Contributions to a Section 529 Plan are not treated as income to the designated beneficiary, but they are not deductible by the contributor.

Prior to a distribution from a Section 529 Plan, the earnings inside the account (including both ordinary income and gain) will not be includible in the gross income of either the designated beneficiary or the contributor. (As discussed below, earnings are not taxed by the states either.)

Distributions from a Section 529 Plan are exempt from federal income tax if they are used for the designated beneficiary's payment of qualified higher education expenses at an eligible educational institution.  This exemption also applies to prepaid tuition programs established by one or more eligible educational institutions (discussed below).

Any portion of a distribution from a Section 529 Plan that is paid for purposes other than qualified higher education expenses will be included in the gross income of the distributee.  The taxable amount will be determined under the annuity rules of Internal Revenue Code § 72. Under these annuity rules, a portion of any non-qualifying distribution will be treated as a return of the donor's contribution (usually nontaxable) but the remainder will be treated as a distribution of the account's earnings and taxed as ordinary income. ("Distributee" means the designated beneficiary or the account owner who receives or is treated as receiving a distribution from a Section 529 Plan.)

A distribution from a Section 529 Plan will not be subject to income tax if within 60 days of such distribution the amount is transferred either to:

If a distribution is made for any purpose other than paying for the qualified higher education expenses of the designated beneficiary, an additional 10% federal tax will be imposed on top of the regular income tax. This additional tax is to be calculated by the account owner and paid for the year in which the refund occurs.  The only exceptions to this rule are in case of the death or disability of the designated beneficiary, or on account of the designated beneficiary’s receipt of a scholarship.

This new add-on tax will not apply to distributions that are included in taxable income but are in fact used for qualified higher education expenses.

Each state has its own rules as to the tax treatment of contributions to and distributions from one of its own 529 Plans.

A Pennsylvania taxpayer can claim a deduction on his or her Pennsylvania income tax return for contributions made during the calendar year to a Section 529 account, subject to a current limitation of $13,000 per beneficiary per year. (The $13,000 amount is based on the current federal gift tax annual exclusion, and thus is subject to change as the exclusion amount changes.)  Spouses filing jointly can each claim the deduction, but for each spouse the amount of the deduction cannot exceed his or her separate taxable income.  (See Schedule O of PA-40 for details as to how the deduction is computed.) Rollovers from another Section 529 plan are not eligible for the deduction, nor is the change of beneficiary within a Section 529 Plan.

Contributions to a Section 529 Plan are treated as completed present interest gifts to the designated beneficiary, and thus are qualified for the annual exclusion under federal law, which is $13,000 for 2009 and 2010.

If the donor's total contributions to a Section 529 Plan exceeds the annual exclusion limit, the donor may elect to treat the aggregate contribution, not merely the excess amount, as having been contributed ratably over the 5-year period beginning with the calendar year of the contribution.

Based on the current exclusion amount of $13,000, this rule will permit donors to shelter up to $65,000 ($130,000 for married donors if they elect to split their gifts) in one calendar year for each designated beneficiary. Any amount in excess of the $65,000 (or $130,000) limit would be treated as a taxable gift in the calendar year of the contribution.

The donor makes the election by checking the box on a Federal Gift Tax return, as well as attaching an explanation to the return disclosing certain information. If gift-splitting is elected, both spouses must make the election and attach the required explanation.

If the donor makes the election, only one-fifth of the total contribution – up to $65,000 – would be reported on the return for the year in which the contribution was made. The donor would then report an additional one-fifth of the total in each of the succeeding four years.

If in any year after the first year of the five-year period described above, the amount of the annual exclusion is increased, the donor will be able to make an additional contribution in any one or more of the four remaining years up to the difference between the exclusion amount as increased and the original exclusion amount for the year or years in which the original contribution was made.

However, it is unclear if the donor also has the right to make a second election if the later contribution exceeds the increase in the annual exclusion amount.

The portion of a contribution excludible from taxable gifts is also excludible for purposes of the generation-skipping transfer tax (referred to herein as the "GST tax").

The Section 529 account will not be includible in the gross estate of the account owner, even though he or she has the retained right to recover the assets in the account. The one exception to this rule is in the event the decedent elected to treat an excess contribution as having been contributed ratably over the 5-year period beginning with the calendar year of the contribution. Any unamortized amount that has not been claimed for the annual exclusion in subsequent years will be includable in the gross estate.

Funds held in a Section 529 account will be exempt from Pennsylvania inheritance tax upon the death of the account owner.