In other posts on this site, and elsewhere on the Web, you’ve likely heard about the tax advantages offered by Section 529 savings and prepaid tuition plans. What I have noticed though is that few sites (once again, including this one) delve very deeply onto exactly what those benefits are.
In this post, we’ll take a look at how using a 529 plan for college can be tax beneficial to you. Having said that, here’s the CY– mine, actually –A statement: I am not a tax expert, adviser or financial planner. This post is simply a compendium of public information that I’ve managed to pull together. Talk to your own accountant or financial planner to see how a section 529 savings plan affects your own situation. Capice? Good.
The biggest advantage a section 529 to a taxpayer on her federal return is the ability to withdraw all the gains in the account without paying any taxes on the accumulated earnings — as long as they are used for qualified college expenses. This means that if you put $5,000 into a 529 plan over the years, and its value has grown to $15,000, you will not pay federal taxes on that $10,000 gain when you use the money for the account beneficiary’s eligible college expenses. That is kind of a big deal.
While the range of 529 eligible expenses is relatively small, each category is broad enough to not be too restrictive. As I noted in an earlier post, section 529 eligible expenses include:
– Tuition and Fees
– Room and Board, for students enrolled half-time or more
– Equipment and supplies required for enrollment
– Computer equipment and supplies
One caution is that, for purposes of the tax exclusion, your section 529 withdrawal is the last source the IRS will look at. So, let’s say your educational costs total $10,000 for one year, and you receive $3,000 in scholarships and another $3,000 in grants. This leaves a $4,000 difference between the aid you received an your educational expenses. The IRS will only allow you to withdraw $4,000 from your 529 plan without incurring a tax. This is because it will take all other forms of aid the student receives into consideration first — only your actual, out of pocket expenditures can be withdrawn tax-free from a 529 plan. The interplay between 529 accounts and financial aid can be delicate.
Many people can reap additional tax advantages from their section 529 savings plans based solely on geography. This is because of the way in which section 529 plans differ from state to state, as well as the disparate ways in which they are treated by each state’s taxing authority.
Let’s use two upper-Midwest states that are home to legacy (i.e., real) Big Ten universities as an example. The Twin Cities of Minneapolis and St. Paul are home to the University of Minnesota and the hub of a metropolitan area that includes part of western Wisconsin. If your family lives in western Wisconsin, and your student attends the University of Minnesota, about 30 minutes from home (instead of the University of Wisconsin at Madison, located nearly 200 miles to the east), you have a huge tax advantage over Minnesota residents who live 5 minutes closer to school. Wisconsin will allow you to deduct a sizable sum (recently as much as $6,000) for college tuition and any mandatory fees from your state taxes. This deduction applies to each student in your household, who is attending school in either Minnesota or Wisconsin. Moreover, the two states have a reciprocity agreement, so students pay state resident rates at public colleges in either state. The state tax deduction for tuition for a Minnesota family: $0. Nothing. Nada.
To add insult to injury, Wisconsin, along with more than 30 other states and the District of Columbia, will allow you to deduct 529 plan contributions on your state tax return. Limits have recently been as much as $3,000 per child per year. So, a student from Hudson, Wisconsin, can attend the University of Minnesota with a friend who lives a mile away in Afton, Minnesota. They will pay the same amount of tuition. But the Wisconsin family will have been able to deduct up to $3,000 per year for contributions it made to its student’s section 529 plan. In addition, another $6,000 or so in deductions can be claimed for tuition paid to the University of Minnesota. The Wisconsin student’s family was able to deduct several thousand dollars per year saving and paying for college in Minnesota. Her friend’s family over in Afton? Not a cent. It is vastly more expensive for a Minnesota family to save and send their child to school at the U of MN than its is for a Wisconsin family to do the same.
The take away from this example is to be mindful of your state’s tax rules with respect to tuition and section 529 tax benefits. This can make a big difference in the value of the section 529 plan to your specific situation. Talk to your tax adviser and try to carve out a savings strategy that makes sense for you.