For many parents, investing in their child’s education is a priority. But as the cost of college has skyrocketed in three decades — doubling between the 1986-87 and 2016-17 academic years, according to the National Center for Education Statistics — parents may find their college savings won’t go as far as they expected.
One smart way for parents to save for college is a 529 plan, a tax-advantaged investment account. A variety of plans are available depending on the state you live in, and it’s important to be aware of the 529 plan tax deduction your state offers as you consider the best 529 plans for your family.
Here’s what every parent should know about 529 plan tax deductions and how the 529 plans work in general:
- 529 plan accounts are investment vehicles
- 529 plan accounts grow tax-free
- There are no federal 529 tax deductions
- Many states have 529 tax deductions for contributions
- You can shop for 529 plans outside your state
- Plan for 529 contribution limits
First, the basics: Although 529 plans are often referred to as college 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 — which also means they can shrink, depending on market conditions.
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: You can maximize the tax advantages by opening the account when a child is young, for instance.
The earlier you invest, the greater the potential for the funds to grow. This means you could invest and grow your college savings and keep up with inflating college prices.
Earnings on 529 accounts are not treated as taxable income. Let’s say, for example, that you save $1,000 in a 529 investment account, which grows by 5% in a year to $1,050. That $50 in growth isn’t taxable.
Plus, if you sold those 529 account investments to pay for your child’s college, you wouldn’t face federal income tax on the sale proceeds or account withdrawals — as long as you use those funds to pay for qualified education-related expenses. But if you use 529 funds for nonqualified expenses, the earnings could be taxed as income. Other penalties might apply too.
The rules for spending 529 funds allow you to use the money for everything from tuition to paying for a student’s internet access. Recent legislation could further loosen rules on how you use money in a 529 plan. Congress could pass a bill that would allow beneficiaries of 529 funds to use leftover money to repay up to $10,000 of their student loans. The bill also would allow borrowers to apply money from their 529 plan to pay for homeschooling expenses and apprenticeships.
No matter the expenses that the 529 money goes toward, growing college funds in a 529 savings account without adding to your tax burden is a significant tax benefit.
While 529s are similar to 401(k)s, the tax advantages and rules are not identical.
One major difference is that, unlike a 401(k), you cannot get federal 529 tax deductions for your contributions to this account. While certain 401(k) and individual retirement accounts offer the chance to save for retirement in pretax dollars, there’s no correlating federal tax benefit for 529 accounts.
Although you can’t write off 529 contributions on your federal income tax return, you might be able to on your state tax return.
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. That can free up more money to save for your child’s education.
Deductions vary by state, and some are more generous than others. Indiana, for example, offers a 529 tax credit equal to 20% of contributions up to $5,000, which means a maximum credit of $1,000. Vermont provides a 10% tax credit for contributions up to $2,500 with a maximum $250 credit per taxpayer for each beneficiary.
Some states, including California and North Carolina, don’t offer a 529 state tax deduction at all. Then there are states, such as Texas and Florida, which don’t levy a state income tax, which means 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 could 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, Minnesota, Missouri, and Pennsylvania, for example, allow savers to claim tax benefits for any in-state or out-of-state 529 plan, according to a report from J.P. Morgan.
- Determine how you plan to use the 529 account: When you figure out when and how contributions will be made to a 529 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 this summary of Morningstar’s 529 plan annual rankings.
- Watch out for fees: 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 pull too much from your earnings.
By widening your search outside of your state of residence, you may be able to 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 the savings you could gain from claiming a 529 tax deduction.
As you choose a 529 plan, pay attention to the 529 contribution limits. According to the IRS, contributions cannot be more than the amount needed to provide for the student beneficiary’s qualified educational expenses.
Each state might interpret this rule differently when it sets 529 contribution limits, so the limits may vary. But typical 529 contribution limits allow savers to accrue up to $300,000 in savings per beneficiary, according to wealth management firm AXA.
Consider limiting annual 529 contributions to $15,000 or less per beneficiary. According to the IRS, a gift tax might apply to any 529 contributions that exceed that amount.
No matter the ways you plan to help your child cover college costs, educational tax deductions and credits can make a big difference. Learning about tax benefits that can help lessen the financial burden of college is one element in deciding how much to save for your child’s education.
Marty Minchin contributed to this report.