Paying college expenses is easier with prepaid tuition plans.
A qualified tuition plan, or 529 plan, is a long-term investment for parents or grandparents to gradually save for a child's college expenses. Prepaid college plans enable investors to lock in tuition rates for children well before they graduate high school. The federal government, along with most state governments, grant favorable tax treatment to these investments in education.
Contributions
Open a 529 plan for a child and make regular contributions to the fund. Choose an investment strategy, such as stock mutual funds or bonds. There are tax benefits on earnings, but you may not deduct these contributions on your income taxes. In fact, you may have to pay a gift tax on annual contributions that exceed the set limit. The IRS set the limit at $13,000 per year as of 2011.
Federal Tax Exemptions
The federal government does not impose taxes on any interest earned on investments through prepaid college plans. You must use the money to pay for qualifying college expenses for the named beneficiary. Qualifying expenses include tuition, books, college fees and computer technology designated for educational purposes. Some plans include funding for on-campus room and board as well. The government tax exemptions only apply to withdrawals from a 529 plan that go toward such expenses.
State Tax Exemptions
States sponsor prepaid college plans and encourage residents to invest in state colleges and universities. Some states make all qualified tuition plan earnings tax exempt, even those from out-of-state plans. Other states only give favorable tax treatment to plans for future students of home-state colleges. Still other states tax the earnings on all prepaid plans. Many states also tax certain transactions, such as rolling funds into a local plan from an out-of-state plan.
Tax Penalties
The funds from any 529 plan must go toward the qualifying college expenses of the student designated as the beneficiary in order to avoid federal taxes and tax penalties. The federal government taxes the earnings on these investments whenever benefactors make withdrawals from the funds for use in any other capacity. The IRS charges a 10 percent fee in addition to current income tax rates on the interest. States tax unqualified withdrawals in various ways.
Tags: college expenses, college plans, federal government, favorable treatment, from out-of-state, from plan