Qualified withdrawals from a Section 529 plan were originally taxed as ordinary income. They were made tax-free in 2001 under the Economic Growth and Tax Relief Reconciliation Act of 2001, but were set to become taxable again in 2011 as part of the 2010 "sunset" provision of EGTRRA. The Pension Protection Act of 2006 has made the tax-free status permanent.
One of the benefits of such an account is that, according to the U.S. Department of Education, when filling out the FAFSA application Section 529 college savings plans are, if owned by the parents, considered to be an asset of the parent and not an asset of the student beneficiary.
As an asset of the parents, a maximum of 5.6% of the account will be considered in the family’s contribution calculation for each academic year. 35% of the student’s assets are considered in the calculation.
If the 529 plan is opened by grandparents or other relatives, with the student as the beneficiary, under current law the money won’t have any effect in determining federal financial aid for the student, as the assets would be considered to belong to the relative who opened the account.
Plus, withdrawals from a Section 529 plan that are used to pay for qualified education expenses are not included in family income for the year on the FAFSA application. So, qualified withdrawals in one year will not affect the student’s financial aid eligibility for the following year.
An excellent website for information on Section 529 Plans is www.savingforcollege.com.