529 plan gifts may be deductible on state income tax returns

October 20, 2020

Friends and family might consider giving the gift of college instead of traditional holiday and birthday presents. According to a recent study from Fidelity, 84% of parents would welcome a gift of college savings in place of traditional gifts. As an added bonus, the gift giver may qualify for a state income tax deduction or credit based on the 529 plan contributions.

One of the most effective ways to help a child save for college is by funding a 529 plan. Investments in a 529 plan grow tax-free and will not be taxed when the beneficiary uses the money for college.

A key question is whether grandparents and other friends and family should contribute to a child’s existing 529 plan or open a new 529 plan account. Each option has advantages and disadvantages.

The 529 plan account owner retains control of the 529 plan funds

One benefit of 529 plan ownership is that the 529 plan account owner has legal rights to funds throughout the life of the account, and makes all decisions regarding investment selection and distributions. This differs from a custodial bank or brokerage account under UGMA/UTMA, where the beneficiary generally takes control of the assets when he or she reaches legal age.

As the account owner, you can be confident that the 529 plan gift will be used for its intended purpose of paying for college. The 529 plan account owner may also take back the funds at any time, although non-qualified distributions will be subject to income tax and a 10% penalty on the earnings.

A 529 plan gift could affect financial aid eligibility

When a 529 plan is owned by a dependent student or the student’s parent, it is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA) and distributions are ignored. Parent assets reduce aid eligibility by up to a maximum of 5.64% of the asset’s value.

Assets held in a 529 plan owned by a grandparent, aunt, uncle, non-custodial parent (if the parents are divorced) or anyone else are not reported as an asset on the FAFSA. But, distributions will count as untaxed income to the beneficiary, which reduces aid eligibility by up to half of the distribution amount. For example, a $12,000 withdrawal from a grandparent-owned 529 plan to help a grandchild pay for college can reduce the grandchild’s need-based financial aid package by $6,000.

Gift givers can consider one of the following workarounds to avoid the negative impact on financial aid eligibility:

If the 529 plan allows, change ownership to the child’s parent.
After the FAFSA is filed, roll over a year’s worth of funds to a parent-owned 529 plan, and withdraw the funds from the parent-owned 529 plan before the next FAFSA is filed.
Wait until after January 1 of the student’s sophomore year of college to take a distribution, if the student will be graduating in four years. The FAFSA looks at income from two years prior, so there should be no subsequent FAFSA to report the distribution. If the student will graduate in five years, wait until January 1 of their junior year to take the distribution.
Wait until the student graduates from college and help them pay down their student loan debt. Up to $10,000 in student loan payments are considered qualified distributions from 529 plans.

529 plan contributions may be state tax deductible

Residents of over 30 states may qualify for a state income tax deduction or credit for 529 plan contributions. In most of these states, anyone who contributes to a 529 plan is eligible for the tax benefit, but the 10 states listed below only allow the 529 plan account owner (or the owner’s spouse) to claim a tax benefit. With the exception of six states, taxpayers generally have until December 31 to make a qualifying contribution.

State	529 Plan State Income Tax Deduction Ownership Rules
District of Columbia	DC taxpayers are eligible to deduct up to $4,000 (and $8,000 married filing jointly) of contributions to a DC 529 plan account they own. Married or domestic partners may each deduct up to $4,000 for contributions to 529 plan accounts they own. Contributions above $4,000 may be carried forward five years or until the total contributions have been deducted. The deduction is per taxpayer, not per beneficiary nor per account
Iowa	Iowa taxpayers are eligible to deduct up to $3,474 of contributions made in in 2021 per beneficiary to an Iowa 529 plan account they own, including rollovers. Married couples may deduct up to $6,948 for contributions made in 2021 to 529 plan accounts they own.
Massachusetts	Massachusetts taxpayers are eligible to deduct up to $1,000 ($2,000 if married filing jointly) to Massachusetts 529 plan accounts they own.
Missouri	Missouri taxpayers are eligible to deduct up to $8,000 ($16,000 if married filing jointly) for contributions to any state’s 529 plan account they own.
Montana	Montana taxpayers are eligible to deduct up to $3,000 ($6,000 if married filing jointly) for contributions to any state’s 529 plan account they own.
Nebraska	Nebraska taxpayers are eligible to deduct up to $10,000 ($5,000 for married taxpayers filing separate returns) for contributions to Nebraska 529 plan accounts they own.
New York	New York taxpayers are eligible to deduct up to $5,000 ($10,000 if married filing jointly) for contributions to New York 529 plan accounts they own. The account owner may take a deduction for contributions made by their spouse.
Rhode Island	Rhode Island taxpayers are eligible to deduct up to $500 ($1,000 if married filing jointly) for contributions to Rhode Island 529 plan accounts they own. Contributions beyond the deduction limit may be carried forward for an unlimited number of years
Utah	Utah taxpayers are eligible for a 5% state income tax credit for contributions up to $2,070 individual ($4,140 if married filing jointly) to Utah 529 plan accounts they own. Account owners may also receive state income tax benefits for 529 plan contributions made by a third party.
Virginia	Virginia taxpayers are eligible to deduct up to $4,000 per Virginia529 account they own, or the or the amount contributed to each account, whichever is less, with an unlimited carryforward until the total contributions have been deducted. Contributions from non-account owners will be deemed as made by the account owner for the state income tax deduction. Contributions beyond the deduction limit may be carried forward for an unlimited number of years. Contributions are fully deductible in the year of contribution for taxpayers at least 70 years of age.