Are you saving for college in accounts other than—or in addition to—a 529 plan? Perhaps you have a mutual fund account, a bank savings or checking account, or an IRA that you've targeted for college bills. If this is the case, you may be shortchanging your savings and your future college student. That's because 529 plans offer benefits that set them apart from other types of accounts and could make them the best of all the rest.
The prime 529 plan benefit? Tax savings
What can be better than lowering your taxes? With a 529 plan, you have no federal tax obligation once your money's invested in your account. You do have to pay federal income tax on money you put into the account (although many states now offer a full or partial tax deduction or credit for 529 plan contributions). But the best part is that your earnings grow federally tax-deferred, qualified withdrawals are tax-free, and some states have other generous tax benefits as well. For instance, in New York up to $10,000 is deductible from the state taxable income for married couples filing jointly; single taxpayers can deduct up to $5,000 annually. (This may be subject to recapture in certain circumstances such as rollovers to another state's 529 plan or nonqualified withdrawals.)
It's tax advantages like these that can make 529 plans so beneficial. With a brokerage or mutual fund account, for example, you'll pay income tax on your annual earnings. And when you exchange or sell shares, you'll pay capital gains tax too. Additionally, interest earned in a savings account is subject to taxes, and some withdrawals from traditional IRAs may be taxable as well.
Keep in mind, however, that earnings on nonqualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes. Tax and other benefits are contingent on meeting other requirements and certain withdrawals are subject to federal, state, and local taxes.
See the tax difference: Compare a tax-deferred account with a taxable account (https://vanguard.wealthmsi.com/collsavings.php)
(Note: This is a Vanguard tool through which the investor can calculate the savings amount and get a comparison bar chart that’s automatically generated.)
Compounding can increase too
The tax breaks you get from a 529 plan could translate into an increase in your 529 plan assets because of compounding. You see, the money you don't have to pay in taxes can stay in your account and potentially generate even more earnings. And the earlier you start saving for college, the more years you have to make compounding work for you.
Tax breaks aren't the only 529 plan perks
529 plans stand out in other areas too. See how the following potential advantages can give 529 plans an edge over other types of savings accounts:
- Contributions. Some states set limits on how much you can contribute to a 529 plan. But for the most part, the maximums are high (usually between $300,000 and $400,000), which is typically more than enough for four years of undergraduate school. Compare this with an IRA, which has much smaller annual limits, making it less likely you can accrue enough to cover the entire cost of college. Plus, your 529 plan contributions can qualify for a gift tax exclusion, which means you can contribute up to $14,000 per year, per beneficiary, without incurring federal gift tax.
- Age and income. Almost anyone can open a 529 plan, and anyone (regardless of age) can be the beneficiary of a 529. In addition, your tax incentives won't disappear because your income is too high—a situation that can occur with IRAs and some education savings accounts.
- Number of accounts. You can open multiple 529 plan accounts—for different beneficiaries or the same beneficiary—in one or more states.
- Investment choices. Many 529 plans offer age-based investment options that gradually become more conservative as your child gets closer to college. That means you can simply choose a fund that meets your risk level and let the fund do the rest. Although it's a good idea to reevaluate your investment selection periodically to ensure that it stays in line with your current situation.
- Tax reporting. April 15 becomes less of a headache because your 529 contributions don't have to be reported on your federal tax return. And there are no taxes when withdrawals are used for qualified educational expenses.
- Plan spending. While you must use your 529 plan assets for qualified educational expenses, the "qualified" category has expanded considerably in recent years. You no longer have to think tuition only. Your savings can be used for room and board, computers, course supplies (paper and pencils included), and even internet access.
- Plan choices. There are many 529 plans to choose from, so take time to shop around. But be sure to look at your own state's plan first to see how it compares with those in other states. You can even roll over an existing 529 into another plan one time during a 12-month period if you find a plan more suitable for you.
- Plan gifts. Remember how Aunt Nelly and Uncle George never know what to give Zach for his birthday? Well, anyone can make a contribution to a 529 plan but, depending on the plan rules, it may not always be tax deductible. Nonetheless, a 529 contribution is a great gift that always fits and never wears out.
A unique 529 plan benefit: They keep you focused
529 plans have sometimes been frowned upon because of their limited purpose. For some investors, the withdrawal rules are too restrictive. But that can be a good thing if you want to be a serious college saver. Multipurpose accounts don't make you aim for a goal, so you might be tempted to tap your assets if a new roof or even a new convertible beckons. However a 529 plan savings are earmarked for education only. If you withdraw your assets for anything else, you'll pay a 10% penalty on the earnings—a good incentive to stay on track toward your goal.
Concerned about what happens if your child decides not to go to college or is fortunate enough to receive a full scholarship? No worries. You can always change the beneficiary or leave the money in your account and allow it to grow and compound for your grandchildren (529 accounts never expire).* Or you can use it for yourself. What's wrong with treating yourself to a college class? Maybe a college course in classic art…in Paris, perhaps?
More investors are discovering the benefits of 529 plans
Proportion of college-saving families using each savings account type.
Note that the percentages listed below represent the percentage of families that use that type of account to save for college, but not all of the assets in each account are used exclusively for college saving.
While interest in 529 plans is on the rise, the majority of investors are still missing out on the advantages these plans can have for their college savings.
Source: Sallie Mae's national study "How America Saves for College” 2016.
*Earnings on nonqualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes. The availability of tax or other benefits may be contingent on meeting other requirements.
Contributions to the Plan in a tax year are deductible from Missouri state income tax up to certain limits, but may be subject to recapture in subsequent years if you make a nonqualified withdrawal.
**Gift or generation-skipping transfer taxes may apply. Please consult with your tax advisor for further information.