Saving for College: Tax Treatment of 529 Plans

October 23, 2015 

This article contributed by Lesley M. Mehalick, J.D., LL.M of McAndrews Law Offices, P.C. 

college_costThe tax deferred nature of a 529 plan can make it a desirable option to assist in saving monies for your child’s future college expenses. This article will provide an overview of the key points for the current Federal and Pennsylvania tax treatment of 529 plans.

Tax Treatment of Contributions to a 529 Plan

Monies deposited into a 529 plan are “after-tax” dollars, meaning that they are monies on which you have already paid any applicable Federal income tax. The contributions are therefore not treated as a Federal income tax deduction; however, they are also not treated as income to the plan beneficiary at the time the monies are deposited into the plan.

Although contributions to a 529 plan are not subject to a Federal income tax deduction, they are eligible to be deducted from Pennsylvania income tax. Pennsylvania allows a Pennsylvania income tax deduction for contributions into a 529 plan up to the annual gifting exclusion amount ($14,000 in 2013) per beneficiary. A married couple can deduct double that amount, assuming both spouses have the requisite income. Pennsylvania is particularly favorable in this regard because it allows this income tax deduction regardless of whether you are contributing to a Pennsylvania 529 or to another state’s 529 plan. Pennsylvania does not currently offer an income tax deduction for other possible types of college savings, such as a Coverdell Educational Savings Account or a Uniform Transfer to Minors Custodial Account.

Contributions to a 529 are treated as completed gifts, and the contributions are therefore exempt from Federal gift tax, so long as they are under the annual exclusion amount. In 2013, a person may gift up to $14,000 per donee without incurring gift tax; thus a married couple may donate up to $28,000 into a 529 each year without gift tax. Additionally, Federal law offers a five-year election for 529 plans, which allows a donor to treat his contributions to a 529 plan made in one year as being made ratably over a five-year period, with the goal of not incurring gift tax. A gift tax return must be filed to make this election. Although the account owner retains the right to recover assets in the account 9subject to applicable taxes and penalties), because the contributions are treated as competed gifts, the 529 plan assets will not be included in the account owner’s estate for purposes of Federal Estate Tax.

Tax Treatment of Accumulating Earnings in a 529 Plan

While monies remain inside a 529 plan, the accumulating earnings are not subject to either Federal or Pennsylvania income tax. Thus, the monies deposited into the 529 GSP grow tax free while in the plan. This untaxed appreciation has a compounding effect, as the tax-free interest also gains interest, which, over time, may have a significant impact on the growth of the account assets.

Tax Treatment of Distributions from a 529 Plan

In general, qualified distributions from a 529 plan will be exempt from both Federal and Pennsylvania income taxes. Qualified distributions are those made for the designated beneficiary’s payment of qualified higher educational expenses at an eligible educational institution. In order to be tax free, the distribution must be less than or equal to the designated beneficiary’s adjusted qualified education expenses, which is the qualified education expenses reduced by any tax-free educational assistance, such as tax free scholarships or fellowships. The exact definition of qualified educational expenses should be consulted before making any distributions, but it can include tuition, supplies and room and board at most accredited school sin the nation. When used appropriately, the full principal and all earnings in the plan can be distributed without incurring Federal or Pennsylvania income taxes. Of course, non-qualified distributions are subject to both Federal and Pennsylvania income taxes, and in addition, unless an exemption applies, a 10% penalty may also be assessed.

Thus, the tax deferred nature of a 529 plan may be a way to help maximize college savings.



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