Question: I’m a new mom and I really want to help set my child up for success when it comes to their college education. I had to take out thousands of dollars in student loans to go to school, and I don't want my child to face the same problem! I know that a 529 college savings plan is the way to go, but I'm not sure what tax benefits are available? I have heard it may vary by state, and I just don't want to make any wrong moves... but I also want to save as much as possible (both on my taxes now, and for my child's future!) Please help.
Answer: Congratulations on your new addition! It’s so smart to start thinking about your child’s future education now. Just like preparing to buy a car or a house, saving early can help alleviate some of the financial stress when the first tuition bill shows up. And you’re right that a 529 plan is the way to go. Here’s a rundown.
What is a 529 Plan?
A 529 college savings plan is a tax-advantaged investment account that is used to save for — then pay for — college, grad school, other forms of continuing education and, recently, K-12 education, as well. The funds can be used for anything from tuition to biology textbooks to a new MacBook Pro, as long as it’s deemed a “qualified educational expense,” which spans a wide range of things needed for education. Anyone can contribute (like a grandparent, parent, or your aunt Cindy, who is twice removed, but still comes to Thanksgiving) and they may get a state tax deduction for doing so (more on that in a moment).
Federal and State Tax Benefits
There are a lot of similarities between 529s and Roth IRAs. Money goes into 529s after you’ve already paid taxes on it, it grows tax-free and then, as long as you use the money for those qualified educational expenses described, it comes out without you having to pay any additional taxes. That tax-free growth is one of the biggest tax benefits a 529 offers — it pays to put money in early and give those funds more time to accumulate.
While there are no federal tax deductions or credits for 529 contributions, there are some benefits available on a state-by-state basis. Some states offer a direct income tax deduction or credit for contributions to their state-run 529 plans. Others offer a “tax parity” benefit, meaning you can contribute to any state’s 529 plan and still receive a state tax deduction or credit in your state. (This offers more flexibility for families who might prefer an out-of-state plan with better investment options or lower fees.)
For example, states like Pennsylvania and Colorado provide tax deductions for contributions to their state’s plan, while other states, such as Oregon and Minnesota, offer a tax credit, which can be even more valuable, and still others like California and North Carolina, do not provide any state tax benefits for 529 contributions. Unfortunately, the rules vary widely by state, and it can get complicated, so check your state’s guidelines to make sure you’re able to snag all the benefits you can.
Also, a heads up: Grandparents are welcome to contribute to your child’s 529, but they may want to open their own separate 529 if they want to see a tax benefit. If a grandparent puts money into a parent-owned 529, they would not receive the state tax deduction, no matter how much they contributed. Instead, the grandparent would need to open a separate 529 as the account owner (with the grandchild as the beneficiary) to take advantage of the state tax deduction. On that note…
Parent vs. Grandparent 529s
Be aware that 529 plans owned by grandparents are treated differently when you apply for college than those owned by parents. Recent changes to the FAFSA (Free Application for Federal Student Aid) means that grandparent-owned 529s may be more advantageous for those applying for need-based financial aid. Previously, taking money out of a 529 owned by a grandparent was considered cash support for the purposes of calculating financial aid. But now, those gifts are not required to be reported — while 529 assets in the parent’s name are counted.
Potential Drawbacks & New Rollover Rules
Don’t lose sight of the fact that the money you save in a 529 must be used for qualified educational expenses. If your child decides not to pursue higher education, or, for example, gets a full-ride scholarship, they might not use the money in their 529. In that case, you could transfer the funds to another beneficiary. However, if you don’t use the funds for education, you’d have to pay income taxes on the withdrawal, and face an additional 10% penalty. (With that said, if your child receives a scholarship, the 10% penalty would be waived for the amount of the scholarship, so you’d only owe the income taxes.)
Alternatively, as of 2024, you can also roll over some unused funds from a 529 plan into a Roth IRA, per the SECURE 2.0 Act of 2022. Rollovers would also be tax and penalty-free, but be aware there are many rules to follow: The 529 must have been open for at least 15 years, your rollover amount can't exceed the annual IRA contribution limit, and you can only roll over $35,000 per beneficiary, for example.
Bottom Line
529 plans can be incredibly beneficial tools for parents (and grandparents!) who want to save money on higher education in the future, and save money on state taxes today. Before you open a 529, take a look at your state’s rules for credits and deductions, and research all your options to determine what type of 529 plan is best for you — many of them will have higher maintenance fees and enrollment fees than others, so choose your plan wisely.
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