Basic Taxation of College Savings Plans

Excerpted from 529 College Savings Plan by Richard A. Feigenbaum and David J. Morton ©2003

The College Savings Plan is a creation of federal tax law, specifically Internal Revenue Code Section 529. As with all tax laws, the legislative intention is to motivate people in a particular way by virtue of tax benefits to be realized. The College Savings Plan is no different. The intention in creating the law was to help families save for college in a tax favored way. Doing so provides those who are saving for college an advantage over those people who do not have children or whose children have already attended college.

In its simplest terms, if you follow the rules, there are no federal or state income taxes on the investment gains in a College Savings Account during the accumulation or growth of the assets. When assets are withdrawn from the College Savings Account, there may be a tax depending on the reason the assets are withdrawn and for what they are used. Section 529 imposes a federal income tax, and an additional penalty tax, in cases where the tax-free withdrawal rules are not followed.

The investments grow tax-deferred, and if used for the appropriate qualified higher education expenses, the growth on the investments will be tax-free.

Qualified Higher Education Expenses
You must use the funds withdrawn from the College Savings Plan for qualified higher education expenses in order to have tax-free investment gains. The basic premise to the plan is that the money saved in this tax-favored savings account is intended to be used to pay for college and college related expenses. Since the law was first enacted in 1996, the definition of qualified higher education expenses has been expanded to include more of what a family would typically expect these expenses to be.

As amended by the Economic Growth and Tax Relief Reconciliation of 2001 (EGTRRA), Section 529 College Savings Plan distributions, including all gains and appreciation, are federally tax-free at the time of distribution if used for one or more of the following:

• tuition;
• room and board (if the student is enrolled at least half-time);
• fees;
• books;
• supplies;
• equipment required for enrollment; and,
• for special needs children—expenses incurred in connection with the child’s enrollment or attendance at an eligible school.

This list has been expanding and may well include in the future necessary incidentals of attending college, such as an automobile to commute to school.

Eligible Institution
The funds withdrawn from a College Savings Plan must be used for one or more of the previously mentioned educational expenses, as well as used at an eligible educational institution. An eligible educational institution is defined in the Higher Education Act of 1965, as being a school eligible to participate in a student aid program. Generally speaking, these are accredited schools offering credits towards a bachelor’s degree, an associates degree, professional, vocational or other post secondary education, such as medical school, law school, and pursuit of doctoral degrees.

Taxes on Distributions
By virtue of tax law changes implemented in 2002, distributions from a College Savings Plan are free from federal income tax provided the distribution is used for payment of qualified higher education expenses. This then raises the question of what taxes are to be paid if the withdrawal is not for the higher education expenses. That is, what if a withdrawal is made from the account and the proceeds are used for some other expense. Under current federal tax law the owner of the account would have to list on his or her income tax return the amount of the distribution that was made up of gains and investment profits. The income portion of this distribution would then be subject to income taxes and a penalty tax.

For example:
In 1999, Sally opened a College Savings Account for the benefit of Mickey and deposited $20,000 into the account. At the close of the year (December 31) in 2006, the account value will be $30,000. If Sally were to withdraw $7,500 from the account and not use the money for qualified higher education expenses for Mickey, then a portion of the withdrawal will be subject to federal income tax. The portion is computed based upon the ratio of income to principal in the account. In this case, the proportion is 2/3 principal 1/3 income. Therefore, one-third of the distribution that was not used for qualified higher education would be subject to income tax. In this example, when Sally withdrew $7,500 from the account, one-third of this, or $2,500, would be put on her income tax return as taxable income.

Deductions for Contributions— Federal
Under present law there is no deduction on your federal income tax return for contributions to a College Savings Plan. While it may be possible that Congress will take this step in the future, there is no indication at the present time that they will do so. Presently, if you wish to save money for retirement, you can also do so on a pretax basis. This is done by using a 401(k), IRA, or an employer’s pension or profit-sharing plan. These types of plans all allow for you to save money before any income tax is imposed on your earnings. Perhaps Congress will see that this pre-tax savings would be an opportunity for families trying to save for college, and may some day offer a similar tax-deductible way to put money into a College Savings Account.

Deductions for Contributions — State
Some states have enacted laws that allow for a partial or complete deduction against state income tax for contributions to a state’s home plan. That means that for someone living in a state that allows for a deduction, the contribution to a College Savings Plan will reduce their current state income tax burden each year.

To put this in perspective, consider the following illustrations of the value (or lack of value) in the deductibility of a contribution to a state’s home plan.

For example:
In 2002, Mary, residing in Illinois, establishes a College Savings Account for her son under Illinois’ Plan Manager (presently Salomon Smith Barney). Under the state’s income tax rules, there is an unlimited income tax deduction when contributions are made to the plan sponsored by the state. In this case, if Mary contributed $20,000 to her son’s account there would be a tax savings of $600 ($20,000 times the state’s flat income tax rate of 3.0%).

In 2002, Sally, a single individual, residing in Mississippi, establishes a College Savings Account for her son under Mississippi’s Plan Manager (presently TIAA-CREF). Under the state’s income tax rules, there is a limited income tax deduction for contributions up to $10,000 when contributions are made to the plan sponsored by the state. In this case, if Sally was in the highest tax bracket and she contributed $20,000 to her son’s account there would be a tax savings of $500 (maximum benefit level of $10,000 times the state’s income tax rate of 5.0%).

In 2002, Nicole, a single individual, residing in Massachusetts, establishes a College Savings Account under Massachusetts’ Plan Manager (presently Fidelity Investments). Under the state’s income tax rules, there is no income tax deduction for contributions made to a College Savings Account. In this case, Nicole would receive no state income tax benefit for contributions to the account.

You can see that states that offer a state tax deduction for contributions to a College Savings Account save

As Featured in the Book

529 College Savings Plan, 2E

Richard A. Feigenbaum, Attorney at Law, David J. Morton, Attorney at Law

Few things can keep a parent awake at night like the seemingly daunting task of saving for a child's education. Thankfully, the government has created the single greatest savings opportunity in many years-the 529 College Savings Plan.

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