529 plans are a type of custodial savings plan. 529 plans are designed to help American families save towards their child’s K-12 or college education. Withdrawals used for education costs are tax-free. The favorable tax implications of 529 plans make these a popular option among families nationwide. However, the tax benefits are conditional. You will have to pay taxes as well as a penalty if you don’t comply with the program’s conditions. 

So how does a 529 plan help with taxes? Understanding how these plans work will help you maximize the benefits of the program.  

How 529 Savings Plans Work

529 plans are tax-advantaged options to save for a child’s education. The federal government in the Internal Revenue Code, Section 529 lays the basic rules and conditions. But, the plans are run by individual states and the specific tax implications of 529 can vary from one state to another. 

Parents or grandparents open the accounts on behalf of a minor. The custodian or person opening the 529 account manages the account as long as the beneficiary is a minor. The beneficiary or minor named on the account can assume control of the account when they turn 18 years of age.  

There’s no limit to how much a custodian can contribute to the account in a year. However, some states put a cap on the total contribution amounts to one 529 account. The custodian can choose from a range of investment options to help the funds grow. The account earnings grow on a tax-deferred basis. That means they may or may not be subject to income tax depending on what the funds are used for. It may also depend on the state in which the account is held. 

Qualified withdrawals, which include money to pay for tuition, fees, books, and room and board, are exempt from federal income tax. At the state level, the tax breaks may differ. No matter which state the account is held in, withdrawals of account earnings for non-education purposes incur income tax as well as an additional 10% penalty. 

Originally the funds in a 529 account could only be used to cover the cost of college tuition. Recent changes allow the funds to be used toward some K-12 education costs as well as apprentice program fees. Another recent change allows up to $10,000 in 529 funds to be used to pay off student loans. 

Federal & State Tax implications of 529 

529 plans allow families to save for their child’s education while also saving on taxes. As far as tax implications of 529 go, this is hands-down a win-win.  But there’s a difference between federal and state tax benefits. 

Federal tax implications of 529

Earnings on your 529 account are exempt from federal income tax. That means the money in the account grows tax-free over the years. 

Withdrawals from a 529 account may or may not be subject to federal taxes depending on what the money is used for. Withdrawals that are used to cover qualified educational expenses are exempt from federal income tax. Qualified education expenses include tuition, room, board, mandatory fees, and books. Withdrawals used for non-qualified expenses are subject to federal income tax and a 10% penalty. 

State tax implications of 529

States differ in the tax benefits they offer on 529 plans. Some states offer tax breaks on qualified withdrawals. Other states may offer a deduction for contributions. Still, others restrict tax benefits to account holders who are residents of the state. A few states offer no tax breaks of any sort. Unqualified withdrawals are subject to state income tax and a penalty in all states. 

Fortunately, you’re not limited to opening a 529 account in your own state. You can invest in a 529 plan in any state regardless of where you live or where your child wishes to attend college. Before opening a 529 account, it’s worth exploring the tax implications of 529 plans in different states.  This will help you maximize the benefits of this program. 

3 Ways To Save On Your Taxes With 529

There are a couple of different ways that you can save on your taxes with 529. Here’s how. 

Save on gift tax – All contributions to a 529 account are considered as a completed gift from the custodian to the beneficiary. Contributions up to $16,000 per individual per year are eligible for the annual gift tax exemption. For married couples filing jointly, the annual tax-exclusion limit is $32,000. That means you can make fairly large contributions to a 529 account without incurring gift tax. Other gifts given to the beneficiary during the same year must be taken into account when calculating the total. 

Deduct your contributions to a 529 plan – Contributions to 529 plans are not eligible for federal income tax deduction, but you may qualify for state income tax deduction depending on your state of residence. The specific terms for this deduction differ among states. Make sure to check which state allows you to save on your taxes with 529. 

Fund your 529 plan with your tax refund – Contributing to a 529 account is a good way to re-invest your tax refund. The money will work for you and keep growing every year and will also help offset your child’s education costs through the years. 

Compare your personalized rates with our lending partners and potentially lower your monthly student loan payments and save money.