529 plans were added to the Internal Revenue Code in 1996 to authorize federal tax-free status of state college savings plans. Federal tax benefits of 529 plans include tax-deferred investment growth, tax-free distributions for qualified education expenses including up to $10,000 in K-12 tuition and tax-free 529 plan rollovers. However, some states do not fully conform with the federal laws regarding 529 plans.
Federal taxation of 529 plan distributions
529 plan distributions are exempt from federal income tax when the funds are used to pay for qualified higher education expenses. This includes tuition, fees, books, supplies, special needs equipment, computers, internet access and room and board when the student is enrolled at least half time and pursuing a degree or certificate program.
The Tax Cuts and Jobs Act of 2017 expanded the definition of qualified higher education expenses to include up to $10,000 in K-12 tuition per year, per beneficiary.
Non-qualified 529 plan distributions are subject to income tax and a 10% penalty on the earnings portion of the withdrawal. Each distribution from a 529 plan contains a prorated portion of earnings and principal.
There are some exceptions to the penalty tax, such as when the beneficiary gets a scholarship, attends a U.S. Military Academy, receives educational assistance through a qualifying employer program, becomes disabled or dies.
529 plan account owners may lower their potential tax liability by making distributions payable to the beneficiary. If there are any non-qualified distributions to report, the earnings will be taxed at the beneficiary’s lower tax rate.
State taxation of 529 plan distributions
In most cases, qualified 529 plan distributions are also exempt from state income tax. However, some states have unique rules regarding taxation of 529 plan distributions:
- In Alabama, distributions from an out-of-state 529 plan are considered non-qualified. For Alabama state income tax purposes, the full amount of a non-qualified distribution, plus 10% of the amount of the distribution must be added back to the contributing taxpayer's income.
- California imposes an additional 2.5% penalty tax on non-qualified distributions.
- Georgia requires that earnings from non-qualified distributions be reported on the account owner’s (not the beneficiary’s) Georgia income tax return.
- In Montana, non-qualified 529 plan distributions within 3 years of the account opening are taxed at Montana’s highest marginal income tax rate.
529 plan distributions used to pay for K-12 tuition
Changes to the federal tax code effective starting in 2018 expanded the definition of qualified higher education expenses to include up to $10,000 per year tuition at eligible K-12 schools.
However, not all states conform to the new federal tax law. As of the date of this publication, 529 plan distributions used to pay for K-12 tuition are considered non-qualified in 13 states and the earnings portion of the withdrawal is subject to state income tax. Nine of these states offer a state income tax deduction for 529 plan contributions (Vermont offers a tax credit), which is subject to recapture if funds are withdrawn to pay for K-12 tuition.
529 plan rollovers
Funds may be transferred from one 529 plan to another 529 plan for the same beneficiary without federal tax consequences, as long as the rollover is completed within 60 days of the distribution. 529 plan rollovers can be completed once every 12 months for the same beneficiary.
But, only a few states conform to the federal tax treatment of 529 plan rollovers. In most states, distributions used to fund another state’s 529 plan are considered non-qualified and subject to state income taxes on the earnings portion of the distribution. In these states, if the 529 plan account owner previously claimed a state income tax deduction or credit, the state income tax benefits attributable to the outbound rollover will also be subject to recapture.
States that fully conform to 529 plan federal tax laws
Twenty states follow the federal tax treatment for 529 plan distributions, conform to the federal definition of qualified higher education expenses (including up to $10,000 in K-12 tuition) and allow tax-free outbound 529 plan rollovers.
· New Hampshire
· New Jersey
· North Carolina
· North Dakota
· South Dakota
· West Virginia
Taxation of qualified distributions
Are K-12 distributions exempt from state tax?
Are outbound rollovers subject to recapture?
Non-qualified withdrawals plus 10% of the amount of the non-qualified withdrawal is included in Alabama income tax; Alabama does not exempt distributions from non-Alabama 529 plans
2.5% California penalty tax on non-qualified distributions
YES, outbound rollovers within 2 years of opening account are subject to recapture
Earnings from non-qualified distributions must be reported on the account owner’s, (not the beneficiary’s) Georgia income tax return
Must be an Iowa K-12 school or accredited under Iowa Code Section 256.11
Only through START K12
Distributions taken within 3 years of opening the 529 account taxed at the highest marginal Montana tax rate
YES, outbound rollovers made within 12 months of the date of contribution are subject to recapture
YES, outbound rollovers are subject to recapture in the 2 taxable years following the year of an income tax benefit claimed
Distributions taken within 365 days of a contribution must be added back to Wisconsin taxable income if previously deducted.