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529 plan tax consequences differ for each plan and from state to state. In some situations, 529 investments are tax deductible, and the earnings are tax exempt. Plans from certain states or employers match the amount of money an individual invests — typically up to a specified percentage — to provide an investment incentive. There are usually penalties, in the form of taxes and fees, for making non-qualified withdrawals from the 529 investment plan. Review the state's guidelines and regulations as well as the information specific to each plan before investing.
Many states allow 529 plan tax deductions. There are usually limits to the deductions, but the actual amount can vary significantly from state to state, and the limit is usually doubled for joint filers. In a case in which contributions exceed the annual limit, many states will allow the deduction to roll over to subsequent years. If a state does not collect income tax, then 529 plans cannot be deducted. Unlike some other types of savings accounts, 529 plans are not pre-tax, so taxes have been taken out of any contribution.
Some states do not allow tax deductions but offer a tax credit for 529 plan contributions. Often, both 529 plan owners and the employers who match 529 contributions are eligible for a credit. Each state's guidelines differ, but this information is commonly available from the state government, the financial aid office of an educational institution, or a tax preparer.
Both deductions and tax credits are typically available only for the owner of the account. Although an individual may gift monies into a 529 plan, tax deductions and tax credits are not available unless he or she owns the account. In some states, a grandparent may make a contribution that is eligible for tax credits or tax deductions.
The contributions and the earnings of a 529 plan are both subject to penalties and taxes if they are withdrawn for non-qualified purposes. Non-qualified withdrawals are anything not directly related to educational expenses, such as tuition, housing, and books. If the beneficiary finishes their higher education but does not use the entire amount in his or her 529 plan, the monies can be transferred to another beneficiary, such as a sibling.
A 529 plan can affect an individual's financial aid status. The amount in the 529 plan is usually included in the assessment of financial need, and an individual can be denied need based financial aid if he or she is the beneficiary of a large 529 investment plan. The individual may still be eligible for other types of scholarships, based on merit or other criteria, however.
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