A 529 plan is an investment plan designed to help families save for college expenses while enjoying certain tax advantages. The name comes from the Internal Revenue Code's Section 529, which allows the plan format and details its tax implications. The plans, which are also called qualified tuition programs, are typically sponsored by states. Each of the 50 states and the District of Columbia sponsor at least one style of 529 plan. Eligible higher education institutions also can sponsor a 529 plan tailored to their school.
Types of Plans
The Internal Revenue Code allows two types of 529 plans. They are the prepaid tuition plan and the college savings plan. A prepaid tuition plan allows for a participant to purchase a portion or all of the tuition at certain colleges ahead of time. The tuition prices are locked at the time of the purchase, so that participants are protected from rising tuition bills. Prepaid tuition plans typically limit their coverage to tuition and mandatory fees. A college savings plan is an account that enables someone to contribute money to investment plans designed to grow and provide funds for college costs. College savings plans usually have more flexibility than prepaid plans regarding eligible schools and expenses.
The chief benefit of the 529 plan is that earnings on the investments in the plan are not subject to federal taxes, as long as the money is used on eligible college expenses. This advantage allows for the funds in a 529 plan to grow without being drained by taxes. When the time comes to withdraw funds to pay for college expenses, no federal taxes are charged on the withdrawals. Participants do not receive any federal tax advantages for their contributions, though some states offer tax deductions for contributions to their college savings plans.
States have the flexibility to offer their own particular tax advantages to those who contribute to their 529 plans. However, contributions to 529 plans are not deductible through the federal tax return, according to the IRS. In addition, robust contributions can occasionally trigger negative tax consequences. A person who contributes more than $13,000 to a beneficiary's 529 plan in a single year may need to pay gift taxes, according to the IRS. On the positive side, 529 plans allow contributions from anyone, regardless of income or relationship to the beneficiary, so that many different interested individuals can contribute to investing in a child's college education.
Possible Penalties and Tax Charges
The various 529 plans lose their tax advantages if the funds are withdrawn for something other than qualifying educational expenses. First, the earnings will become subject to federal taxes, so that the withdrawals will be taxed as income. In addition, the 529 plan code dictates that the owner of the account will be charged a 10-percent federal tax penalty on the earnings, making the withdrawal especially costly. If the distributions that a beneficiary receives from a 529 plan does not exceed the qualified educational expenses in a given year, then the beneficiary does not need to report the distributions as income. However, if the distributions do exceed the qualified education expenses needed that year, then the beneficiary must report it as income.