The tax benefits of 529 plans are all based on the gains generated, if any, from how you invest your 529 plan money and whether or not you use the money invested for qualified college expenses. There are essentially four types of taxable gains you could eliminate by using a 529 plan correctly. They are:
- Long term capital gains
- Short term capital gains
- Qualified dividends
- Ordinary interest or dividends
What Is a 529 Plan?
Before having a discussion about the tax benefits of a 529 plan, one should understand the basics of what a 529 plan is. A 529 plan is a state sponsored savings vehicle particularly targeted for families trying to save money for college expenses for their children. The benefits include the following:
- No taxes on the gains if used for qualified higher education expenses.
- Control of the money by the owner (if your child doesn’t go to college the money remains in the control of the parent).
- The owner can change the beneficiary from one child to another if one of the children decides not to go to school.
- If all the money is not used for college expenses it can be used for retirement with the remaining gains being taxable.
An Example of Tax Benefits
The tax you would pay varies on each of the above listed 529 tax benefits;
Long Term Capital Gains are taxed at a maximum of 20% depending upon a person’s tax bracket, plus the 3.8% Obamacare tax. For this discussion of 529 tax benefits we will assume the highest tax rate available or 23.8% in the example to follow later.
Short Term Capital Gains are taxed with ordinary income tax rates where the highest tax bracket is 39.6% plus Obamacare Tax of 3.8% for a total of 43.4%.
Qualified Dividends from a mutual fund as an example, would be taxed at a maximum of 20% plus Obamacare (same tax of 3.8%) for a total of 23.8%.
Ordinary Interest or Dividends are taxed at the highest tax bracket of an individual taxpayer (ranges from 10% to 39.6% plus 3.9% Obamacare tax), so for the example to follow we will use 39.6% + 3.8% for a total of 43.4%.
The following example of potential 529 tax benefits will assume the money was invested in a mutual fund and the fund generated long term capital gains, qualified dividends and ordinary dividends as follows:
Amount invested (after tax) $15,000
Long term capital gain $3,000
Qualified dividends $1,000
Ordinary dividends $1,000
Total value of account $20,000
If you used the above money for qualified college expenses, your tax savings would be as follows, assuming the highest tax bracket:
. Tax Rate Tax Savings
. Amount invested $15,000 0 0
. Long term capital gain $3,000 23.8% $714
. Qualified dividend $1,000 23,8% $238
. Ordinary dividend $1,000 43.4% $434
. Total Tax Savings $1,386
The above example of 529 tax saving benefits would allow you to pay for qualified college expenses (assuming the highest tax bracket) and have $1,386 more money to pay for your child’s college than if you didn’t use a 529 plan.
The effective tax savings ($1,386 divided by $20,000, the total value of the account) represents 6.93% of your total college fund. You should calculate your 529 plan tax savings based on your effective tax bracket. The above example represents the best possible 529 tax benefits.
Are the 529 Tax Benefits Right For You?
First of all, a majority of 529 plans are invested in mutual funds which also expose you to the risks of the stock and bond markets. This should not be an understated risk in your consideration of using a 529 plan for accumulating money for your child’s college expenses. Taking the above example of 529 tax benefits of $1386 (best case), your $20,000 invested in the market would only have to lose 6.93% just before beginning to use your 529 plan money to wipe out your 529 tax benefits. Obviously you would still have $18,614 to pay for your child’s education but the 529 tax benefit portion of the plan would have been nullified. A loss greater than 6.93% would make your 529 plan less effective than if you had put your money into a savings plan of some sort.
Secondly, because 529 plans are sponsored by a state such as Texas, California, or any other state, the expenses to run the mutual fund are higher than normal because the state participates in the management fees charged. It has become a money maker for state governments that sponsor such plans.
Finally, the most important consideration to determine whether a 529 plan is right for you or not is to calculate how the value of your 529 effects your need based aid. Assuming you had $20,000 in a 529 plan and depending upon your individual financial situation, it could at maximum cost you $4000 in need based aid the first year of your child’s college. If you didn’t spend all the 529 money in your child’s first year and had $15,000 remaining, the second year it could potentially cost you $3,000 in need based aid.
Carefully Weigh the Pros and Cons of 529 Plans!
- Tax savings.
- Control of money for child’s education
- Decrease of aid from college and universities
- Risk of loss in investments
- Higher expenses of mutual funds due to state involvement
There are alternatives to 529 plans that accomplish the same thing without the drawbacks. The benefits would include tax savings, control of the money, money does NOT decrease potential need based aid, no risk of loss from investment in the stock or bond markets.
In conclusion, parents and/or grandparents need to carefully evaluate the risks versus the rewards of using 529 plans in attempting to accumulate funds for your child’s or grandchild’s college education expenses.