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What Are 529 Plan Tax Consequences

The college savings plans are tax-deferred plans that allow for a certain contribution amount each year. The contribution amount is limited to  the cost of tuition. Normal tax deductions include the tuition and fees deduction, deductable up to $4,000 and the student loan interest deduction, which allows interest payments to be tax-deductable. However, 529 plans are not tax-deductable they normally do not need to be reported at all.

Qualified Expenses

Qualified tuition programs (QTP)s, also known as section 529 plans, are tax free distributions. As long as they are used for qualified school expenses, the expenses are tax deductibles. Here is a list of qualified expenses:

  • tuition
  • room and board
  • fees
  • books
  • supplies
  • computers and technology

Taxes

Distributions are recognized as a return of investment and need to be reported on form 1099Q. Anything in excess of cost of tuition and qualified school expenses will be taxed as a ratio of total distribution and reportable on form 1090Q.

The cost of annual tuition, plus qualified expenses should not exceed $10,000. If, for example, a distribution is made in the amount of $15,000, that leaves earnings in the amount of 5,000 as taxable. The tax rate will be 5,000/15,000, which is in essence 33%. Thirty-three percent tax rate times 5,000 equals $1,650 which would be reported in box 2 on form 1090Q. This is in addition to the 10% tax penalty of a non-qualified distribution.

Exemptions

Like other qualified plans, there are exemptions:

  • death
  • disability
  • purchasing first home
  • paying medical expenses
  • periodic series of payments

Section 529 plans allow a one-time gifting contribution of $65,000. Otherwise, the allowable gift is $13,000 per year for five years. All qualified tuition programs are treated as one so the combined annual contribution recognized as a gift can be $60,000 in all programs. Each state has different contribution limits, however, the maximum cumulative contribution limit for a section 529 plan is $305,000.

Anything above $65,000 within 5 years gifted to each beneficiary in the plan will be reportable on form 709 and taxable according to the gift tax ruling of that year. If the gifting parties are husband and wife they can gift up to $130,000 to each beneficiary in one year without having to report or pay gift tax. 

State Requirements

Each state has their requirements with section 529 plans. Although they are not federally taxable, section 529 plans are taxable on the state level. Each state establishes their tax rates.

Other concerns

The investment options within the sponsored plan are a big concern as well. If the investment options are not good, then the savings plan could be worse than storing money under the mattress, because it may not be there later.

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