There’s no such thing as the perfect tax-advantaged savings vehicle. But when it comes to saving for education expenses, the 529 plan comes pretty close. Like anything else, 529 plans have their pros and cons, but they offer fairly significant advantages, particularly when it comes to your tax return.
Here are the top 10 benefits of 529 plans that you should know about.
1. 529 Plans Offer Unsurpassed Income Tax Breaks.
Although a contribution to a 529 plan is not an income tax deduction, earnings in a 529 plan grow federal tax free and are not taxed when you withdraw the money to pay for certain college and other qualified education expenses.
While many parents plan to use 529 money for college, these funds can help pay for other education expenses, too. Tax-free withdrawals may include up to $10,000 in tuition expenses for private, public, or religious elementary and secondary schools (per year, per beneficiary). You can also withdraw up to $10,000 for student loan payments (per beneficiary and per sibling and step-sibling of the beneficiary, lifetime). The costs of apprenticeship programs are also now considered qualified education expenses, so you can take 529 funds tax free to put toward these programs.
By contrast, if you invest in other investment vehicles, such as mutual funds, you’ll pay taxes on a portion of your annual investment earnings, plus capital gains tax when you withdraw the money.
The tax advantages of 529 plans, which were made permanent in the Pension Protection Act of 2006, have incentivized Americans to sock away money for their kids’ — or their own — education.
2. Your own state may offer tax breaks as well.
In addition to the 529 federal tax benefits, over 30 states and the District of Columbia currently offer a full or partial tax deduction or a tax credit for 529 plan contributions. In some cases, then, 529 contributions reduce taxable income as far as your state taxes are concerned.
You can generally claim state income tax benefits each year you contribute to your 529 plan, so it’s a smart idea to continue making deposits until you’ve paid your last tuition bill.
Be sure to research all of your 529 plan options. Remember that you don’t have to use your home state’s 529 plan. If your state benefits are lacking, you can choose another state’s plan
3. You’ll Benefit from High Contribution Limits
Unlike some other types of tax-advantaged savings plans, 529 plans have high maximum aggregate limits, or lifetime contribution limits, and no annual contribution limits. Depending on the state you live in, the maximum aggregate limit for your 529 plan will fall between $235,000 and $550,000.
These high contribution limits can help you maximize the available 529 plan tax benefits.
4. You Can Use 529 Plan Contributions to Reduce Your Taxable Estate
You may be able to contribute as much as you’d like to a 529 plan each year, but after a certain threshold, the IRS will take notice.
As of 2023, donors can contribute up to $17,000 per year per beneficiary to a 529 plan, but anything more will count against their lifetime gift exemption. They’ll also have to report the gift to the IRS on Form 709. (It’s important to note that the lifetime gift exemption is $12.92 million in 2023, so not too many people have to worry about hitting it.)
There is a way around this limit, however. Donors can front-load contributions for up to five years at once. So you can contribute $85,000 in one year as long as you don’t make any additional contributions for that beneficiary for five years.
This type of accelerated gifting is unique to 529 plans and can reduce the size of your taxable estate.
5. You Stay in Control of Your Account
With few exceptions, the beneficiary has no legal rights to the funds in a 529 account — the account owner ultimately controls the money. This differs from custodial accounts under UGMA/UTMA, where the child takes control of the assets once he or she reaches legal age.
A 529 account owner can withdraw funds at any time for any reason, but the earnings portion of non-qualified withdrawals will incur federal income tax and an additional 10% penalty tax.
6. 529 Plans are Low Maintenance
A 529 plan is a simple, hands-off way to save for education. To enroll, simply visit our Best 529 Plans page, select the plan you like best, and fill in the info for yourself and your beneficiary. You can also contact your financial advisor for guidance.
Contributions are also often “set it and forget it.” Many plans allow you to automate contributions via payroll deduction or bank account auto-draft. A third-party company will typically handle ongoing investment management, though the account owner may be able to make some decisions.
7. You’ll Enjoy Simplified Tax Reporting
You don’t have to report 529 contributions on your federal tax return.
The year you start to make withdrawals, the beneficiary will receive a Form 1099 to report investment earnings, but not before.
8. 529 Plans are Highly Flexible
You can change your 529 plan investment options twice per calendar year, and you can roll your funds over into another 529 plan once in a 12-month period. However, there is no federal limit on the frequency of these changes if you replace the account beneficiary with another qualifying family member at the same time.
9. Everyone is Eligible to Take Advantage of a 529 plan.
Unlike Roth IRAs and Coverdell Education Savings Accounts, 529 plans have no income limits, age limits or annual contribution limits. Whatever your financial situation is, you can benefit from a 529 plan’s tax advantages. Most plans have a low minimum contribution or no minimum.
You can also start saving as early as possible. You can open a 529 plan in your own name as an adult, so you can start saving even before a child is born and change the beneficiary later (or even use 529 plan funds for your own education expenses). This flexibility can be helpful if your child receives enough financial aid not to need all the money in their 529 account.
10. You Can Roll 529 Funds Over to a Roth IRA
The Secure 2.0 Act of 2022 made it possible to roll 529 funds over to a Roth IRA without incurring penalties or taxes. The lifetime rollover limit is $35,000, but the contributions are subject to annual IRA limits ($6,500 for most, $7,500 for those over age 50). The 529 must also have been open for more than 15 years.
Factors That Can Influence 529 Plan Tax Benefits
There are two kinds of 529 plans: savings plans and prepaid tuition plans. Although each type of plan is treated the same in terms of income taxes and offers the same tax advantages, they each define “qualified education expenses” differently.
The qualified education expenses for 529 prepaid tuition plans are generally limited to tuition and fees for participating colleges and do not usually include graduate school.
Qualified education expenses for 529 savings plans include:
- Full tuition for undergraduate and grad school
- Room and board
- Books and equipment for college and grad school
- K-12 tuition up to $10,000 per year
- Student loan repayment up to $10,000 lifetime
- Registered apprenticeship program fees
It’s also important to coordinate your tax benefits of 529 contributions with those you receive from other education benefits, like the American opportunity tax credit and the lifetime learning tax credit, to avoid doubling up on benefits for the same education expenses.
As always, when dealing with taxes, reach out to a professional like a CPA or enrolled agent if you have questions.