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529 Plans- Taxes - Pinnacle Investment Management, Inc.

529 Plans- Taxes

May 31, 2016 / Blog


Tax Benefits

529 accounts offer a number of potential tax benefits and its worth being aware of how 529’s interact with federal and state income taxes, gift taxes, and estate taxes.


The contributions made into a 529 account are not tax deductible, however the earnings are tax-deferred and can be tax-free if used for qualifying higher education expenses. This is one of the biggest benefits to a 529 account. For instance, if you contribute $50,000 to a 529 account over 15 years, and that account has grown to $150,000, you can take out the $150,000 tax-free if used for qualifying expenses. There will be no taxes at all on the $100,000 that you made! Qualified Higher Education Expenses will determine if your withdrawal from the 529 will be tax-free or not. These are discussed below.

If you save for college in a regular taxable account, you will have to pay taxes every year on any dividends, interest, or capital gains that are produced. The income produced could also have a negative impact on financial aid eligibility. With a 529 you wont have those yearly taxes and, if used for college costs, any capital gain on the account is tax-free.

The following chart from aboutchet.com illustrates the benefits to tax-free growth. This example shows that over an 18 year time frame the 529 account could offer an $8,000+ tax saving versus a taxable account.

Benefits of Tax-Free Growth: Taxable = $46,788, Tax-Free = $54,958 over 18 years

This example assumes an initial investment of $5,000, monthly contributions of $100, and a 6% annual rate of return over 18 years. The taxable account assumes a 28% federal and 5% state tax rate. The illustration does not represent the performance of any specific Investment.




No matter what state’s 529 plan you use, the federal tax advantages will be the same. For example, if you are a Connecticut resident you can use the Idaho 529 plan and the account will still be federally tax-free is used for college costs.

Many states also offer their own state tax advantages. Of the 41 states that have an income tax, 33 of them offer some degree of state tax deduction or credit for using their home state 529.
The State of Connecticut offers an income tax deduction for residents that contribute to the Connecticut 529 Plan (named CHET, Connecticut Higher Education Trust). From aboutchet.com:

Contributions are deductible for Connecticut income tax purposes up to $5,000 per year for a single return or $10,000 per year for a joint return. If you exceed this amount, you can carry over the excess amount for the five taxable years following the deduction.

Again, if you are a Connecticut resident, you are allowed to use a 529 plan from any state that you would like. However, to get the Connecticut state income tax deduction, you must use the Connecticut 529 plan.

There are 6 states that offer “tax parity” which means that they allow state tax deductions to their residents no matter what state’s 529 plan they use. Those states are: Maine, Kansas, Pennsylvania, Arizona, Missouri, and Montana

The state and federal tax benefits to 529 accounts can not be overstated. The ability to get tax-free growth and a possible state income deduction gives it a large head start to other savings vehicles.


Gift Tax

The gift tax annual exclusion allows you to gift $14,000 to as many people as you would like every year without creating a taxable gift or filing a gift tax return. An added benefit that is available to 529 plans is the ability to bunch 5 years of gifts together in one year. That allows you to contribute up to $70,000 to a 529 plan in one year without creating a taxable gift.


Estate Tax

A great advantage of a 529 plan is that even though the account owner maintains control of the 529 account, it is excluded from your gross estate. For grandparents that are looking to help their grandchildren with college and lower their gross estate, 529 plans can offer a great opportunity.



Qualified Higher Education Expenses

Qualified Higher Education Expenses (QHEE) includes:

– Tuition
– Room & Board (student must be enrolled at least half time)
– Fees
– Books, supplies, and equipment (including computers)

Room & board includes on-campus and off-campus housing. For off-campus housing the amount that qualifies cant exceed the allowance for room and board included in the schools cost of attendance. So, if your child is living off campus, you cannot claim expenses that are more than the college’s estimates for room and board.

When you withdraw funds from your 529, the program administrator will send you a 1099-Q. It is up to you to match up the withdrawals to the QHEE.  While you do not have to list the QHEE on any tax return, you will need to keep records in case of audit. If you take distributions in excess of QHEE, you will need to report that on your tax return as “other income.”



So what happens when you don’t have any or not enough Qualified Higher Education Expenses to match up with your 529 withdrawals? If you take non-qualified distributions from your 529 plan, then the earnings on the account are subject to federal (and possibly state) income tax and a 10% penalty. Here’s an example to help illustrate how this may work:

Jim has a 529 account for his daughter Emily. He contributed $10,000 to the account and today it is worth $25,000. Emily has decided not to go to school. If Jim takes the $25,000 out of the 529, that will be considered a non-qualified distribution. He will owe ordinary income tax and a 10% penalty on $15,000. The original $10,000 that he put in is a return of principal so it is not taxed or penalized.

In general, you don’t want to overfund a 529, unless you have other people in your family you would like to give the money to (.i.e. other children).

There are a few exceptions to the 10% federal penalty:

– Disability
– Death of beneficiary
– Withdrawal made on the account of a tax-free scholarship
– Coordination restrictions with the Lifetime Leaning Credit or American Opportunity Credit.

When you take a non-qualified distribution from a 529 account, the recipient of the distribution is the one who owes taxes and penalties on it. If you are going to be taking a non-qualified distribution, it may be best to pay it directly to the beneficiary as they may be in a lower tax bracket than the account owner.


Sources & Further Reading
About Chet


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About the author

John Shanley: CFP ® is a Financial Advisor with Pinnacle. He joined in 2015 after previously working as a Financial Consultant for Fidelity Investments. John is a Certified Financial Planner, a graduate of Fordham University and is currently pursuing his Masters degree in Financial Services. John is a native of Pawling NY and currently resides in Suffield with his wife, Jennifer, who is an Immigration Attorney. In his free time, John enjoys reading and is an avid hockey fan.

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