A 529 plan is an investment account that provides tax benefits when withdrawals are used for qualified higher education expenses. This investment account has tax breaks that each state determines individually. A 529 plan acts similar to a Roth plan in which the investment grows on a tax-free basis and can even be withdrawn tax-free.
Everyone has hopes and dreams for their children. Maybe they become a famous writer, a heart surgeon, or a successful entrepreneur. In many cases, parents hope their children will reach their dreams by attending a college, university, or training program that will boost them to the next level of success.
Unfortunately, however, the cost of higher education in the U.S. has increased exponentially in the last decade. In fact, the cost of education has outpaced the inflation rate by 179.2% in the last 20 years for an average annual increase of 9.0%. The government has offered a few different ways for citizens to handle the high cost of education in the United States. Among these is the 529 investment account, which allows parents, grandparents, or general well-wishers to invest their money into an account with certain tax advantages.
Federal tax benefits
A 529 plan works similar to a Roth IRA or 401(k), in which contributions are not exempt from federal income taxes when contributions are made.
This means that the contributions made to a 529 plan are taxed at the federal level without any federal income tax deduction. For example, if you contribute $5,000 to a 529 plan, then you must first pay taxes on the contribution before you invest it.
Instead, they are allowed to grow and be withdrawn tax-free as long as the money is being used for qualified education expenses. This is significant because you don’t need to worry about paying capital gains tax on the account’s growth or income tax from withdrawals on a federal level.
Example of tax benefits
Let’s take a look at how these benefits work in practice. In this scenario, Person A invests in a normal account without any special tax treatment, and Person B invests in a 529 account. For this example, we assume that the federal capital gains tax (CGT) rate for both investors is 15%. Both investors place $15,000 into their account, which after five years is worth $50,000.
|Initial Value||Value After 5 years||Capital Gains Tax||Taxes Due||Total Value after CGT|
The person who didn’t use a 529 plan will need to pay capital gains tax on their growth, equaling $5,250. Person B, who used a 592 investment account, will receive the entire $50,000. This is because although the investment grew, they paid $0 in taxes on the gains from the investment on a federal level.
Furthermore, say that the 529 investor is holding stocks that pay a dividend or an income. In normal circumstances, this dividend would be taxed at the federal level; however, with a 592 plan, that income is tax-free.
Looking for the right investment and tax strategy? These are some of the recommended investment advisors that can help with both.
State tax benefits
The United States is famous for its federal system that allows states to greatly determine their own economic and tax policy. In the world of 529 investment accounts, different states have different rules in terms of tax exemptions.
Unlike the federal level where contributions are taxed before they enter the account, in some states, they are completely exempt from all state taxation whatsoever through a state income tax deduction. However, this differs greatly from state to state.
In North Dakota, for instance, there is a $5,000 state tax deduction for a single filer and a $10,000 deduction for joint filers. This number jumps to $10,000 for a single filer in Oklahoma and $20,000 for a joint filer. In New Mexico, they let you deduct the full amount of the contribution. Thus, if you contribute $8,000, you can deduct $8,000 from state income taxes in New Mexico.
|State||529 Deduction||State||529 Deduction|
|Alabama||$5,000 single / $10,000 joint beneficiary||Nebraska||$10,000 ($5,000 for married taxpayers filing separate returns)|
|Alaska||No state income tax||Nevada||No state income tax|
|Arizona||$2,000 single or head of household / $4,000 joint (any state plan) beneficiary||New Hampshire||No state income tax|
|Arkansas||$5,000 single / $10,000 joint beneficiary||New Jersey||None|
|California||None||New Mexico||Full amount of contribution|
|Colorado||Full amount of contribution||New York||$5,000 single / $10,000 joint beneficiary|
|Connecticut||$5,000 single / $10,000 joint beneficiary, 5 year carry-forward on excess contributions||North Carolina||None|
|Delaware||None||North Dakota||$5,000 single / $10,000 joint beneficiary|
|Florida||No state income tax||Ohio||$4,000 single / $4,000 joint beneficiary, unlimited carry-forward of excess contributions|
|Georgia||$4,000 single / $8,000 joint beneficiary||Oklahoma||$10,000 single / $20,000 joint beneficiary annually, five-year carry-forward of excess contributions|
|Hawaii||None||Oregon||$150 single / $300 joint beneficiary up to $30,000 income, higher income lowers % of deduction|
|Idaho||$6,000 single / $12,000 joint beneficiary||Pennsylvania||$15,000 single / $30,000 joint beneficiary|
|Illinois||$10,000 single / $20,000 joint beneficiary||Rhode Island||$500 single / $1,000 joint, beneficiary, unlimited carry-forward of excess contributions|
|Indiana||20% tax credit on contributions up to $5,000 ($1,000 maximum credit)||South Carolina||Full amount of contribution|
|Iowa||$3,439 single / $6,878 joint beneficiary||South Dakota||No state income tax|
|Kansas||$3,000 single / $6,000 joint beneficiary (any state plan), above the line exclusion from income||Tennessee||No state income tax|
|Kentucky||None||Texas||No state income tax|
|Louisiana||$2,400 single / $4,800 joint beneficiary, unlimited carry-forward of unused deduction into subsequent years||Utah||5% tax credit on contributions of up to $2,040 single / $4,080 joint beneficiary (maximum credit of $102 single / $204 )|
|Maine||None||Vermont||10% tax credit on up to $2,500 single / $5,000 joint beneficiary (maximum $250 tax credit per taxpayer, per beneficiary)|
|Maryland||$2,500 single / $5,000 joint beneficiary, 10 year carryforward||Virginia||$2,000 single / $2,000 joint beneficiary, full contribution for taxpayers over 70, unlimited carry-forward of excess contributions|
|Massachusetts||$1,000 single / $2,000 joint beneficiary||Washington, D.C.||$4,000 single / $8,000 joint beneficiary|
|Michigan||$5,000 single / $10,000 joint beneficiary||Washington||No state income tax|
|Minnesota||$1,500 single / $3,000 joint beneficiary||West Virginia||Full amount of contribution|
|Mississippi||$10,000 single / $20,000 joint beneficiary||Wisconsin||$3,340 single / $3,340 joint beneficiary|
|Missouri||$8,000 single / $16,000 joint beneficiary||Wyoming||No state income tax|
|Montana||$3,000 single / $6,000 joint beneficiary|
Is 529 considered a gift tax?
A gift tax is a federal tax that is levied on a transfer of assets or property from one person to another. The receiving party is receiving the assets for less than or equal to the current value. The gift tax is applied regardless of whether the donor intends to send the gift. Gift taxes are usually declared on IRS 709 Form.
The IRS generally considers 529 college savings as a gift from one entity or another. This means that in some cases, it falls under the federal gifting rules. This comes with both advantages and disadvantages related to the federal annual gift tax income exclusion. Currently, the federal gift tax exclusion stands at $16,000 per individual being gifted. This $16,000 exemption is applied to each person sending a gift.
For example, say you have three kids and you are married. This means that for each kid, you and your spouse can give $16,000 each, or $32,000 per child together. This means that you and your wife can contribute $96,000 that is exempted from any kind of federal gift tax.
Five-year gift tax rule
Fortunately, those transferring a large amount of wealth at once have a bit of a tax advantage. The federal government allows you to average the initial gift amount over five years and use your annual gift tax exclusion for the five-year average.
Say, for example, a grandparent dies, and the remaining grandparent would like to transfer a substantial sum of money to the grandchildren’s 529 savings account. For simplicity purposes, let’s say that the amount being given is $75,000.
The federal government allows you to take the $75,000 and divide it by five years. This equation can be explained in the table below.
|Initial Value||Average Annual Gift Tax Exemption||Annual Tax Exemption over 5 year||Taxable Amount|
|Contribution not using 529||$75,000||$16,000||$0||$59,000|
|Contribution using 529||$75,000||$16,000||$15,000||$0|
In the first example, the grandparent plans on transferring the $75,000 directly to the grandchild. They have an annual gift tax exclusion of $16,000. They are then liable to pay gift tax on the remaining $59,000.
In the second scenario, the grandparent allocates the entire $75,000 gift to a 529 plan. They can now divide that number by five for an average annual gift of $15,000. This means that when transferring the gift to the 529 accounts, they are paying $0 in gift tax because the $15,000 per year is smaller than the annual exclusion of $16,000. In fact, in this scenario, they can contribute another $1,000 per year as a gift if they choose to do so.
Does a 529 plan affect financial aid?
A 529 plan can indeed impact financial aid, but the impact is limited. This impact typically applies if the 529 account is owned by a parent or custodian of the beneficiary. Assets in a 529 account owned by a parent are typically counted as the parent’s assets on their FAFSA applications.
The first $10,000 (approximately) a parent contributes is protected by the Asset Protection Allowance. However, past that $10,000, the student’s potential financial aid will gradually reduce. Fortunately, the federal government caps this reduction at 5.64% of assets.
Can I have 529 plans from multiple states?
Yes, you are available to open a 529 account in multiple states. Though you may not have much use for multiple 529 accounts, you can open accounts in several states at once.
Can I use 529 plans outside of my state?
Yes, you can use a 529 to pay for college in any state. However, rolling over a 529 plan into a new state may come with different state tax requirements, so keep this in mind before acting too quickly.
How do new tax changes promote 529 investments?
The Consolidated Appropriations Act of 2021 is one example of recent tax changes that should promote 529 investments by treating non-custodial accounts differently than before. This should have an impact on non-parent-owned 529 accounts when assessing financial aid eligibility. However, this won’t come into effect until the 2024 – 2025 school year. This gives ample time to speak to a qualified tax advisor if this affects you.
- A 529 investment account is an account that lets people put aside money for college with tax advantages similar to a Roth tax structure.
- On a federal level, the contributors must pay federal income tax before investing the funds into a 529 plan. However, the money is allowed to grow tax-free. You are also able to derive income tax-free.
- On a state level, different states have different rules on state tax exemptions for deductions towards a 529 plan.
- A 529 contribution is considered a gift and thus liable for gift tax if over the annual exclusion of $16,000. However, this can be averaged over five years if the lump sum is greater than the annual exclusion.
- 529 does affect financial aid eligibility. However, the impact is capped at 5.64% of assets to pay for college if a parent or guardian owns the account.
View Article Sources
- Topic No. 313 Qualified Tuition Programs (QTPs) — IRS
- AZ Tax Incentives — Arizona’s Education Savings Plan
- What is a 529 Plan? — SuperMoney
- Is a 529 Plan Worth It? — SuperMoney
- Roth IRA vs. 529 Plan: Which Should You Use to Save for College? — SuperMoney
- 529 Qualified Expenses: A Complete List — SuperMoney
- How Many 529 Plans Can a Child Have? — SuperMoney
- Does a 529 Plan Affect Financial Aid? — SuperMoney
- How to Save for College: Complete Guide to Saving for Education — SuperMoney
- Saving for College: How to Deal with Outrageous College Costs — SuperMoney
- Ultimate Guide to Financial Aid — SuperMoney
- The Definitive Guide to Federal Student Loans — SuperMoney