Please ensure Javascript is enabled for purposes of website accessibility

Watch Out: 529 College Savings Plans Can Bite You at Tax Time

By Amanda Alix – Mar 22, 2014 at 9:00AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

While 529 plans are a great way to save for college, complicated tax rules can dull their benefits

Source: Flickr / RCB.

As a long-range savings plan for college expenses, 529 plans are hard to beat. Since their inception back in 1996, these plans have been gaining in popularity, and contributions from 2012 to 2013 saw the average account grow by nearly $2,500, to well over $19,000.

These plans, which are set up and run by individual states, have both tax benefits and pitfalls. While money invested in a 529 account is not tax-deductible, the earnings on that money grows tax-free – and usually remains so as long as it is withdrawn to pay qualified educational expenses. This last part, along with a few other confusing issues regarding these plans, must be thoroughly understood if you are to avoid unexpected tax and penalties.

Without further ado, here are a few possible disadvantages associated with 529 plans that should be considered before setting up one of these accounts.

American Opportunity Tax Credit
If you use money from a 529 account to pay educational expenses, you probably won't be able to claim this credit. Why not? Simply put, the government won't let you take a tax break twice – once on the tax-free earnings distribution portion of the 529 withdrawal, and then, again, with the AOTC.

Missing out on this benefit would be a shame. The credit could be worth a total of $2,500 in credits, and up to $1,000 of the credit can actually be refunded to you if you owe no tax in that particular year.

"Qualified" expenses only
Making a mistake regarding which college expenses are allowed and which are not can cost you dearly. For example, using funds from a 529 to pay for computer equipment is now not considered a qualified expense unless the purchase is a requirement for enrollment. Housing expenses can also be tricky, as they are decided by the college or university, not the IRS. Using 529 funds incorrectly will subject the earnings portion of the disbursement to taxes – as well as a 10% penalty.

This same problem crops up after the 529 account has outlived its usefulness, as well, and many super-savers find themselves facing these same penalties when the family's last child graduates from college – with money remaining in the account.

For large contributions, gift taxes may apply
If a contributor to a 529 account wants to make a large donation to the fund, gift taxes on the giver kick in for any amount over $14,000. Remember that any other gifts bestowed during the tax year count toward this limit, something to which grandparents might want to pay particular attention.

None of the above means that 529 college plans are not worthwhile savings vehicles, of course, but you should understand the details of this particular product before jumping in – just as you would any other investment. There are tax benefits to 529 plans, particularly at the state level – with at least 30 states allowing some type of deduction if you own a 529 account.

Another bonus is that 529 plan fees, which have been high in the past, have been dropping, a trend expected to continue this year. Once you consider all the pros and cons of these accounts, you may find that a 529 college savings plan fits your family's needs very nicely.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.