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3 Tax Time Tips for College Savers

Reyna Gobel

Most states require that contributions to a 529 plan be made before the end of the year to get a state income tax deduction or credit for that year. However, College Savings Plan Network Chairman Michael Fitzgerald says five states allow filers to count contributions made to these tax-advantaged college investment accounts up to April 15: Georgia, Mississippi, Oklahoma, Oregon and South Carolina.

Whether parents live in one of these states or not, tax season is a great time to review both this year's and future years' federal and state income tax strategy for college savings.

[Explore 10 ways to save on college costs.]

1. Explore federal and state income taxes on savings account interest: Federal and state income taxes are charged on savings account interest and investment account earnings as you file, Fitzgerald says. If part of this is college savings for an immediate family member, part of this tax could be reduced.

The college savings portion could be growing tax-free in a 529 plan, he says. If $4,000 were in an investment account that earned 12 percent, its earnings, $480, would be taxed. However, if this same amount was stashed in a 529 plan account to be used for educational spending at a later date, the earnings wouldn't be taxed, he says.

That's just federal tax benefits - consider state income taxes too. Idaho parents Marty Lindgren and his wife have invested in Idaho's IDeal 529 plan for more than 10 years for their children, now 20 and 16 years old.

"It's nice at tax time to see 8 to 9 percent of 529 plan funds come back to us," he says. His family contributes up to the maximum for Idaho's 529 plan income tax deduction: $8,000. With 8 percent earnings, they would get a refund of or reduce their tax bill by $640.

Since Idaho doesn't allow contributions made up to April 15 for the past tax year, Lindgren suggests using this time of a year to consider changes for next year's contributions.

[Get more information about the benefits of 529s.]

2. Consider the tax implications of required individual retirement account distributions: It's widely thought that the 529 plan tax benefits are for seniors who can afford to give a maximum of $14,000 to each grandchild, says Jeff Howkins, president of Sallie Mae's Upromise Inc. This is often thought of as part of an estate planning strategy.

However, seniors who are required to take distributions from their retirement accounts because they are at least 70 1/2 years old may not want to reinvest all the money in the stock market and be taxed on earnings, he says. They could give their grandchildren the amount they normally would give from other accounts from these retirement accounts instead.

For example, a grandmother with extra money beyond what's needed for her own expenses wants to invest in her grandchildren's education. Instead of depositing money into a savings account where her interest would be taxed, she deposits it in a 529 plan account. She isn't taxed on earnings and could get an income tax deduction or credit, depending on the state, Howkins says.

[Discover how grandparents can help save for college.]

3. Think about investing state and federal tax refunds in college savings: The average tax refund for tax year 2011 was $2,913. Use this year's refund to help pay for your children's' education, Howkins advises.

If a couple who received the average tax refund invested $2,913 in a 529 plan account, they could accumulate nearly $5,000 in 10 years, given 5 percent annual earnings. Plus, they could possibly deduct or get a tax credit for the contribution from their state.

If a couple did this every year for 10 years, they could accumulate more than $40,000 for their children's education.

Trying to fund your education? Get tips and more in the U.S. News Paying for College center.

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