Are Contributions to a 529 Plan Tax Deductible?

by Kathryn Hatter

Qualified tuition plans -- also called 529 plans -- help encourage people to save for college expenses. States and educational institutions sponsor 529 plans that fall into two categories: college savings plans and prepaid tuition plans. Unlike prepaid tuition plans, college savings plans have no age limits, residency requirements or set enrollment periods. Contributions to a 529 plan have the added benefit of being tax deductible in many states.

Federal Tax Benefits

The federal government does not provide tax deductions for 529 plan contributions. However, the federal government does not tax withdrawn earnings when a beneficiary (the student) uses them for qualifying education expenses. Qualified education expenses include tuition and living expenses.

Federal Tax Penalties

The federal government taxes money withdrawn from a 529 plan if the beneficiary fails to use the money for qualifying education expenses. In addition, expect a 10 percent federal tax penalty on any earnings from the 529 plan if you use them for non-qualifying education expenses (unless you claim distributions because of death or disability of the beneficiary). You may be able to direct the withdrawal to the beneficiary, which may mean a lower income tax bracket. Read the fine print of your 529 plan to learn if this is an option. Use IRS Form 1099 to report both taxable and nontaxable earnings for the year in which you made a withdrawal.

State Tax Benefits

As of 2012, 34 states and the District of Columbia allow residents a tax write-off for 529 plan contributions. Some states limit contributions and other states do not place limits. Some states do not have state income taxes, making state tax write-offs a non-issue for their residents. The maximum state income tax deduction is equal to the highest income tax bracket of an individual state.

Tax Deduction Parity

If you choose a 529 plan for a state other than your state of residence, your contributions will probably not be tax deductible. Several states are exceptions to this generality, however. Arizona, Kansas, Maine, Missouri and Pennsylvania allow state income tax deductions for contributions to any state’s 529 plan.

Gift and Estate Tax Guidelines

Contributions to a 529 plan are gifts to the beneficiary, falling under gift and estate tax guidelines. Contributions under $12,000 annually, as of 2012, qualify for a gift tax exclusion, which means contributors incur no gift tax. Report contributions between $12,000 and $60,000 over five calendar years for gift taxes to spread out a large contribution.

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