A 529 plan gives parents, grandparents, and others a vehicle in which to save funds for college, invest those funds, and receive possible tax-free treatment of all gains, dividends, and interest. Some states offer incentives such as tax deductions or tax credits for contributions to their 529 plans. While both federal and state taxing authorities promote these plans, their treatment of contributions or distributions may not always align. Depending on the state, the newly added K-12 tuition qualified education expense may not prove quite as valuable as initially thought.
The federal contribution limitation lines up with the annual gift tax exclusion of $15,000. This exclusion allows gifts up to the exclusion amount from a donor without paying gift tax or using your lifetime exemption. There are other nuances like the five year gift tax averaging that allows for super funding a 529 plan, but this limitation also coordinates with the annual gift tax exclusion.
As mentioned above, many states promote contributions through tax incentives. Georgia, for example, allows a tax deduction up to $2000 for single filers ($4000 for joint filers) per beneficiary per year. Each state is different.
The investments in a 529 plan grow and cash distributes tax free if distributions are spent on qualified educational expenses either directly or through reimbursement. Qualified educational expenses include tuition, fees, books, supplies, equipment, computers (added in 2015), and sometimes room and board. Non-qualified distributions are “discouraged” similar to an early IRA distribution. Both incur a 10% penalty and income taxes on any growth distributed.
There are many factors to consider in any planning decision, but all things being equal, a 529 should still be used for qualified higher education costs (college). The 2 main reasons are:
1) The primary benefit to 529s remains the possible tax free growth especially over longer periods of time due to compounding returns. Contributions in the plan for a short term with little or no growth and used to pay for K-12 tuition leave the state tax deduction as the only possible substantive benefit. This can be slightly more advantageous than paying directly.
2) The state may not actually allow spending on K-12 tuition without making one pay income tax or a penalty, so please check with a tax advisor to confirm state distribution qualifications before writing the check.
Generally, one would want to contribute more funds to a 529 early in the beneficiary’s life, maximize any state incentives in continuing years, earn strong positive returns on the investments, spend the funds late in the beneficiary’s educational career rather than early, and, if you live in Georgia with multiple children like myself, hope that the beneficiary receives the Zell Miller scholarship!