To help save for college, states and some educational institutions offer 529 plans, which have both state and federal income tax benefits. These plans come in two varieties: prepaid tuition plans, which allow you to buy credits for future education, and 529 savings plans, which allow you to invest money in a tax-sheltered account.
You can't claim any income tax deductions for contributing to a 529 plan on your federal income tax return. The IRS doesn't offer any credits or deductions for contributions. However, depending on where you live, you might be able to claim a deduction for your 529 plan contributions on your state income taxes because some states, including Alabama, Arizona and Kansas, allow you to take a tax deduction. However, if you contribute to an out-of-state plan, you may not be able to claim a state tax deduction.
While the money in the 529 plan grows, you don't have to report any of the income generated on your income taxes because 529 plans are "tax-sheltered." For example, if you were using a regular savings account to save for college and you earned $1,000 in interest, you would have to pay income taxes on that $1,000 that year. However, if you earn that same $1,000 of interest on money in a 529 plan, you don't pay any taxes on that interest in the year you earn it.
Qualified distributions from 529 plans are tax-free and don't have to be reported on your federal income taxes. Distributions are qualified if you use the money for qualified expenses of the account beneficiary, which include tuition, required fees, supplies, books and, if the student enrolls at least half-time, room and board. For example, if you take a distribution of $10,000 and use it all to pay college tuition, you don't have to pay any taxes on the distribution.
If you take a non-qualified distribution, which is a distribution used for anything except for qualifying expenses, you must report the earnings portion of the distribution as taxable income. In addition, unless an exception applies, you'll have to pay a 10 percent additional tax penalty. For example, assume you have $10,000 of contributions and $2,000 of earnings in your 529 plan. If you take it all out and don't use it for qualified expenses, you'll have to pay taxes and the 10 percent penalty on the $2,000 of earnings. Exceptions to the penalty include if you take the distributions after the original designated beneficiary dies, you are permanently disabled or you receive scholarships to cover your qualified expenses.
- university auditorium,cnetury tower,university of image by Earl Robbins from Fotolia.com