529 Basics – Part II of V (Taxes)

Welcome back to Your Money.  Today we’ll talk taxes – our second topic in a series of five on 529 plans. 

But first, I wanted to let you know that NASD, formerly known as the National Association of Securities Dealers, has issued an investor alert on stock spam emails.  The alert advises that these emails may be part of pump and dump schemes.  The bottom line with these unsolicited emails: delete them.  The title of the alert is “I hope this is your email” Scam Offers No Hope of Profits” and you can find it on NASD’s website at nasd.com. 

Now back to 529 plans.  You may have heard that 529 plans offer college savers special tax benefits.  And they do.  Here’s how.  Earnings in 529 plans are not subject to federal tax, and, in most cases, state tax – as long as withdrawals are used for qualified higher education expenses.  What’s a qualified higher education expenses?  Think: Tuition and room and board and similar expenses.  What’s actually covered and what’s not varies may vary by plan –although no plans I know of cover college sweatshirts or junk fund yet.  If you’re not sure whether a plan covers a particular college expense, grab the plan’s disclosure document and look it up. 

What happens if you don’t use the money for an eligible expense?  You guessed it.  In most cases, you’ll pay taxes – income tax and, ouch, a 10% federal tax penalty on earnings.  There are some exceptions.  If young Einstein gets a scholarship, for example, the federal penalty like won’t apply.  

The federal tax benefits of 529 plans have gotten a lot of attention lately because of the Pension Protection Act of 2006, which made the federal tax treatment I’ve been discussing permanent.  Previously, those benefits – and tax free withdrawals – were set to expire beginning in 2011. 

But state tax benefits for 529 plans also are an important consideration.  In fact, many states offer state income tax, or other benefits, such as matching grants, for investment in a 529 plan.  But you may only be eligible for these benefits if you participate in a 529 plan sponsored by your state of residence. 

So you want to make an informed decision about picking a 529 plan?  The first step is easy.  Investigate your home state’s plan. 

We’ll talk about additional considerations for picking a plan next time.  Thanks for listening.  Your Money is brought to you by the Securities and Exchange Commission.  Write us at podcast@sec.gov.