Tax Deduction Rules for 529 Plans: What Families Need to Know

April is generally tax season (although COVID-19 has pushed back the 2020 filing deadline to July). While filing and paying taxes can be painful, governments offer several deductions that can reduce a family’s tax burden and increase any possible refund. Families who invest in 529 plans may be eligible for tax deductions. A 529 plan can be a great alternative to a private student loan. This article will explain the tax deduction rules for 529 plans for current and future investors.

What Is a 529 Plan? 

A 529 plan – named after Section 529 of the Internal Revenue Code – is a tuition account established and operated by a state. The plan allows a family to set money aside for a student’s education. All 50 states and Washington, D.C., offer 529 plans. 

There are two types of 529 plans. Both, as explained in more detail later, offer significant tax advantages.

With a prepaid tuition plan, the family identifies a qualifying institution of higher education. (While the rules vary from state to state, usually, public universities qualify.) The family’s contributions go toward the school’s tuition and fees. Prepaid plans usually do not allow families to prepay room and board. The primary benefit of prepaid tuition plans is that they are guaranteed to increase in value at the same rate as college tuition, giving families peace of mind.

An education savings plan (or college savings plan) is a type of investment account where families can save for college. However, unlike a prepaid tuition plan, funds from an education savings plan can be used for tuition and room and board. 

Tax Deductions vs. Penalties 

The greatest benefit of 529 plans is their tax advantages. But to understand these benefits, you must understand deductions and penalties. 

Tax penalties punish taxpayers for taking certain actions. Generally, they exist to discourage people from making certain financial decisions. For example, there is a tax penalty for withdrawing funds from retirement accounts before reaching a certain age. 

On the other hand, tax deductions reward taxpayers under certain circumstances. Tax deductions reduce a filer’s overall tax liability to reward them for responsible financial choices. Two examples of deductions are income reductions for families with dependents and those paying student loan interest. 

Federal and State Tax Deduction Rules for 529 Plans 

The federal tax deduction rules for 529 plans are straightforward. Unfortunately, the federal government does not allow families to deduct contributions to a 529 plan. There is no indication that this rule will change anytime soon.

Families should note that while the federal government does not reward 529 contributions, it does penalize early withdrawals. Families can make 529 withdrawals in any amount without penalty as long as the withdrawal is used for qualified educational expenses. (Qualified educational expenses include funds spent to cover costs at colleges, student loan repayments, or K-12 schools.) However, families will pay a 10% penalty for any withdrawals made for noneducational purposes. 

While federal tax rules do not allow families to deduct 529 contributions, states have their own policies. Remember that each 529 plan is owned and operated by a state government. Therefore, many states allow families to deduct 529 contributions on their state taxes.

State-by-State Tax Deduction Rules for 529 Plans  

While most states’ tax deduction rules allow families to subtract 529 contributions from their gross income, the rules vary from state to state. The chart below provides an overview of the rules in each state. It lists the rules for state residents who buy a plan sponsored by the state where they reside. (The rules may be different for those who buy plans in other states or who roll over plans from one state to another.) 

Please note that some states offer tax deductions, while some offer tax credits. Deductions reduce the amount of income taxed, while credits reduce a person’s tax liability. 

Finally, the rules below assume that the parents are making the contributions. Some states restrict tax benefits to parents, while others allow any contributor (such as grandparents, aunts, or uncles) to take advantage of the tax benefits. 

Note: This information is not legal or accounting advice. Please consult an attorney or accountant for professional guidance on your particular tax situation.