If you want to start saving money for your child’s college education, a 529 plan is a great option. Many investments, unfortunately, have complicated taxes and high rates. If you are worried about the tax consequences of this type of savings account, go ahead and relax. Fortunately for you, 529 plans offer savers with tax benefits instead of drawbacks, on both the state and federal levels.
Federal Income Tax Benefits
When you contribute money to most investments, you are required to pay federal income taxes on your earnings. For instance, if you earn $1,000 of interest income on your personal savings account this year, you will be required to pay federal income taxes on this amount. 529 plans, though, can accumulate earnings tax-free.
As long as you use your 529 plan to pay for qualified educational expenses such as tuition and required fees, you can accrue income free of taxes. If you decide to withdraw funds from your 529 plan to pay for non-educational related things, you will owe income taxes on your accumulated earnings and a 10% withdrawal penalty.
State Income Tax Benefits
Aklthough 529 Plan rules vary by state, most states also allow you to accrue tax free earnings in your 529 plan. Some states even allow you to deduct contributions to 529 plans from your income taxes. Before enrolling in a particular college savings plan, find out what tax rules apply to your state of residence. Transferring your 529 plan from one state government to another one may also incur tax consequences, so it helps to know the facts.
Federal Estate and Gift Tax Benefits
In addition to federal and state income taxes, 529 plans affect federal estate and gift taxes as well.
- Estate Tax: If you contribute money to a beneficiary’s college savings account, the value of your estate decreases by the amount donated. Therefore, this type of transaction can lower your future estate taxes.
- Gift Tax: Single account owners are typically allowed to contribute up to $14,000 per year without being subjected to a gift tax. If you are married and file your federal income taxes with your spouse, you can donate $28,000 before gift taxes kick in.
The amount of information about college saving options can be overwhelming. 529 plans are no exception. However, after researching them, you may be pleasantly surprised at the tax benefits they offer. In fact, for some people, the tax savings alone make 529 plans the best college savings option available.