Tax Deduction Rules for 529 Plans: What Families Need to Know

VD October 10 2021

Higher education is highly expensive, and most people these days can not afford it. It’s best to start saving money while your children are still learning to talk, not when they are ready for college. Most families know how to save for college: 529 tax schemes encourage saving and offer the smartest way to save money for your children's future. But they have intricate rules.

What Is a 529 Plan?

A 529 plan is the funds for eligible schooling costs that are tax-free. Families who put money aside or save in a 529 plan early might benefit from compounding returns and, in some jurisdictions, a tax break on expenditures.

529 plans are named after Section 529 of the Internal Revenue Code because they were created under the income tax law. If you follow these rules carefully, 529 plan withdrawals will not be taxed.

The benefits of a 529 Plan include: no taxes on any investment earnings (interest, dividends, or capital gains) and there is no age limit.

The downside to opening an account with your state’s plan is that all your contributions are considered gifts by the IRS - there is a gift tax for higher amounts ($13,000 per year). Although many states offer residents generous incentives for donating money to their state's program, there are also many other great options available to save money for college education. You can look at prepaid tuition rates through various companies or you can even use your employer’s education assistance program (EAP) to save for college.

There are two types of 529 plans:

  • Prepaid Tuition Plans
  • College Savings Plans.

Here is a brief description of each type:

  • Prepaid Tuition Plan – allows the investor/plan owner to lock in tuition rates, meaning that any school within the state (and sometimes outside) will charge the current price and all future charges remain locked at that rate. This means that if your child decides to go here instead there is no need to renegotiate costs as they didn't change from when you first opened your account. Prepaid plans work best with younger children as those who have already finished their K-12 education are usually already behind in their college education.
  • College Savings Plan – lets the investor/plan owner invest any amount of money, not just a lump sum payment. This is an individual investment where you control the account and only name the 529 beneficiaries, which can be changed at any time (useful if your children decide to attend different schools or don’t want to go into higher education). You can also transfer investments between plans (personal contributions are eligible for rollover up to five times per year, while non-rollover transactions are limited to one per 12 month period). This allows investors more freedom.

The contribution limit for both College Savings Plans and Prepaid Tuition plan is $14,000 per year; parents should note that the limit is per beneficiary. If two children are going to college at the same time, you can contribute up to $14,000 for each one of them. 529 plans usually have a limited number of investment options and fee structures, but there are other types of accounts that allow more freedom in choosing your investments.

529 Education Savings Plans – also referred to as “age-weighted” plans – work by using a special formula that takes into account both age and years until enrollment (in case you need it at a later date). The older your child the higher rate of return on this plan; if your child gets sick or simply doesn't want to use it after high school – you get all the money back.

Coverdell Education Savings accounts are another great option for parents who want to save money but don’t have the full $14,000 per year to contribute. The contribution limit is much lower at $2,000 per year and it works best with parents who know their child wants a college education in the future. It can be combined with 529 plans to give you all the options you need when saving for your children's future.

If you are not sure what program will work best for you, consult your financial advisor. There are many programs available so make sure you do some research before committing yourself to anyone plan type.

One of the great things about 529 plans (apart from the tax benefits) is that you can change your investments as often as you wish. If you have a prepaid plan and suddenly realize that it will just cost too much to send your child there, then changing over to a College Savings Plan should lower costs significantly.

Remember that 529s are not just for higher education – any type of post-secondary schooling qualifies so if your child decides on trade school or college later in life – go ahead and sign up! It’s never too late to start saving.

529 plans are great tools for parents who want to help their children or grandchildren with paying for a future education without breaking the bank. Even though they don’t work exactly like educational IRAs, they are still tax-advantaged way of saving for the future.

Don’t wait any longer – visit your state government website to see if they offer 529 plans and start saving today!

The ideal 529 plans for your children will depend on your state's tax deductions for 529 plans.

529 Tax Deduction – Everything That You Should Know

For your convenience, we have compiled all the information about the 529 tax deduction. Let’s get started!

529 Investing Accounts

The sooner you invest, the higher the potential return. Your 529 plan is more like a 401(k) than a savings account. Many of the concepts apply to a 529 as they do to a 401(k). Establishing the funds when kids are young helps enhance the tax benefits.

Tax-Free Growth In 529 Plans

The guidelines for using 529 cash allow you to pay for student internet access as well as tuition. The Secure Act of 2019 has made it simpler to use money from a 529 plan. It allows 529 recipients to return up to $10,000 in student loans. The law also allows borrowers to use 529 funds to pay for homeschooling, apprenticeships, and private education.

No Federal 529 Tax Breaks

While 529s and 401(k)s are similar, the tax benefits and rules differ. Apart from a 401(k), you cannot deduct contributions to a 529 plan from your federal income tax. While some 401(k) and IRA plans allow pretax retirement savings, 529 plans do not.

Seek 529 Tax Breaks Elsewhere

Some states do not offer any 529 state tax deductions. Like Texas and Florida, other states do not have a state tax, so you can not lessen your tax burden.

If filing a state 529 government tax subsidy won't save you much, shopping for retirement accounts outside your state can be a good idea.

Some States Provide 529 Tax Deductions

However, you may be able to claim 529 advantages on your local tax form. Many states offer a 529 tax exemption or refund, allowing you to deduct your contributions and reduce your state income tax. That means having more money left for your child's education.

Plan For 529 Tax Deductions But Not Contribution Caps

Consider the 529 contribution restrictions while selecting a plan. The IRS states that contributions can not exceed the student beneficiary's eligible educational expenses. Aim for a maximum annual 529 contribution of $14,000. Surplus 529 contributions may be subject to an IRS gift tax.

Bottom Line

Whatever you plan to assist your child in paying for college, educational tax credits and deductions can help. Finding out about tax breaks that can help your child afford college is part of calculating how much to save.


What is a 529 plan?

529 plans are types of investment or savings accounts that you can use for college tuition. If the account holder qualifies, then up to $14000 in contributions per year can be deducted from state income tax when filing.

Can anyone open up a 529 account?

You do not have to be related to someone in order to set up an account for them. You can even set one up anonymously if you so wish. Please note that the beneficiary must still meet residency criteria in your state - they cannot be considered residents of any other states besides yours when making this contribution for it to qualify as deductible on your state taxes.

Are there any fees associated with setting up and maintaining a 529 plan?

There may be a fee to set up a 529 plan, but there are no fees or minimums that you have to maintain in order for the account to remain open. The only way you will have any fees at all is if your child makes a withdrawal from their 529 plan and they do not attend college. In this case, the IRS may charge a 10% federal tax penalty on anything over what they use towards out-of-state colleges (this is waived if certain instances of extreme financial hardship apply).

What can I expect my return on investment with 529 plans?

The rates of return vary depending on which state 529 Plan your money goes into. You can choose your state's plan or an out-of-state one; some plans offer as high as a 7% rate of return while others offer as low as 2%.

What are some examples of colleges that I can use money from a 529 plan towards?

You can put money into a 529 savings account and it will only be able to be used for college tuition and fees, room and board, books and supplies, transportation expenses, etc. Please keep in mind that any withdrawals made from the funds MUST ONLY be used to pay for college - this is what qualifies this as an exempt 529 plan.