These 529 Tax Benefits Can Help You Save for College

By Maurie Backman Markets Fool.com

With the cost of college rising faster than inflation, many parents are doing their best to save for when those tuition bills eventually come due. If you're saving for college, you generally have a number of options. You can put your money in a savings account, where you won't risk losing money but will also earn minimal interest. You can also put money into a traditional brokerage account, where you might score a sizable return. The main problem with that approach, however, is that when the time comes to withdraw your money, you'll be subject to capital gains taxes. That's why the tax benefits of 529 plans make them an appealing option for so many families.

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A 529 plan is a dedicated college savings plan that offers key tax advantages. While contributions to a 529 plan aren't tax-free, you can benefit from the fact that your earnings will grow tax-free. Furthermore, some states offer tax deductions for investing in 529 plans. Maximizing these tax benefits can help stretch your savings and make paying for college less daunting.

Tax benefits of 529 plans

When you invest using a traditional brokerage account, you'll pay capital gains taxes on your earnings. Most Americans are currently subject to a long-term capital gains tax rate of 15% for investments held more than a year -- a category investments earmarked for college are likely to fall into. And while that's still a more favorable rate than what you'd pay on short-term gains, saving for college via a traditional brokerage account means forking over some of your earnings to the IRS instead of keeping them for your children's benefit.

Let's say you buy securities for $10,000 and manage to grow that amount to $20,000 over the course of 10 years. When you go to withdraw that money, you'll pay taxes on your $10,000 gain. Assuming it's a long-term gain and you fall into the 15% bracket, you'll lose $1,500 of your earnings to taxes.

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With a 529 plan, however, the money you earn on investments isn't subject to taxes. Though 529 plans are funded with after-tax dollars, your money is allowed to grow tax-free and won't be taxed when removed provided you withdraw it for eligible college expenses. So if you're looking at a $10,000 gain in a 529 plan, you'll actually get to keep that entire $10,000 as long as you use it to pay for qualified expenses like tuition, fees, books, room and board, and even computer equipment.

State tax benefits of 529 plans

Some states offer additional incentives for putting money into a 529. Most states, for example, will give you a tax deduction if you participate in their own plans, but if you live in Arizona, Kansas, Maine, or Pennsylvania, you'll get a deduction for participating in any state's 529 plan. Furthermore, Pennsylvania offers a deduction of up to $13,000 per beneficiary, per contributor. If you're a couple filing jointly, you can take a deduction of up to $26,000 per beneficiary.

Additionally, three states offer state tax credits for 529 plan contributions. Indiana will give you a credit equal to 20% of your contributions for a maximum of $1,000 (which you'd get for making a $5,000 contribution). Utah, meanwhile, offers a 5% tax credit on contributions of up to $1,740 for single tax filers and $3,480 for joint filers per beneficiary. So if you're a single filer, you'll get an $87 credit per beneficiary; as a joint filer, you'll get $174 per beneficiary. Finally, Vermont offers a 10% tax credit on up to $2,500 in contributions per beneficiary -- which means you'll get as much as $250 back per beneficiary.

You should also be aware that there are eight states that currently don't offer any incentives for saving with a 529:

  • Alabama
  • California
  • Delaware
  • Hawaii
  • Kentucky
  • Massachusetts
  • Minnesota
  • New Jersey

Though these states have their own 529 plans, they don't give out credits or deductions for participating. That said, you shouldn't choose or rule out a plan based on the tax incentives alone. Other factors, such as fees and plan performance, should also play a role in your decision.

Weighing your options

While the tax benefits of 529s make them a worthwhile option to consider when saving for college, you should know that these plans have one major drawback: If you overfund your 529 and withdraw money for non-education purposes, you'll be assessed a 10% penalty. That penalty, however, will apply only to the earnings portion of your withdrawal, not your principal contribution. As long as you use your 529 money for qualified expenses only, you'll benefit from a world of tax savings that other vehicles simply don't offer.

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