American Dream

The 529 College Savings Plan: Save for College While Lowering Your Income Tax

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It’s not easy paying for a college degree. Recent College Board survey data reveals that the 2014–2015 college year cost, on average for a moderate budget, $23,410 for public in-state colleges and a whopping $46,272 for private colleges.

The good news is that valuable programs are available to help you save for your children’s college education. One of the best options is the 529 college savings plan, which offers a number of tax benefits, including a possible deduction on your state income taxes.

The 529 College Savings Plan

529 savings plans are state-run programs for Americans who want to put money aside for college. Every state has its own 529 program, and you can sign up for plans offered outside your state of residence. This helps you pick the best plan for you or your children’s needs.

There are two types of 529 plans. The first option is to buy prepaid semesters of college tuition at a list of approved schools. This locks in today’s price so that you don’t have to worry about a future price hike. However, not all states offer these types of 529 plans, and many schools do not offer prepaid tuition.

The more common type of 529 plan, offered by every state, allows you to invest savings in a variety of different assets, such as stocks, bonds, and mutual funds, to grow those savings over time. When your kids get to college, you take the money out to pay for their expenses.

Tax Benefits

The 529 college savings plan comes with a couple of helpful tax benefits that help you save more money than you would if you just used a regular investment account. First, 34 states plus the District of Columbia offer some sort of tax deduction or credit for your contributions into a 529 plan. If you live in one of these states, the money you put aside for college will also lower the amount you owe in state income taxes. However, there is no federal tax deduction for contributing to a 529 plan.

Another tax benefit of these plans is that they are exempt from both state and federal income tax on your investment earnings. As long as your money stays in the 529 plan, you won’t owe taxes on your investment gains. When you take the money out to pay for college savings, your withdrawals are also tax free. As a result, you completely avoid taxes on your gains, creating a much better after-tax return than you’d get from saving through a taxable account.

Spending the Money

Since the 529 plan is a college savings plan, you’re supposed to spend the money on qualified college expenses, namely tuition, room and board, books, and other college fees. If you don’t spend all of your 529 savings on college expenses, you can take the money out for yourself. However, you’d owe income tax as well as an extra 10 percent penalty on your investment earnings, canceling out the tax benefit.

Reaching your college savings goals can be a challenge. By taking advantage of the tax benefits of a 529 college savings plan, your tax savings can get you that much closer to your goals.