College Taxes: Beware of 529 Plan Taxes

Ever hear about college taxes?

No this isn’t a joke. If you aren’t careful you could owe college taxes on your 529 plan.

Nobody tells you that you could ultimately owe taxes on a 529 college plan, but plenty of people discover this nightmare during tax season.

Before I get to the bad news, let me review why parents gravitate to 529 plans. Here are the three main reasons:

1. The money inside these college 529 plans grows tax free.
2. When you pull the cash from a 529 plan for college, taxes are usually not triggered.
3. Some states provide a 529 plan tax deduction for contributions.

All of that sounds good, so what’s the problem?

The tax-free 529 promise isn’t guaranteed. If you withdraw more from a college 529 plan than a student’s college expenses, you will owe income taxes on the surplus cash and a 10% withdrawal penalty.

Now you might be thinking that it would be easy to avoid pulling out more cash from a 529 plan than expenses.  But as I explain in a post I wrote on this topic last week for CBSMoneyWatch, a double-dipping rule can push parents into this tax trap:

Here’s the problem: The government will punish you if you try to claim the American Opportunity, Hope or Lifetime Learning education tax credits for the same expenses that you pay with the cash from your 529 plan or Coverdell Education Savings Account.

Why the double-dipping rule? You are already enjoying a tax benefit via Uncle Sam when you pull tax-free money out of a 529 or Coverdell. The government doesn’t want you to get yet another tax freebie for the same cash.

Because of the tax hazard, be sure you consult your tax preparer and read  IRS Publication 970: Tax Benefits for Education before you draw down your 529 plan or Coverdell account.