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Whether contributions to a 529 plan can be deducted from income for state tax purposes has been discussed and is documented in many places. However, I am interested in the California state tax treatment for 529 distributions that count as earnings, i.e., withdrawals above the amount that was originally invested.

Imagine that I invested $10,000 in a California 529 plan and make no more contributions. In 10 years it has grown to $16,000 and I withdrew all of it to pay for college for my child. Is the $6,000 taxable by the state?

More generally, does it depend on which state I am in? Does it depend on which state hosts the plan?

I need a reference or link to an authoritative source that answers this question.

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    The answer to this will be state-specific. Are you specifically asking about California, or did you just use that state as an example? – Ben Miller - Reinstate Monica Jun 29 '17 at 12:31
  • I am interested in California, but I thought that perhaps the rules were uniform across states, just as Treasury bond interest is exempt from state taxes regardless of state. – rlandster Jul 1 '17 at 13:48
  • Here's a quick question... if you're a California resident and choose an out-of-state 529 that offers a contribution benefit (e.g. tax-free contribution), can you make use of that? Or does that fact that you live and earn your income in California prevent that? – evolross Nov 15 '18 at 20:19
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This is from the (only) State Sponsored 529 program for California..

ScholarShare is a state-sponsored, tax-advantaged 529 college savings plan that’s helping families and individuals plan for the cost of higher education. It’s available to any citizen or tax payer. And just about anyone can help contribute including Grandparents, other family members and friends.

Federal Income Tax Benefits As a 529 Plan, ScholarShare offers unsurpassed income tax benefits. Although contributions are not deductible on your federal tax return, any investment earnings can grow tax-deferred, and distributions to pay for the beneficiary’s college costs come out federally tax-free.

State Income Tax Information In addition to federal tax benefits, there are state tax benefits as well. For ScholarShare, tax treatment is as follows: While contributions are not deductible for California income tax purposes, earnings accrue free of state income tax. Qualified Withdrawals and any outgoing rollovers free from federal income tax are also free from California income tax. California tax benefits related to ScholarShare are available only to California tax payers. You should talk to a qualified advisor about how California tax provisions affect your circumstances.

Estate Tax Planning Benefits There’s another tax advantage unique to the 529 plan. There’s no federal gift tax on contributions up to $15,000 per year for single filers and $30,000 for married filers. There’s even an option to gift amounts up to $75,000 for single filers and up to $150,000 for married filers if pro-rated over 5 years. This means you could make a one-time gift equivalent to the 5 year amount and it could all qualify for the federal gift tax exclusion. Consult your tax advisor.

  • This is as close to a definitive answer (for CA) as I have seen. As you note, the ScholarShare Initiative is the official 529 plan administrator for California so I think its tax information can be trusted; the above text can also be found here: scholarshare.com/plan/details.shtml – rlandster Jan 29 '18 at 4:47
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Well, just ask the IRS:

Q. What is the main advantage of a typical 529 plan?

A. Earnings are not subject to federal tax and generally not subject to state tax when used for the qualified education expenses of the designated beneficiary, such as tuition, fees, books, as well as room and board. Contributions to a 529 plan, however, are not deductible.

(emphasis mine).

And this site has more details:

Taxes on Non-Qualified Distributions

If you don’t use all of the distribution for qualified expenses, you have to include the portion of earnings not used for qualifying expenses as taxable income. For example, if your 529 plan has 85 percent contributions and 15 percent earnings and you take a non-qualified distribution of $1,000, $150 of that distribution is considered earnings and therefore is taxable income. If you use half of that distribution for qualified expenses, half the earnings, or $75, is taxable. Report the taxable income on line 21 of Form 1040.

Though this isn't directly about state taxes.


Added based on comments: I can't find anything definitive, but this site says:

Interest Not Taxed

Interest earned by a California 529 program is not taxed, but California is one of only of only six states with an income tax that does not give a deduction for 529 contributions. Contributions also are not deductible from federal income taxes. That's true whether the 529 plan is in California or another state. California also does not tax interest earned in another state's 529.

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    I saw that first quote, but the word "generally" makes me uneasy. – rlandster Jun 29 '17 at 12:22
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    @rlandster It's there because each state has its own tax laws specific to 529 plans. A definitive answer for you will depend on what state you live in and which state's 529 plan you invest in. – D Stanley Jun 29 '17 at 13:33
  • @rlandster I can't find anything definitive, but I'd find it hard to believe that CA is the only state in the union that taxes an otherwise tax-deferred account. See my addition, which speaks to this issue specifically for CA. – Peter K. Jun 29 '17 at 15:06
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I have found lists that are not authoritative. The states fall into several groups regarding earnings used for expenses that are deemed qualified expenses by the US government.

1) They don't have state income taxes, so for them the issue is moot.

2) Earnings from any 529 plan are exempt from state tax.

3) earnings from our 529 plans are exempt, the ones from other states aren't exempt.

So it is specific to the state involved, and can change every year.

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