Tax deductions for college savings?

Karin Price Mueller/The Star-Ledger  writes: Question:  When can I apply a state income tax deduction? When I enter money into a 529 account for my grandchild, or when I actually send the money to a college for my grandchild’s tuition?

Answer. Great question. You certainly don’t want to run afoul of the Internal Revenue Service.  The tax deduction for a 529 contribution is taken in the year that the contribution is made into the plan, which can be many years before the expenses are incurred for college, said Howard Hook, a certified financial planner and certified public accountant with EKS Associates in Princeton.

New Jersey isn’t among the states that offer a tax deduction for 529 plan contributions.

Still, 529 plans can be a terrific way to save for college.

In a normal investment account, interest, dividends and capital gains are subject to income taxes in the year the earnings are realized, said Bernie Kiely, a certified financial planner and certified public accountant with Kiely Capital Management in Morristown.

But in 529 plans, the money grows tax free and can be withdrawn tax free as long as it’s used for qualified education expenses.

Kiely said there are three players in a 529 plan: the owner of the account, the beneficiary and the successor owner.

The owner is the person who sets up the account and who is in control of the account, usually a parent or a grandparent.

The beneficiary is the person who will attend college, usually a child or grandchild — but it can be anybody, including you.

The successor owner obviously becomes the owner if the owner passes away or is otherwise incapacitated.

Because there is only one beneficiary for a 529 plan account, you must open a separate 529 accounts for each beneficiary, he said.

"With a 529 plan, the owner actually owns the account. The owner can change their mind and take the money back, subject to tax and a 10 percent penalty on the earnings," he said. "The owner can change the name of the beneficiary at any time."

So if the child gets a full scholarship to college, you can name another child as the beneficiary.

"A contribution made for the benefit of someone else is a gift subject to gift taxes and gift tax return requirements," Kiely said. "If you make a gift to someone of more than $14,000 in a year — $28,000 if it’s a joint gift from a husband and wife — you have to file a gift tax return and possibly pay a tax."

The $14,000 gift limit is called the annual gift tax exclusion, but Section 529 of the code makes an exception for this, too. You can contribute five years’ worth of annual gift tax exclusions in one year, said Kiely.

If the funds in a 529 plan are used to pay for qualified expenses, which include tuition, fees, books, supplies and more, the distributions are free of federal and New Jersey income tax.