later expanded to be able to be used at any college in the nation, so the name is a bit of an anachronism. These days, 529 plans are nearly-exclusively run by each of the fifty states and the District of Columbia, and the funds can be used both inside and outside the state.
Money enters the account after-tax: that is, no deduction is allowed for contributions to these accounts. However, earnings grow tax-free, and distributions are tax-free if used for qualified higher eduction expenses. Contributions may be withdrawn at any time tax- and penalty-free. Any earnings used for non-qualified expenses is subject to taxation and a 10% penalty.
Unlike Roth IRAs, there are no income restrictions on making contributions to a 529 plan. There are also no limits on contribution amounts, unless the aggregate amount of money in the account exceeds probable higher education costs (which is next to impossible). Each state's plan may have a separate limit on how large the account can get before new contributions are disallowed.
Contributions to 529 plans are subject to gift tax limits (no individual may give more than $12,000 to another individual without triggering a gift tax). However, there is a special exemption that allows a front-loading of a 529 plan of five year's worth of contributions. Theoretically, a wealthy couple could give $120,000 to a grandchild's 529 plan and then take the next five years off. However, this would technically mean no birthday or Christmas presents for that time period, either!
"Qualified higher education expenses" include: books, tuition, fees, supplies, and equipment at an eligible educational institution (basically, any place you can use financial aid). It also includes room and board for an at least half-time student.
No expenses paid for with 529 plan money can also benefit from any other tax advantage (the lifetime learning credit, the Hope credit, the tuition and fee deduction, Coverdell ESA money, etc.)
If you contribute to the 529 plan run by your state, you can often get a full or partial deduction off your state income taxes. Please consult savingforcollege.com to see the full details.
Amounts in a 529 plan can be rolled over or the designated beneficiary changed if the new beneficiary is also a member of the old beneficiary's family.
Thanks to a new law Congress passed, 529 plan amounts do not count against students applying for federally-subsidized student loans and grants.