By Kelley Hope, Communications Officer, Virginia529
April 18, 2017
Tax benefits of 529 plans make them especially attractive to families and individuals looking to maximize their savings. However, thinking about those advantages only when choosing or setting up a plan can cause one to miss out on valuable account growth opportunities, possibly for years down the road.
While making contributions, consider these important questions each year (even smarter would be twice a year, once at year-end and again in spring as you prepare your annual tax return):
• Am I taking full advantage of a state tax benefit for contributions to my 529 plan?
• Can I direct deposit a tax refund to my 529 plan?
If you’ve begun using your account for higher education, ask these questions about withdrawals:
• What expenses qualify for tax-free withdrawals?
• How does use of my 529 plan coordinate with other available tax programs, such as the American Opportunity Tax Credit?
Tax benefits for contributions
While there is no federal income tax deduction for contributions to a 529 plan, many states offer taxpayers a deduction or credit on personal income tax returns for contributions made to the in-state program. Some states allow a deduction or credit for contributions to any 529 plan.
The contribution benefit varies by state, with some applying to total contributions made in the year and others to contributions by individual account. Two examples:
• Arkansas – Taxpayers who contribute to an Arkansas plan can deduct up to $5,000 (or $10,000 total for a married couple) from their Arkansas adjusted gross income for the year such contributions are made.
• Virginia – The $4,000 deduction cap in Virginia applies per Virginia529 account. That means a parent or grandparent who contributes $4,000 to three accounts can deduct $12,000 ($4,000 times three) from his or her Virginia adjusted gross income. There is a carryover allowance as well.
Some individuals may be equipped to use gift provisions of federal tax code to grow a 529 account. For instance, the Internal Revenue Code allows an individual to contribute up to $14,000 annually ($28,000 for married couples filing jointly) without paying gift taxes or filing a gift tax return assuming no other gifts are made to the beneficiary in the same year. While not everyone has excess funds of this size, some circumstances, such as receiving an inheritance, make it beneficial.
If you find yourself receiving a tax refund, especially one made possible by your smart use of 529 plan tax deductions or credits, complete the loop by reinvesting the refund back into your plan. Some states make this easy with direct deposit. If not available in your state, follow your regular contribution method.
Tax benefits for withdrawals
As long as a withdrawal is used to pay qualified higher education expenses (QHEE), it is exempt from federal and, in most cases, state income tax. QHEE include tuition, mandatory fees, room and board expenses, books, computers and certain supplies and equipment. In addition, expenses of special needs beneficiaries that are necessary in connection with enrollment or attendance at an eligible educational institution also may be QHEE.
Be careful about claiming multiple higher education-related tax benefits on your return. Follow this advice from irs.gov: “you can’t take more than one education benefit for the same student and the same expenses.” Careful recordkeeping and review of IRS Publication 970, Tax Benefits for Education can keep you on the safe side of the rules.
State and federal tax codes are something few people enjoy digging in to. Understanding the allowances of a specific plan is important for all account owners. (CSPN offers comparisons of plans, including tax benefits.) Contact the 529 program you’ve selected or are considering, plus the tax department in your state, to determine the specific state tax rules that apply to investing in that plan. Then work with your accountant or tax advisor to ensure your tax return takes advantage of all available benefits.
About the Author
Kelley Hope is the communications officer for Virginia529, the largest 529 plan with more than $58 billion in assets under management and 2.5 million accounts as of December 31, 2016. Flexible, affordable, tax-advantaged programs and early commitment scholarship program SOAR Virginia® assist students of any age in reaching their higher education goals. Find out how you can dream, save and achieve at Virginia529.com.