Contributing to a 529 for a Deduction & Then Withdrawing
Preparing for higher education expenses by contributing to a qualified tuition program, also called a 529 plan, can save you some money in taxes. The tax benefits, however, don't include a deduction for your yearly contributions. In fact, taking cash out of a 529 plan for something other than certain education expenses may cost you more in taxes than if you didn't contribute.
529 Tax Savings
You fund a 529 plan with after-tax money. The main tax benefit of putting cash into the plan is the federal government allows the investment earnings to grow tax-free -- so do most state governments. The account's beneficiary also doesn't have to pay income taxes on withdrawals used to pay qualified education expenses. In contrast, the interest you would earn from a bank account you open to save for higher education costs is taxable and must be reported on your tax return each year.
Qualified Education Expenses
When a 529 plan's beneficiary begins withdrawing money, she doesn't have to report each distribution as income on her tax return if the amount doesn't exceed her qualified education expenses. Two requirements must be met for an education expense to be qualified. First, the student beneficiary must enroll in any post-secondary school that's eligible to participate in the federal student aid program. Second, the 529 plan money can only be used for tuition and related enrollment fees; textbooks, equipment and other supplies needed for classes; and certain housing expenses. If a student receives other types of tax-free aid such as a Pell grant, distributions remain tax-free to the extent they don't exceed her total qualified expenses, minus the total amount of other tax-free education assistance.
You must pay regular income taxes and a 10 percent penalty on the portion of a nonqualified withdrawal that represents your investment earnings. This is to discourage account owners and beneficiaries from withdrawing money for non-education purposes. Because of the penalty, contributing money to a 529 plan with the intention of withdrawing it soon after offers no tax savings and can actually cost you money.
Deducting Investment Losses
One potential tax deduction you can take for your 529 plan contributions is for investment losses. Essentially, you won't know whether you have a deductible loss until all of the money has been withdrawn from the account. If the amount you put in is larger than what you took out, you'll need to claim the loss by itemizing your deductions on IRS Schedule A. Because you report the hit as a miscellaneous deduction, you can only write off the amount that exceeds 2 percent of your adjusted gross income.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.