The main tax advantage of a 529 Plan (in a state-sponsored college savings plan) is that distributions for qualified expenses are tax-free. In other words, contributions grow tax-free and earnings won’t be taxed when withdrawn for QUALIFIED EXPENSES. In certain states, you may also benefit from a State tax deduction when contributing to a 529 Plan, unfortunately California is not one of them.
Now, you may wonder what the IRS means by Qualified Expenses? Or, how did the Tax Cuts and Jobs Act of 2017 (TCJA) change the definition of Qualified Expenses for 529 Plans?
The TCJA modified Section 529 plans to allow distributions up to $10,000 in tuition expense incurred during a taxable year for enrollment or attendance of the designated beneficiary at a public, private, or religious elementary or secondary school. The limit of $10,000 per year applies on a per-student basis so if a child is the designated beneficiary of several 529 plans, the limit is $10,000 for that year rather than $10,000 from each account.
Please note that the real benefit of funding a 529 Plan is the years of tax-free growth, and tax-free distribution of earnings (contributions are never taxed when withdrawn). In most cases, distributing 529 Plan funds for K-12 tuition does not make sense because there would not be enough time for the contributions to grow.
Qualified Expenses for higher education (e.g., college) include the following: tuition and fees, books and supplies, computer and related equipment and services (such as printer and internet access), and room and board (if the student is enrolled at least half-time).
Keep in mind that you cannot use the same qualified expenses for two different claims: for example, if a taxpayer paid $2000 of tuition and used that expense to claim another educational tax benefit such as the American Opportunity Tax Credit, he cannot use the same $2000 for a tax-free 529 plan distribution. Additionally, 529 Plans can affect financial aid and reduce your eligibility depending on who owns the account.
As part of our services, the Inspired Financial team helps clients plan for education and creates customized strategies tailored to each situation. Please feel free to reach out to our team for questions.