Tax Benefits of 529s
In addition to the obvious benefit of having money available for your student's college education, Section 529 plans offer tax relief as well. Since it took effect in January of 2002, the Tax Relief Act of 2001 has made Section 529 plans very appealing to many people looking for ways to pay for a college education, whether a child's or their own. Not only are there tax benefits on the account's interest (earnings), there also may be benefits on the money you put into the account (contributions), and money you take out (distributions).
As of January 1, 2002, all of the earnings from a Section 529 plan account are exempt from federal tax, as long as they are eventually withdrawn for the exclusive use of paying for qualified education expenses. This means that unlike the taxes an investor is normally required to pay on earnings from most types of investments, no taxes are paid on the interest earned by money invested in a Section 529 plan. This holds true unless you withdraw the money for uses other than your student's higher education. Section 529 plan earnings are currently tax-deferred in nearly all states as well, meaning you don't pay taxes on the money as long as it is in a 529. Ask your Section 529 provider if your state gives these tax deferrals.
The assets in a Section 529 plan belong to the owner of the plan, not to the student beneficiary. If a parent is the owner of the plan, then the assets must be reported on the FAFSA. If someone other than the parent or student is the owner of the plan, it should not be reported as an asset of either the parent or student on the FAFSA.
Contributions and Distributions
A tax break on your Section 529 earnings is only one of the tax advantages that comes with using these plans. Section 529 contributions are not pretaxed, meaning you do not pay state or federal tax on money deposited into an account. Some states also allow you to deduct a set portion of your contributions from state tax. Again, ask your 529 provider about what your state's particular policies are before you start counting on receiving these exemptions.
Generally, distributions (withdrawals) are also tax-free, as long as you don't take out more than the amount equal to the beneficiary's adjusted qualified tuition expenses. Anything above and beyond that amount will be taxed.