The income tax benefits offered by 529 plans
make these plans attractive to parents (and others) who are saving for college
or K-12 tuition. Qualified withdrawals from a 529 plan are tax free at the
federal level, and some states also offer tax breaks to their residents. It's
important to evaluate the federal and state tax consequences of plan
withdrawals and contributions before you invest in a 529 plan.

Federal income tax treatment of qualified
withdrawals

There are two types of 529 plans — savings plans and prepaid tuition plans. The
federal income tax treatment of these plans is identical. Your contributions
accumulate tax deferred, which means that you don't pay income taxes on the
earnings each year. Then, if you withdraw funds to pay the beneficiary's
qualified education expenses, the earnings portion of your withdrawal is free
from federal income tax. This feature presents a significant opportunity to
help you accumulate funds for college.

Qualified education expenses for 529 savings plans
include the full cost of tuition, fees, room and board, books, equipment, and
computers for college and graduate school, plus K-12 tuition expenses for
enrollment at an elementary or secondary public, private, or religious school
up to $10,000 per year.

Qualified education expenses for 529 prepaid tuition
plans generally include tuition and fees for college only (not graduate school)
at the colleges that participate in the plan.

State income tax treatment of qualified withdrawals

States differ in the 529 plan tax benefits they offer to their residents. For
example, some states may offer no tax benefits, while others may exempt
earnings on qualified withdrawals from state income tax and/or offer a
deduction for contributions. However, keep in mind that states may limit their
tax benefits to individuals who participate in the in-state 529 plan.

You should look to your own state's laws to determine the
income tax treatment of contributions and withdrawals. In general, you won't be
required to pay income taxes to another state simply because you opened a 529
account in that state. But you'll probably be taxed in your state of residency
on the earnings distributed by your 529 plan (whatever state sponsored it) if
the withdrawal in not used to pay the beneficiary's qualified educations
expenses.

529 account owners who are interested in making K-12
contributions or withdrawals should understand their state's rules regarding
how K-12 funds will be treated for tax purposes. States may not follow the
federal tax treatment.

Income tax treatment of nonqualified withdrawals (federal
and state)

If you make a nonqualified withdrawal (i.e., one not used for qualified
education expenses), the earnings portion of the distribution will usually be
taxable on your federal (and probably state) income tax return in the year of
the distribution. The earnings are usually taxed at the rate of the person who
receives the distribution (known as the distributee). In most cases, the
account owner will be the distributee. Some plans specify who the distributee
is, while others may allow you (as the account owner) to determine the
recipient of a nonqualified withdrawal.

You'll also pay a federal 10% penalty on the earnings
portion of the nonqualified withdrawal. There are a couple of exceptions,
though. The penalty is generally waived if you terminate the 529 account
because the beneficiary has died or become disabled, or if you withdraw funds
not needed for college because the beneficiary has received a scholarship. A
state penalty may also apply.

Deducting your contributions to a 529 plan

Unfortunately, you can't claim a federal income tax deduction for your
contributions to a 529 plan. Depending on where you live, though, you may
qualify for a deduction on your state income tax return. A number of states
offer a state income tax deduction for contributions to a 529 plan. Again, keep
in mind that most states let you claim an income tax deduction on your state
tax return only if you contribute to your own state's 529 plan.

Many states that offer a deduction for contributions
impose a deduction cap, or limitation, on the amount of the deduction. For
example, if you contribute $10,000 to your child's 529 plan this year, your
state might allow you to deduct only $4,000 on your state income tax return.
Check the details of your 529 plan and the tax laws of your state to learn
whether your state imposes a deduction cap.

Also, if you're planning to claim a state income tax
deduction for your contributions, you should learn whether your state applies
income recapture rules to 529 plans. Income recapture means that deductions
allowed in one year may be required to be reported as taxable income if you
make a nonqualified withdrawal from the 529 plan in a later year. Again, check
the laws of your state for details.

Coordination with Coverdell account and education tax
credits

You can fund a Coverdell education savings account and a 529 account in the
same year for the same beneficiary without triggering a penalty.

You can also claim an education tax credit (American
Opportunity credit or Lifetime Learning credit) in the same year you withdraw
funds from a 529 plan to pay for qualified education expenses. But your 529
plan withdrawal will not be completely tax free on your federal income tax
return if it's used to cover the same education expenses that you are using to
qualify for an education credit. (When calculating the amount of your qualified
education expenses for purposes of your 529 withdrawal, you'll have to reduce
your qualified expenses figure by any expenses used to compute the education
tax credit.)

Note: Before investing in a 529 plan, please consider the
investment objectives, risks, charges, and expenses carefully. The official
disclosure statements and applicable prospectuses - which contain this and
other information about the investment options, underlying investments, and
investment company - can be obtained by contacting your financial professional.
You should read these materials carefully before investing. As with other
investments, there are generally fees and expenses associated with
participation in a 529 plan. There is also the risk that the investments may
lose money or not perform well enough to cover college costs as anticipated.
Investment earnings accumulate on a tax-deferred basis, and withdrawals are
tax-free as long as they are used for qualified higher-education expenses. For
withdrawals not used for qualified higher-education expenses, earnings may be
subject to taxation as ordinary income and possibly a 10% federal income tax
penalty. The tax implications of a 529 plan should be discussed with your legal
and/or tax advisors because they can vary significantly from state to state.
Also be aware that most states offer their own 529 plans, which may provide
advantages and benefits exclusively for their residents and taxpayers. These
other state benefits may include financial aid, scholarship funds, and
protection from creditors.

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