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 a better option.
The prime 529 plan benefit? Tax savings
What can be better than lowering your taxes? When you invest money in a 529 plan, you have no federal tax obligation, as long as you use the funds for qualified education expenses. Your earnings grow federally tax-deferred, qualified withdrawals are tax-free, and some states have other generous tax benefits. 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.**
It's tax advantages like these that can make 529 plans so beneficial. With a brokerage or mutual fund account, for example, you may pay income tax on your annual earnings. And when you exchange or sell shares, you may 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. Please see your tax advisor about your particular situation.
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. States set limits on how much you can contribute to a 529 plan. But for the most part, the aggregate maximums are high. New York, for example the maximum is $520,000, 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 may qualify for a Federal gift tax exclusion, which means you can contribute up to $15,000 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, 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.
- Investment choices. New York’s Direct Plan offers 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, the typical tax deadline, becomes less of a headache because your 529 contributions don't have to be reported on your federal tax return. And there are no federal taxes when withdrawals are used for qualified expenses.
- Plan spending. To take advantage of the full benefits of a 529 plan, you need to use your 529 assets for qualified educational expenses. Those expenses include room and board, computers, course supplies (paper and pencils included), and even internet access, not just tuition and fees. Refer to IRS Publication 970 for a full list.
- 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. Ugift is a simple way to encourage family and friends to help build your child’s college savings.
A unique 529 plan benefit: They keep you focused
The limited purpose of 529 plans is a great financial planning tool. 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. Since 529 plan’s savings are earmarked for education only, and there are penalties attached to non-qualified withdrawals, it’s 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 for retraining or a career shift.
Any way you look at it, now is a great time to learn more about 529 accounts.