Tax Benefits of 529 Plans
April is Financial Literacy Month and you probably just did your taxes, so now seems like a good time to talk about the tax benefits of 529 plans-- and there are lots! These tax benefits add up to significant additional dollars available for college, so much so that it's surprising that only about 1/3 of families saving for college use 529s.
529 plans are tax-advantaged college savings accounts established under Section 529 of the Internal Revenue Code. 529 plans can be operated by states or by private entities. Several tax benefits are available to all 529 plans, regardless of who establishes them:
Tax-free growth. This means that while the funds are in the account, any distributions or capital gains do not generate income on your tax return. This is especially helpful in an account like a 529 where you want to rebalance on an ongoing basis to keep the risk profile appropriate for the student's time horizon to college.
Tax-free distributions for qualified expenses. This means that as long as the money in the account goes to specific costs-- tuition, fees, room, board, books and required supplies for college students; up to $10,000 annually for private K-12 tuition; up to $10,000 lifetime for student loan repayment; and up to $35,000 lifetime for Roth conversions-- you don't have to pay any income or capital gains tax on the growth in the account.
Removal of assets from your estate. Transfers into a 529 plan are considered completed gifts to the beneficiary and are therefore excluded from your estate for purposes of calculating federal estate tax liability.
Many state-sponsored plans offer an additional tax benefit for contributions, and in some states both parents and students can claim the tax benefit.
So, how much additional savings would you have if you used a 529 instead of a taxable brokerage account? Let's suppose you save $100 per month for your child's education for 18 years starting when they're born. For the sake of simplicity, we'll assume a 6% annual return and that all investments in the taxable account would receive long term capital gains treatment.
After 18 years, you would have contributed $21,600 and your account would have grown to a total value of $38,793. If it were in a 529, you'd have $38,793. In a taxable account, you'd pay 15% capital gains tax on the growth, which would cost you $2,579 (15% × $17,193.40 = $2,579), so net of taxes you'd have $36,214.
But that's only the federal piece of it. You also save on state taxes, and you might get a state tax benefit for your contributions. Let's assume a $300 annual state income tax credit for your contributions and a state tax rate of 6%. After 18 years, state taxes would subtract another $1,032 from the total in the brokerage account. Plus, the annual income tax credit would save you $5,400 over 18 years. But if you reinvested that $300 into the 529 every year, you'd have another $9,272 in the 529 when your student graduated from high school.
And guess what? If your state offers a tax benefit for contributions, you can keep contributing during the college years to keep claiming that benefit. In fact, if you kept up the $100 monthly contributions through the college years and invested the money conservatively-- in your age-based fund or a stable value or FDIC insured option in your plan-- you'd get another $1200 in tax credits plus some additional tax savings on your investment.
The tax benefits here are incredible: in this scenario a family would have saved about $9,000 in taxes by using a 529-- and by reinvesting the tax benefits, they'd have another $9,000 available to pay for college. On a $38,000 account, that's an almost 50% benefit.
Do you need any more reasons to start saving in a 529?
