As a parent, I want to help my kids get the best start in life by investing in their education.
The cost of college has skyrocketed in the past three decades, increasing by 336 percent from 1985 to 2015. And although tuition increases are finally slowing, many parents will find that their college savings won’t go as far as they expected.
I’d heard about 529 tax deductions and knew they were tax-advantaged accounts. But I was a bit lost when it came to choosing the best college savings plan and 529 tax deduction for my family.
I made it my mission to find out more about 529 college savings plans and understand how their tax benefits could help parents keep up with college costs. Here are six things I learned about 529 savings plans that every parent should know.
1. 529 accounts are investment vehicles
First off, a 529 is an investment account. Although 529s are often called “savings plans,” the contributions you make don’t just sit there until you decide to use them. Rather, 529 account funds are invested and given the opportunity to grow (they also have the risk of shrinking).
Basically, your 529 plan has more in common with your 401(k) than your savings account. If you understand the tax benefits and implications of your 401(k), many of the same principles apply to a 529.
The good news is this means you can invest and grow your college savings and keep up with inflating college prices.
2. 529 accounts grow tax-free
I also wanted to understand how 529 contributions affected my federal income tax.
The answer: not very much.
But that’s part of the beauty of it — earnings on 529 accounts are not treated as taxable income. Let’s say, for example, you have a $1,000 in a 529 account that grows by 5 percent in a year to $1,050. In a 529 investment account, that $50 in growth isn’t taxable.
Plus, if you sold those 529 account investments to get ready to pay for your child’s college, you wouldn’t face a capital gains tax on that income — as long as you use those funds from investments you sell to pay for qualified education-related expenses.
But if you use 529 funds for nonqualified expenses, earnings could be taxed as income. Other penalties might apply too.
Overall, growing college funds in a 529 savings account without adding to your tax burden is a significant tax benefit.
3. There are no federal 529 tax deductions
Although a 529 is more like your 401(k) than your savings account, don’t assume the tax advantages and rules are identical.
One major difference is that, unlike a 401(k), you can’t get federal 529 tax deductions for your contributions to this account. Although a 401(k) or IRA offers the chance to save for retirement in pretax dollars, there’s no correlating federal tax benefit for 529 accounts.
4. Many states have 529 tax deductions for contributions
Although you can’t write off 529 contributions against your federal income tax, you might be able to for your state income tax.
More than 30 states (plus the District of Columbia) offer a 529 tax deduction or credit, allowing you to write off 529 contributions and lower your state income tax burden. And that can free up more money you can save for your child’s education.
The most generous state 529 tax deduction, according to SavingForCollege.com, is in Indiana. This state offers a 529 tax credit equal to 20 percent of contributions up to $5,000 — netting you a tax savings of up to $750, according to an analysis of state 529 tax benefits from J.P. Morgan Asset Management.
See the image below, captured from the J.P. Morgan report, for a full rundown of 529 tax deductions by state.
5. You can shop for 529 plans outside your state
The state 529 tax deductions can be significant, depending on where you live.
But in states such as Georgia, the most you can save is around $100. Other states, including California and North Carolina, don’t offer a 529 tax deduction. Then there are states such as Texas and Florida that don’t levy a state income tax — and you can’t lower a tax burden you don’t have.
If you’re unlikely to generate much savings by claiming a state 529 tax deduction, it might be a smart move to shop for savings plans outside your state. Here are a few tips to follow when you compare 529 savings plans:
- Research your state’s 529 plans and tax benefits. This can help you decide whether an in-state plan is your best bet or if you should expand your search nationwide. Arizona, Kansas, Maine, Missouri, and Pennsylvania, for example, allow savers to claim tax benefits for any in-state or out-of-state 529 plan, according to Bankrate.
- Detail how you plan to use the 529 account. When you know when and how contributions will be made to a 529 savings plan, you can choose features that match your needs. For instance, it might be important to you to find a plan with a low minimum contribution level or one that allows non-account owners to make contributions.
- Find an investment profile that matches your goals. The mix of investment types on 529 accounts can range from conservative to aggressive. Compare them to your own risk tolerance and growth targets to choose a smart fit.
- Compare 529 plan performance. Many (but not all) 529s have a solid track record of delivering consistent growth. Compare the historical performance of 529 accounts to find ones that result in higher returns. You also can check out 529 plan performance comparisons, such as these rankings from SavingForCollege.com.
- Watch for fees and costs. Although many 529 plans allow you to enroll directly, others are offered through brokers or fee-based planners. Look at the fee structure of each 529 plan you consider, and make sure the costs won’t eat too far into your earnings.
By widening your search, you can select a 529 account with a solid performance history, higher return rates, and low fees. It’s possible the growth offered by an out-of-state 529 plan could outstrip your potential savings of claiming a 529 tax deduction.
6. Plan for 529 contribution limits
Lastly, as you choose a 529 plan, you’ll want to pay attention to 529 contribution limits.
“Contributions can not exceed the amount necessary to provide for the qualified education expenses of the beneficiary,” according to the Internal Revenue Service (IRS). Each state might interpret this rule differently when it sets 529 contribution limits, so the limits vary.
However, typical 529 contribution limits allow savers to accrue up to $300,000 in savings per beneficiary, according to wealth management firm AXA. If you expect to run up against contribution limits (a good problem to have), include 529 contribution limits as an item to evaluate as you compare plans.
You also might want to limit annual 529 contributions to $14,000 or less per beneficiary. According to the IRS, a gift tax might apply to any 529 contributions that exceed that amount.
However you plan to help your child cover college costs, educational tax deductions and credits can make a big difference. From 529 tax deductions to the American opportunity credit, spend time learning about tax benefits that can help lessen the financial burden of college. That way, you can figure out the right amount to save to fund your child’s education.
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