Tax advantages of a 529 college-savings plan

Make the right investment decision to finance your children's higher education.

Brandon Lafving
by Brandon Lafving, IRS contributor (@TechDragoon)

 

Considering the rising cost of education, the earlier you start your college savings plan, the better. And 529 plans are one powerful tax incentive to aid families in their ability to finance their kids' advanced schooling. So let's get down to what the federal tax benefits of a 529 plan are.

Although many of the specifics of 529 plans are dictated by your state of residence, all plans are provided with two federal tax benefits.

READ: What is often overlooked when planning for college?

The first is similar to those of an IRA or 401(k) account. You don't detract investment income on an annual basis, as is the case with most other investments. Capital gains, dividends and bond income are untaxed as long as the money remains in the account.

This is a much stronger investment edge than most people recognize. Long-term capital gains and qualified dividends can be taxed at up to 20%, which means that one-fifth of your earnings are taken every year. If your investment account earns 5%, then you would sacrifice 1% of that to taxes, for 4% real growth. Short-term capital gains suffer an even greater reduction (39.6%).

So the tax benefits of a 529 plan depend largely upon the investment portfolio covered by the plan. Assuming you go whole-hog into short-term investments for a 5% gain, then without the protection of a 529 plan, the growth rate would be reduced to 3%, annually.

READ: Your 7-point strategy for lowering future college costs

In addition to the IRA-like benefits, money can be taken out of 529 accounts without being taxed if it is applied to qualified college expenses. A qualified college expense is basically tuition, minus the amount of help you have received in the form of scholarships, student aid, etc. There are exceptions to the general rule, but they are a topic for another time. For now, it is important to see that a 529 plan allows you to use completely untaxed investment income toward your kids' most significant college expenses.

As stated above, each state harbors different relations with 529 plans. Usually a state will provide some tax benefits of its own to power 529 growth. Some are generous in their treatment. Others provide no tax benefits at all. Check with your state to see how your specific 529 plan will be taxed, and if you have friends who are recently married, you might suggest they look into the matter before they choose a permanent residence for the family.