At least one 529 tax plan -- designated as a "qualified tuition program" in the federal tax code -- is offered by every state and the District of Columbia, as well as by a number of private educational institutions. They offer tax advantages and other incentives to make it easier for you to save for a child or grandchild's college expenses. Contributions to the plan are not tax deductible, but they have other advantages that make them worth your consideration.
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The Relative Importance of Deductible Contributions
Compare 529 contributions with contributions to an IRA -- an Individual Retirement Account. Whatever you contribute to your IRA up to the current annual contribution limit is deductible from your income. For the tax year 2014, someone with a taxable income of $150,000 pays $35,175, an effective tax rate of a little more than 23 percent. A $5,000 IRA contribution reduces the tax by almost $1,200. However, if your income is $50,000, your effective tax rate overall is under 12 percent. Making the same $5,000 contribution to your IRA reduces your taxes by less than $600. The same taxable income factors enter into your consideration of the importance of the non-deductibility of 529 contributions. The less you earn, the less it matters that 529 plan contributions aren't deductible from income.
Tax-Deferred Growth and Tax-Free Contributions
Once you've contributed to a 529 plan, income growth in that plan is always tax-deferred and distributions from the plan are tax free when you use them to pay the beneficiary's college costs. Consider, for example, that over 20 years you contribute $100,000 in equal annual contributions -- the maximum overall contribution can be as much $350,000, depending on the specific plan and the state you live in -- and that the money grows at 9 percent annually. After 20 years there will be nearly $311,000 in the account. If you had to pay taxes on the money as you withdrew it, which is the case with IRA distributions, withdrawals over four years would generate taxes of over $37,000 even at a low 12 percent effective tax rate. That 529 earnings are tax-deferred and may eventually be distributed tax free offers significant benefits that may far outweigh the disadvantage of non-deductibility of contributions.
Other Related 529 Benefits
Managing a 529 account is relatively easy. You put the money in the plan and either the state government or a designated plan manager manages your investment until you choose to distribute it. Costs in a well-managed plan are moderate, about the same as for a 401k retirement plan. You have considerable freedom to change plan managers and you may also change or add plan beneficiaries at any time. For high-income earners, the generous contribution allowances mean that in many cases, even an expensive Ivy League education can be financed entirely from plan distributions if you start a plan early.
Taxation and Deduction Rules
State rules for 529 contributions and withdrawals aren't complex, but they vary considerably from state to state. Some states allow you to contribute to a 529 plan even if you're not the plan owner; others do not. Although the federal government doesn't allow you to deduct your contributions from income, some states do. Most states do not allow you to contribute to another state's plan. Most states have contribution limits that are considerably lower than the federal governments -- you can contribute more, but amounts in excess of the state limit will not be deductible from your income in the year of contribution. It's best to check with your own state's taxation and deduction rules when you initiate the plan.