Yahoo Finance 4 Important Questions for Taxpayers with a 529 College Savings Plan
As Tax Day looms, last-minute filers may be wondering how to account for their college savings fund on their federal and state taxes.
Investors who have recently opened or started withdrawing from a 529 plan -- or tax-advantaged college savings plan -- are likely wading through new tax territory.
What do you need to file on federal versus state tax returns? Do you need to file a gift tax return? How do you coordinate 529 tax benefits with other tax credits?
While the accounts are relatively low-maintenance, experts weigh in with answers to commonly asked questions and ways to avoid tax traps.
[Learn five steps for using funds from a 529 plan.]
1. What do I need to report on my federal taxes if I've made contributions in the past year but taken no withdrawals?
Likely nothing on a federal tax return, says Joseph Hurley, founder of college savings website savingforcollege.com. The accounts allow investors to make contributions that grow tax free, and withdrawals are not taxed as long as they are used for qualified educational purposes.
"That's one of the benefits of 529s," he says. "You don't have to report anything."
However, some families may need to file a gift tax return if they have given more than $14,000 ($28,000 for married couples) per beneficiary -- that includes money put into a 529 account as well as other gifts during the year. But investors likely won't have to pay a gift tax because there's a $5 million lifetime exemption against taxable gifts that's adjusted for inflation, he says. They can also opt to use the five-year election rule, which allows them to treat the gift as if it were made evenly over a five-year period without generating a taxable gift, Hurley says.
2. How about on state taxes?
Investors may be able to claim a credit, so they should check their state's rules, says Eva Rosenberg, an enrolled agent who runs the tax advice website TaxMama. Keep track of contributions throughout the year and who is making them.
[Find out what tax paperwork to gather for college savings accounts.]
"If they're making contributions, then for state purposes, they need to find out what programs their state has, because some states offer credits for the contributions that the IRS doesn't offer," she says.
Currently, 34 states including the District of Columbia offer a full or partial tax credit or deduction on 529 plan contributions, according to savingforcollege.com. There are contribution limits for the tax incentives, which vary by state.
Rosenberg says it's especially worth checking for people who have recently moved to a new state. Most states only offer tax breaks to residents who use the home-state plan, but there are six states that offer deductions regardless of which state sponsors the 529 plan.
3. What do I do if I made withdrawals?
Investors who made withdrawals should have received form 1099-Q from the 529 plan, which breaks down how much they received in distributions, and how much of that was principal, Hurley says.
Next, they need to figure out whether the distributions were for what's considered qualified educational expenses, which includes expenses such as tuition, fees, books and supplies, and some room and board.
Any excess is called a nonqualified distribution. The earnings portion has to be reported as ordinary income on an investor's tax return and is also subject to 10 percent penalty, Hurley says.
[Know what you can buy with 529 savings plan distributions.]
This can be a little tricky for investors, says Chelsea Watkins, founder and CEO of College Application Training, a company that helps families grow wealth while attaining their educational goals. For instance, an airline ticket to college is not considered a qualified expense.
"The main issue is what counts as a qualified educational expense," she says. "That's the key. You really have to check before you make a distribution. ... Otherwise you are going to be hit with taxes and penalties."
4. How do I coordinate the 529 tax benefits with other tax credits?
Families planning to claim a tax credit like the American Opportunity Tax Credit, which covers up to $2,500 of $4,000 in tuition and fees for the first four years of college, need to make sure to deduct that amount from their qualified 529 expenses.
"They have to be coordinated," Hurley says. "You can't double dip and use both on the same expenses."
For instance, if a student's higher ed expenses -- tuition, fees, books, and room and board -- add up to $20,000, but he or she is also planning to file for the American Opportunity Tax Credit, the student needs to subtract $4,000 from those expenses. That only leaves the student with $16,000 of qualified expenses for 529 purposes.
However, the 10 percent penalty doesn't apply if there's an excess distribution due to the tax credit, Hurley says. It also doesn't apply to excess distributions due to scholarships.
Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.
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