There’s no such thing as the perfect tax-advantaged savings vehicle. But when it comes to saving for college – and other education expenses – the 529 plan comes pretty close. Like anything else, 529 plans have pros and cons but offer relatively significant advantages, particularly regarding 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 numerous college and other qualified education expenses.
While many parents plan to use 529 money for college, these funds can also help pay for other qualified higher education expenses. 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 Pension Protection Act of 2006 made tax advantages of 529 plans permanent and 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 state tax deduction or a tax credit for 529 plan contributions.
You can generally claim state income tax benefits each year you contribute to your 529 plan, so it’s wise 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. But bear in mind that most states require your contribution to the in-state 529 plan to be eligible for a tax deduction.
3. You’ll Benefit from High Contribution Limits
Unlike some tax-advantaged savings plans, 529 college savings plans have high maximum aggregate, or lifetime, contribution limits and no annual contribution limits. Depending on your state, the maximum aggregate limit for your 529 plan will be from $235,000 to over $550,000.
These high contribution limits 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, each taxpayer can contribute up to $17,000 per year per designated 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 tax exemption is $12.92 million in 2023, so not many people 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 if you don’t make any additional contributions for that beneficiary for a five-year period. For married couples, each spouse can contribute up to that amount for a total contribution of $170,000.
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 they reach 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.
Best of all, 529 plans offer investment portfolios that automatically adjust to include more conservative investments as your beneficiary approaches college age. If you choose to invest in one of these age-based or year-of-enrollment portfolios, you’ll enjoy a low-maintenance approach to managing the investments in your plan as well.
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 only after that.
8. 529 Plans are Highly Flexible
You can change your 529 plan investment options twice per calendar year and 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 simultaneously replace the account beneficiary with another qualifying family member.
9. Everyone is Eligible to Take Advantage of a 529 plan.
Unlike Roth IRAs and Coverdell Education Savings Accounts, 529 plans have no income, age, 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 name as an adult, so you can start saving before a child is born and change the designated beneficiary later (or even use 529 plan funds for your 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 makes 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 and prepaid tuition. Although each type of plan is treated the same regarding income taxes and offers the same tax advantages, they 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 of 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, contact a professional like a CPA or enrolled agent when dealing with taxes if you have questions.