529 Plan Gifts May Be Deductible on State Income Tax Returns

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Kathryn Flynn

By Kathryn Flynn

November 22, 2023

With the costs of college education soaring, one impactful gift that friends and family members could consider is the gift of a college savings plan. According to a recent study from Fidelity, 84% of parents would welcome a gift of college savings instead 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. Whether or not the contributions will be deductible depends on the state of residence of the gift giver and to which state’s plan they are contributing. 

There are two ways that grandparents, relatives, and friends can give the gift of college savings. They can contribute to an existing 529 plan or open a new 529 plan account in their own names, with the child as the beneficiary. Each option carries its own set of tax benefits and implications. As we investigate this topic, we’ll explore these factors further to empower you to make informed decisions.

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

If you choose to make a gift by opening a new 529 plan, you will retain legal rights to the funds throughout the life of the account and make all decisions regarding investment selection and distributions. This differs from a custodial bank or brokerage account under UGMA/UTMA, where the beneficiary assumes control of the assets upon reaching legal age.

As a 529 account owner, you can ensure that the funds are used for their intended purpose, namely to cover the costs of college or other education expenses. As long as you withdraw the funds for qualified education expenses, you will not pay income taxes on the earnings. 

Another benefit of 529 plan ownership is that you can withdraw the funds for your own purposes at any time. The funds in the account belong to you. However, as per IRS guidelines, withdrawing funds for non-qualified purposes may result in income tax and a 10% penalty on the earnings.

Who owns the 529 plan could affect financial aid eligibility

If a dependent student or their parent owns the 529 plan, it’s considered an asset of the parent when applying for federal student aid through the Free Application for Federal Student Aid (FAFSA). This could decrease the eligibility for aid by as much as 5.64% of the plan’s value.

If a grandparent, aunt, uncle, or anyone else owns the plan, it is not reported as an asset on the FAFSA. For the 2024-25 FAFSA, which is in effect for the school year and beyond, qualified 529 plan distributions from accounts owned by grandparents and anyone else are not reported as income on the FAFSA. 

This is a big change from how FAFSA previously treated 529 plan withdrawals from a non-parental account. Under the old regulations, these were reported as untaxed student income, with 50% of the gift counted as available funds for college on the FAFSA. This change has made it more attractive for grandparents or others to consider opening their own 529 plan, as it will no longer negatively impact the student’s financial aid.

While the impact of a parent-owned 529 plan on financial aid is modest, with only 5.64% of the plan’s value counted on the FAFSA, the impact of a grandparent plan is zero under the new rules.

529 plan contributions may be state tax deductible

Contributions to 529 plans might be eligible for state income tax deductions. Over 30 states offer a state income tax deduction or credit for contributions to 529 plans. This tax benefit is typically available only for contributions to a 529 plan within the resident’s state. But states including Arizona, Arkansas, Kansas, Maine, Minnesota, Missouri, Montana, Ohio, and Pennsylvania extend this benefit to any 529 plan contributions.

At the time of publication, in seven states, only the account owner of the 529 plan can claim a state income tax deduction or credit: the District of Columbia, Iowa, Montana, Nebraska, New York, Virginia, and Utah. Of these, Utah and Virginia permit the 529 plan account owner to receive a state income tax deduction for contributions made by others. 

In all other states that provide a tax deduction for 529 contributions, anyone can claim the tax deduction, regardless of whether they are the account owner.

Taxpayers generally have until December 31, except for six states, to make a qualifying contribution. You can view a complete list of 529 tax deduction rules by state here.

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