529 plans are an investment vehicle that allows taxpayers to save for all levels of education. Contributions are made with after-tax dollars, but accumulated earnings and qualified withdrawals are tax-free for federal taxes. If savings towards education for your child or another beneficiary is a priority to you, this type of plan is a great tax advantage.
There are two types of 529 plans: savings and prepaid tuition. Each has different rules for what they define as qualified withdrawals. The 529 savings plan can go to most school expenses such as tuition, fees, books, room and board, and equipment. It also can be applied to schools for K-12 as well as undergraduate and graduate programs. For schools K-12, up to $10,000 may be withdrawn from this type of plan every year. The 529 prepaid tuition plan only pertains to undergraduate studies for tuition and fees. There is no limitation on the dollar amount withdrawn every year for undergrad and graduate studies, but expenses will only count towards certain colleges that participate in the plan.
Nonqualified Withdrawal Treatment
Withdrawals that do not fall under the categories listed above are treated as nonqualified. The earnings are taxed at the regular rates of the beneficiary in the year they are withdrawn. There is also a 10% penalty that is applied to this amount, with some exceptions. If the money is no longer needed for the beneficiary due to receipt of a scholarship, disability, or death, then the 10% penalty will be waived.
State Tax Implications
States have their own rules pertaining to 529 plans. States may offer a deduction on contributions and have all the tax-free benefits listed above. Some may not offer any tax benefits at all. Check with your state laws in order to know the implications for your specific state.
For those who already have a Coverdell savings account, you may fund both this plan as well as a 529 plan for the same beneficiary without any sort of penalty being imposed.
Anyone who is seeking to claim the American Opportunity or Lifetime Learning education tax credits with the same expenses withdrawn from a 529 may still take the credit(s). The only consequence is the amount used towards the credit will not be able to count towards a qualified withdraw, causing some tax to be imposed on the earnings.
Investing in education for your child can be an important financial goal. If you would like to learn more about the 529 plan and how you can reduce taxes while saving for this goal, call us at 513-241-8313 or click here to contact us. We look forward to hearing from you.