Tax benefits and a new Roth IRA feature make 529 college savings plans attractive, but they’re not a one-size-fits-all option.
By Shane Cummings, CFP®, AIF®, Wealth Advisor & Director of Technology/Cybersecurity as featured in Kiplinger
There are many different approaches to saving for college, but 529 plans are used by more Americans than any other option — 30% of Americans use a 529 plan. It’s easy to see why, since there are many benefits to 529 plans. But they aren’t a one-size-fits-all solution, and it’s important to consider if they are the right plan for you and your family. In honor of 529 College Savings Day, here are some key reasons to consider a 529, as well as reasons to consider alternatives.
Reason #1 to use a 529: Tax deferral and growth strategies.
One of the most well-known advantages of a 529 savings plan is that the earnings and growth on the investments grow tax-deferred. So long as the expenses you ultimately pay for with the funds are for qualified higher-educational expenses (such as tuition, books and school supplies, room and board), the investment growth and earnings are also tax-free.
In essence, the 529 plan confers the benefits of tax-deferred growth like in an IRA or 401(k) plan, but with the added advantage that taxes aren’t due on cash distributions when it’s time to take funds out. This is a federal tax benefit, which can be fairly substantial for investors in higher tax brackets. There are not many types of accounts that allow these types of tax benefits.
Additionally, some states also allow for state tax deductions on contributions made into a 529 college savings plan. In my state of Colorado, for instance, there is a generous state tax deduction available — up to $20,700 per taxpayer, per beneficiary in 2023 for individual tax filers (or $31,000 per beneficiary per tax filing for joint tax return filers). That is a dollar-for-dollar reduction in state tax liability, which can be fairly powerful.
Certain states allow for tax deductions for contributions made to only their own state-specific plans, while other states will allow for tax deductions made to other states’ plans. Arizona, for example, allows up to $4,000 in state tax deductions for joint tax filers for contributions made to any 529 plan, not just Arizona 529 plans.
To understand the nitty-gritty details of your situation and state allocations, contact your financial adviser.
Reason #2 to use a 529: Gift tax benefits.
Taxpayers are allowed to gift a certain dollar amount each calendar year that is free of gift taxes. Normally, that means you can make a $17,000 gift each calendar year per individual. If you have a generous family member or extra cash to invest, this could be put in a child’s or grandchild’s 529.
However, due to special 529 rules, you can accelerate five years of contributions into a single calendar year so long as you file the appropriate forms with the IRS. That would mean an individual could contribute as much as $85,000 in one year to a beneficiary’s 529 without any gift tax ramifications. That would mean you can’t contribute funds free of gift tax for another four years, but typically there is a benefit to getting a larger amount of assets invested and generating growth and income now versus later.
