Written By Melanie Lockert
A 529 plan is a great way for parents to save for their kids’ college education. College costs have skyrocketed over the years with student loan debt ballooning to $1.6 trillion dollars. Using a 529 college savings plan can help your child offset the costs of higher education while avoiding, or limiting, debt.
There are special tax benefits with a 529 and many reasons why they’re an attractive option. A common question is, “Are 529 contributions tax-deductible?” Below is more information into 529 plan tax benefits and perks.
What is a 529 college savings plan?
A 529 plan is a college education savings vehicle which is also referred to as a 529 savings plan or qualified tuition plan. The number “529” refers to the specific tax code from the IRS. There are two types of plans: the prepaid tuition plan, and the more common education savings plan.
The prepaid tuition plan option allows parents to buy credits at participating colleges for tuition in the future. The 529 education savings plan (which we’ll cover extensively, below) lets parents put money away that’s invested and can be used for qualified higher education costs in the future.
Education savings plans are sponsored by the state government. It’s important to note that 529 funds that are invested are not federally guaranteed, so there’s some level of risk.
529 plan tax benefits
Using a 529 account, you can save for college but also take advantage of some tax perks. There are unique tax advantages with a 529 education savings plan that make it an attractive savings vehicle.
Your money grows tax-free
Like other investments, the power of time can be a powerful tool in growing your money. The good thing about a 529 plan is that your money grows tax-free. That means any earnings you have from your deposits won’t be taxed. It’s like free money without Uncle Sam getting his cut.
Withdrawals are tax-free when used for qualified education costs
On top of your earnings growing tax-free, you won’t be hit with a tax bill when you withdraw. It’s important to note that withdrawals are tax-free if funds are used for qualified higher education costs, like tuition and fees.
However, if you end up withdrawing and using the money for something else that isn’t a qualified expense, you’re liable for federal and state taxes plus a 10% federal tax penalty fee on any earnings.
Some states offer tax benefits on contributions
Many people ask “Are 529 contributions tax-deductible?” The answer depends on your state. Your contributions to a 529 plan aren’t tax-deductible on a federal level. But some states provide a 529 tax deduction tax benefit.
You might be able to deduct your contributions from your state income tax. However, not all states participate. For example, a large state like California offers no 529 tax deductions, but Illinois allows a $10,000 529 tax deduction for individual filers and up to $20,000 for joint filers.
No tax consequences if you change the beneficiary
The good news is that the 529 education savings plan is fairly flexible. When you open an account, you’ll have a beneficiary. You’re asked to list one person as the beneficiary; for example, this could be your child or grandchild. It’s possible to open one for yourself, too.
Let’s say you have an account for one child and they end up not wanting to go to college. You can change the beneficiary to another child or roll over the funds to another account.
There are no income restrictions or requirements
The 529 plan also has no restrictions or specific requirements for your income. There are no minimum income requirements or income limits that disqualify you from participating. For example, some people might not be eligible to open a Roth IRA due to income limits. A 529 plan is available to all income earners.
You can open many different accounts
If you have several children or grandchildren you want to save for, there’s some good news. There is no limit to how many 529 college savings plans that you can open. So if you want to spread the wealth among your family, you can do so. It could be a worthwhile and impactful gift for them that they will appreciate in the future.
529 plans lessen the need for student loans
Many people take out student loans to attend college. But higher education costs are on the rise and student loan balances are, too. Having a 529 plan can reduce the need for student loans. If there’s enough saved, it could eliminate the need for student loans altogether and fully cover educational costs.
FAQ: 529 plan tax benefits
The states which allow a 529 tax deduction include: Alabama, Arizona, Arkansas, Colorado, Connecticut, Georgia, Idaho, Illinois, Indiana, Iowa, Kansas, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, Utah, Vermont, Virginia, Washington D.C., West Virginia, and Wisconsin.
How much you can deduct varies by state. Other states that don’t qualify might not have a state income tax.
If you have a 529 savings plan, you can’t deduct contributions on a federal level. However, many states do offer some tax benefits for a 529 plan. In some cases, you can deduct 529 contributions from your state income tax. Every state will have a different policy, so it’s important to check if your state offers any 529 tax benefits.
There are 529 contribution limits. According to the IRS, the 529 contribution limit is based on the projected cost of higher education. Each state may have varying 529 contribution limits, so it’s important to check with your state. If your contributions are more than $15,000 for a year, you will pay the gift tax.
If your beneficiary on your 529 plan doesn’t go to college, you can change the beneficiary to a sibling or family member. It’s also possible to put it in the account holder’s name. If you use the 529 funds for anything aside from qualified higher education costs you’ll pay taxes and a 10% penalty on the earnings.
One thing worth mentioning is that you can shop for a 529 in any state specially if your state does not offer a tax advantage. For example, NJ does not have a 529 tax benefit so you can choose the NY 529 plan. This plan allocates the investment in a vanguard mutual fund (or mix of funds) that accomodates investors at all levels. The expense ratio is competitive and get this…slightly lower than if you were to open the 529 directly with vanguard! To top it off the minimun to invest is lower as well. For example if you wanted to allocate to an aggresive growth portfolio in a 529 directly with vanguard you would have to make a min contribution of $3000. With NY saves 529 you can allocate to this same portfolio with a significantly lower minimum, as low as $150 if I recall correctly. This is great for investors who want to start saving for their loved ones but dont have a large portfolio to start investing.