Like 529 plans sponsored by other states, California's
state-sponsored 529 plan can offer tax-advantaged growth as well as a way to potentially shrink your estate for federal tax purposes.
While contributions to California's plan are not deductible at the state or federal level, all investment growth is free from state and federal taxes, and the earnings portion of withdrawals used for qualified education expenses are federal and California state income tax-free. (Note that contributions to some states' plans can be state tax deductible for residents of those states.)
As with other
529 plans, under the California 529 plan individuals can contribute up to a certain amount per year per beneficiary without triggering any federal gift taxes or using any of your lifetime gift tax exclusion amount. You may also step up your giving by making five years' worth of contributions per beneficiary in one year without using your lifetime gift tax exemption. But if you do, you won't be able to make additional annual tax-free gifts to the beneficiary for five years unless the gift tax exclusion amount increases during that time or you use some of your lifetime gift tax exemption. To learn more, refer to the
Annual Limits Guide (PDF).
— Richard Polimeni, head of Education Savings Programs, Bank of America
Since California doesn't provide a tax deduction for contributions to 529 accounts, California residents can invest in any state's 529 plan and still benefit from potential tax-advantage growth. However, if you are not a California resident you should consider
whether your home state offers state tax benefits for investing in that plan. You can make withdrawals free from federal — and possibly state and/or local — income taxes to pay for qualified higher education
expensesFootnote 1 for the beneficiary. Qualified expenses include the following:
- Tuition and fees
- Certain room and board expenses for beneficiaries enrolled at least half-time
- Books, supplies and equipment required for the enrollment or attendance of the beneficiary at an eligible educational institution
- Certain expenses for special needs beneficiaries incurred in connection with enrollment or attendance at any accredited school, including certain public or private universities, graduate schools, community colleges and accredited vocational and technical schools
- Computers or peripheral equipment, computer software or internet access and related services if used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution
- Up to $10,000 per year per beneficiary to help pay for tuition in connection with enrollment or attendance at an eligible elementary or secondary public, private or religious school. Note: California does not consider withdrawals for elementary and secondary tuition as a qualified expense and, therefore, the earnings portion of such withdrawals are subject to California state income tax and a 2.5% additional income tax.
- Expenses for fees, books, supplies and equipment required for the participation of a designated beneficiary in a registered and certified apprenticeship program
- Payment of student loans up to a lifetime maximum of $10,000 for a designated beneficiary or sibling of the beneficiary (the lifetime maximum is applied separately for the sibling's loans versus the designated beneficiary's loans)
- For accounts meeting certain eligibility requirements, 529 assets (including earnings) may be rolled over into a Roth IRA for the beneficiary federal income tax-free, subject to certain limits. Note: California does not consider amounts rolled over to a Roth IRA as a qualified expense and, therefore, the earnings portion of such withdrawals are subject to California state income tax and a 2.5% additional income tax.
If you use funds from a California 529 plan account for non-qualified purposes, the earnings portion of withdrawals will be taxed as ordinary income and may be subject to a 10% additional federal tax as well as a 2.5% additional income tax in California.
You can open a 529 plan account and name as beneficiary your child, your grandchild, yourself or even someone outside your family. Once the account balance in a California 529 plan account (or the total of all California accounts for one beneficiary) reaches $529,000, you can't make any further contributions — though the account balance can continue to increase thereafter through investment growth.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Footnote
To be eligible for favorable tax treatment afforded to the earnings portion of a withdrawal from a section 529 account, such withdrawal must be used for "qualified higher education expenses," as defined in the Internal Revenue Code. The earnings portion of a withdrawal that is not used for such expenses is subject to federal income tax and may be subject to a 10% additional federal tax, as well as applicable state and local income taxes. The additional tax is waived under certain circumstances. Qualified higher education expenses include tuition, fees, books, supplies and equipment required for enrollment or attendance of the beneficiary at an eligible educational institution; certain room and board expenses; special needs services incurred in connection with enrollment or attendance at an eligible educational institution; and computers or peripheral equipment, computer software, or internet access and related services that are to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution. The beneficiary must be attending an eligible educational institution at least half time for room and board to be considered a qualified higher education expense, subject to limitations. Institutions must be eligible to participate in federal student financial aid programs. Some foreign institutions are eligible. You can also take a federal income tax-free distribution from a 529 account of up to $10,000 per calendar year per beneficiary from all 529 accounts to help pay for tuition at an elementary or secondary public, private or religious school. Qualified higher education expenses include expenses for fees, books, supplies and equipment required for the participation of a beneficiary in an apprenticeship program registered and certified with the Secretary of Labor under the National Apprenticeship Act and amounts paid as principal or interest on any qualified education loans of the beneficiary or sibling of the beneficiary, up to a lifetime maximum of $10,000 per individual. Distributions with respect to the loans of a sibling of the beneficiary will count toward the lifetime limit of the sibling, not the beneficiary. Such repayments may impact student loan interest deductibility. State tax treatment may vary for distributions to pay for tuition in connection with enrollment or attendance at an elementary or secondary public, private or religious school; apprenticeship expenses; and payment of qualified education loans.
Before you invest in a Section 529 plan, request the plan's official statement from your Merrill Financial Solutions Advisor and read it carefully. The official statement contains more complete information, including investment objectives, charges, expenses and risks of investing in the plan, which you should carefully consider before investing. You should also consider whether your home state or your designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds and protection from creditors that are available only for investments in such state's 529 plan. Section 529 plans are not guaranteed by any state or federal agency.
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