Understanding the Tax Benefits of 529 Plans

Funding a child’s education can often feel stressful and overwhelming in even the best of circumstances. However, for parents, guardians, and relatives contributing to higher education expenses, 529 plans are transforming their college savings approach. These tax-efficient investing options not only ease the burden of education costs — but they can also potentially enhance your overall financial strategy. By understanding and maximizing the tax benefits of 529 plans, you can create a robust strategy for college savings that aligns with your financial goals.

What Are 529 Plans?

529 plans are state-sponsored investment accounts designed specifically for education planning. Named after Section 529 of the Internal Revenue Code, these plans allow you to save and invest for future education expenses while enjoying substantial tax advantages, making them a viable option for families hoping to defray the future cost of schooling for their children. 

A recent report in College Savings Statistics reveals that 30% of families use a college savings fund, like the 529 plan, to fund education costs. Still, despite the growing use of these programs, many U.S. families are still missing out. The same report goes on to say that “while over 16 million American families save for college using 529s, 54% of parents are unaware of the 529 program(s).” As a result, each year countless U.S. families could be missing out on investment opportunities that help support both their child’s and their own financial future.

Federal Tax Benefits of 529 Plans

Knowing the benefits of 529 plans can help you recognize the best ways to leverage these programs to maximize savings and reduce the overall tax burden. One of the most attractive features of 529 plans is the array of federal benefits they offer, including: 

Tax-Free Growth

Contributions to a 529 plan grow federal tax-free. This means that the interest, dividends, and capital gains on your earnings are not subject to federal income tax as long as the funds are used for qualifying education expenses. This type of financial growth can lead to exponential savings over time, especially for families that begin investing early. 

Tax-Free Withdrawals

Distributions from a 529 plan are also federal tax-free when used for qualified education expenses. These withdrawals can be used on expenses, such as:

• Tuition and fees
• Room and board
• Books and supplies
• Computer equipment and internet access

The tax-free withdrawal provision is another potentially significant advantage, allowing families higher savings on education investments.

Gift Tax Benefits

Contributions to a 529 plan are considered a gift to the beneficiary and can qualify for the annual gift tax exclusion. For 2024, this exclusion is up to $18,000 per year per beneficiary ($36,000 for married couples filing jointly). Additionally, 529 plan contributions can be front-loaded using a special five-year gift tax averaging provision, allowing you to make a large lump-sum contribution while still enjoying the benefits of the annual exclusion — more on that later.

State Tax Benefits of 529 Plans

While federal tax benefits are consistent across the country, state-level benefits can vary significantly. Understanding your state’s specific offerings can help you maximize your advantages. Consulting with an accounting professional or financial advisor can help you make the right investment decisions based on your state legislation. Some potential benefits may include: 

State Income Deductions and Credits

Many states offer income deductions or credits for contributions to 529 plans. However, the rules and limits can differ. Additionally, the amount and eligibility requirements vary, so it’s essential to understand your state’s specific rules. For example, some states provide deductions for contributions to any 529 plan, while others restrict the benefit to donations made to the state’s own 529 plan.

State Tax-Free Withdrawals

In addition to federal tax-free withdrawals, many states also allow tax-free withdrawals for qualified education expenses. However, it’s essential to check your state’s specific rules, as some may have additional restrictions or requirements.

State-Specific Incentives

Some states offer unique incentives, such as matching grants or scholarships, to encourage participation in their 529 plans. These incentives can further enhance the advantages of 529 plans and should be considered when evaluating options for college savings.

Parity Programs

A few states have introduced tax parity programs, allowing residents to claim a state deduction or credits for contributions to any state’s 529 plan, not just their home state’s plan. Parity states include:

• Arizona
• Arkansas
• Kansas
• Maine
• Minnesota
• Missouri
• Montana
• Ohio
• Pennsylvania

The flexibility of a parity program enables families to choose a plan based on features such as fees and investment options without losing out on state benefits.

Maximizing Tax Savings with 529 Plans

Of course, knowing the tax benefits of a 529 plan is only one component of successful college savings. To fully leverage the 529 tax advantages, it’s critical to have a strategy in place to help ensure you know how to best leverage the plan for future costs. 

As you begin your education planning journey, consider consulting with a professional financial advisor who can help you navigate the complexities of the plan and create an investing approach that supports your unique situation. Beyond seeking professional advice, other tips to help maximize savings with your 529 plan include:

Start Early

We’ve said it before and we’ll say it again — it’s never too early to start planning for your child’s or your financial future. The power of compound growth makes starting early one of the most effective strategies for tax-efficient investing in a 529 plan. The longer your money has to grow tax-free, the more you can potentially save on taxes over time.

Contribute Consistently

Regular contributions (even small ones) can significantly add up over a prolonged period of time. If you’re worried about remembering to contribute your plan, consider coordinating automatic monthly withdrawals to stay on track and potentially boost your long-term returns.

Optimize State Tax Benefits

If your state offers income tax deductions for 529 contributions, make sure you’re taking full advantage of them. This might mean contributing up to the deduction limit each year or choosing an in-state plan if required.

Stay Informed on Qualified Expenses

While these college savings plans offer extensive tax benefits, it’s important to understand that they also can wield potential penalties. Stay informed on qualified education expenses to ensure you don’t accrue unnecessary fees. When in doubt, consult with an accounting professional for the peace of mind that comes with knowing you have access to the latest standards and legislation. 

Consider Front-Loading Contributions

For those with the means to do so, front-loading contributions can be a powerful strategy. Utilizing the five-year gift tax averaging provision allows you to contribute up to five times the annual gift tax exclusion in a single year without incurring gift taxes. By contributing five years’ worth of gifts at once, you can potentially maximize tax-free growth over the long term.

Use 529 Plans for K-12 Education

Most people assume that 529s must only be used for college expenses. However, this is no longer the case. Recent changes to 529 plan rules now allow for tax-free withdrawals of up to $10,000 per year for K-12 tuition expenses. This expansion provides additional flexibility in your education planning.

Understand Account Owner Flexibility

As the account owner, you have the flexibility to change beneficiaries or transfer funds between accounts. This can be particularly useful if one child doesn’t use all the funds or if you want to save for future generations.

Schedule a Free Consultation With Destiny Capital Today

Destiny Capital specializes in helping parents and families navigate the complexities of college savings and create tailored education funding strategies. Schedule a free consultation today to learn more about how we can help you develop an approach that aligns with your future education vision.