Every December, Indiana parents Paul and Michelle Dumas contribute to their children's tax-advantaged college investment accounts, known as 529 plans. Other priorities tend to get in the way during the rest of the year. But at the end of the year, the couple remembers that they can't claim the 20 percent income tax credit Indiana offers unless the contribution is made by Dec. 31.
"The tax advantages are the biggest advantages of 529 plans because there's nothing else unique about 529 plans," Paul Dumas says. He can buy a mutual fund without putting it in a college savings plan but he can't score state tax incentives or federal income tax-free earnings.
Families considering making end-of-the-year 529 plan contributions need to make sure they know the answers to the following questions first.
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1. Do contributions need to be postmarked by or received by Dec. 31? In Indiana, contributions must be received by Dec. 31 in order to qualify for the current year's income tax credit, says Jodi Golden, executive director of the Indiana Education Savings Authority.
Other states may only require that contributions be postmarked by that date, says Jerry Love, a Texas-based personal financial specialist and certified public accountant. Families can find out what their state requires by going to the state's treasury website.
For states that require a postmarked date, Love says not to drop the check in the mailbox. Instead, go to the post office and get a certified mail receipt – that will give you both proof that it was sent and the name of the person who received it.
Also, remember that mail is slower this time of year. If receipt is required by a specific date, mail it a couple of extra days early to give the check time to arrive.
If you're sending a payment electronically, experts recommend checking the day the electronic transfer is supposed to complete. It doesn't matter if you clicked on Dec. 31 if it wasn't actually sent on that date.
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2. Are there limits for tax deductions or credits? Each state sets its own limit on how much of a contribution qualifies for the tax benefit. For example, Indiana's contribution limit for the tax incentive is $5,000 for single individuals or married couples filing jointly, Golden says. Married couples filing separately do not qualify, she says.
The 529 plan contribution limit for Alabama's tax deduction is $5,000 per person contributing, or $10,000 per married couple filing jointly. Illinois' contribution amount for its Bright Start plan is $10,000 per person and $20,000 per couple.
Additional contributions by one person will not have any effect on state income taxes. However, families won't pay federal taxes on the account's earnings on federal tax returns, unless they withdraw the funds for something besides allowed education expenses. Remember to check state rules on whether there's a requirement to contribute to specific 529 plans to save on income tax.
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3. Is the contribution affordable? Love cautions families to pay attention to how much they can afford instead of just maximizing deductions. It's easy for parents to become cash-poor because they contributed too much.
The penalty for taking out funds after contributing can be severe. Potential penalties include a 10 percent penalty from the IRS plus taxes on earnings as well as repaying the state income tax deduction and penalties.
4. Could family members also use the tax deduction? For relatives who haven't purchased Christmas presents just yet, a 529 plan contribution could bring a tax benefit. In some states, such as Indiana, anyone who contributes directly to a 529 plan qualifies for a tax deduction.
Paul and Michelle Dumas have thought about letting relatives who live in Indiana know about the 20 percent state tax credit they can get on their holiday college savings gifts to 6-year-old Jacob, 2-year-old Julia or their relatives' own children – something the gift-givers couldn't get if they bought a toy.