529 plans and the state deduction

How it works

Any adult can open a 529 for a named beneficiary and contribute after tax money, with no federal income limit on who can contribute. Earnings are not taxed while inside, and withdrawals for tuition, fees, books, required supplies, a computer, and room and board for a student enrolled at least half time are free of federal tax. Up to this year's official 529 k12 tuition limit (not yet verified here; see the official source below) a year can pay elementary or secondary tuition, and up to this year's official 529 student loan lifetime limit (not yet verified here; see the official source below) over a lifetime can repay the beneficiary's student loans. Many states allow a deduction or credit on the state return for contributions, often only to that state's own plan, under limits each state sets. Earnings taken out for anything else are taxed as income plus a 10 percent addition. The beneficiary can be changed to a family member without tax.

What it gives

Growth and qualified withdrawals are free of federal income tax, and most states match that.

Contribution limits are set per plan and are very high, and gifts from grandparents can go straight in.

The beneficiary can be switched to a sibling or other relative if the first child does not use it.

What it costs, or where the catch is

Earnings spent on anything other than qualified costs are taxed and hit with a 10 percent addition.

Each plan has its own fund menu and fees, and some state plans cost more than others.

A state deduction is often lost when the money goes into another state's plan.

A worked example

Yuki opens a 529 for her daughter and puts in $200 a month, which is $2,400 a year, for 15 years, a total of $36,000 contributed. At a 6 percent return the account grows to about $58,000. The $22,000 of growth, which is $58,000 minus $36,000, comes out with no tax when it pays tuition and dorm fees. Her state allows a deduction for her contributions, which at her 5 percent state rate saves her about $120 a year, since $2,400 times 0.05 is $120.

Where it goes wrong

The common miss is taking a withdrawal in a different calendar year than the bill it pays, which turns a qualified withdrawal into a taxable one.

Who confirms it for you

For your own numbers, a CPA or enrolled agent. This page explains how the rule works for people in general; it does not know your situation and does not tell you what to do.

The official source

IRS Publication 970, Tax Benefits for Education. Every figure that changes by year comes from the site's rules table, which the watcher checks against the official page on a schedule; where a figure is not yet verified, this page says so instead of printing a number.