• Harry N. Stout

Savings Tax Breaks for Middle America - 529 Plans


This is the fourth and final installment in our series on savings breaks for middle class Americans. A 529 Plan is a special incentive created by Congress to help families educate their children. Let’s learn more about this valuable provision.


A 529 College Savings Plan (529 Plan) is an investment account that offers tax-free earnings growth and tax-free withdrawals when the funds are used to pay for qualified education expenses. The 529 Plan can also have financial aid benefits. 529 Plans may also be used to save and invest for up to $10,000 in annual kindergarten through grade twelve tuition payments in addition to college costs. There are two types of 529 Plans: college savings plans and prepaid tuition plans. Almost every state offers at least one 529 Plan. There is also a 529 Plan operated by a group of private colleges and universities.


529 Plan Tax Benefits

Much like a Roth IRA, contributions to a 529 Plan are made with after-tax dollars and are not deductible for federal income taxes. However, the majority of participating states offer state income tax deductions or tax credits for contributions to 529 Plans, though you may be restricted to investing in your home state's 529 Plan in order to claim the benefit. Funds in a 529 Plan grow federal tax-free and will not be taxed when the money is withdrawn for qualified education expenses.


The funds in a 529 Plan are yours, and you can always withdraw them for any purpose. However, the earnings portion of a non-qualified distribution (not for qualifying educational expenses) will be subject to ordinary applicable federal and state income taxes and a 10 percent tax penalty, though there are exceptions. Since your original contributions were made with after-tax money, they will never be taxed or penalized on these contributions.


Types of 529 Plans

529 Plans are usually categorized as either prepaid tuition or college savings plans:

  • College savings plans work much like a Roth 401(k) or Roth IRA by investing your after-tax contributions in mutual funds or similar investments. The 529 college savings plan offers several investment options from which to choose. The 529 Plan account will go up or down in value based on the performance of the selected investment options.

  • Prepaid tuition plans let you prepay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges, sponsored by more than 250 private colleges. Educational institutions can offer a prepaid tuition plan but not a college savings plan.

What Education Related Expenses Are Covered?

At the college or post-secondary level, a general rule of thumb is that expenses required for enrollment in an eligible institution are covered. There are some costs, however, that you may believe are necessary, but the IRS does not consider a qualified expense. For example, a student's health insurance, transportation costs, and student loan payments are not considered qualified expenses.


Qualified expenses do include tuition and fees, books and materials, room and board (for students enrolled at least half time), computers and related equipment, internet access, and special needs equipment for students attending a college, university, or other eligible post-secondary educational institutions. The 2017 Tax Cuts and Jobs Act also expanded the allowable use of 529 Plan assets by permitting tax-free distributions of up to $10,000 per year, per beneficiary, to pay for kindergarten through grade twelve tuition expenses at private, public, and religious schools.


Changing Circumstances

When it comes to putting money into a 529 Plan, many parents are concerned about what will happen in the future when their child is ready to attend college. In particular, some parents worry about losing the money they have saved in a 529 Plan if their child doesn't go to college or gets a scholarship. There are a myriad of situations that can arise in the future such as the death of a child, the receipt of full academic or athletic scholarships, or the receipt of employer educational assistance. These and many other situations require research and understanding of the regulations surrounding 529 plans. A good online source is the website Savingforcollege.com. This website covers the gamut with all issues relating to 529 plans and is a great place to start your research.


Remember, you can withdraw leftover money in a 529 Plan for any reason. However, the earnings portion of a non-qualified withdrawal will be subject to taxes and a penalty, unless you qualify for one of the exceptions in the regulations. If you are contemplating a non-qualified distribution, be aware of the rules and options rules for reducing taxes owed. My advice is to consult your personal tax advisor before taking such a withdrawal.

There are a number of key tax advantaged savings provisions that Congress has established to help primarily middle class families save for life’s key events. It is up to you to know them and decide if they can help you reach your financial goals.


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