Why We Love 529 College Savings Plans
We’re always in awe of the creativity congress utilizes when naming tax-advantaged accounts for us. The 401(k)! The 529 plan! Such ingenuity to just call the thing by its section number of the Internal Revenue Code (that’s sarcasm folks). Allow me to suggest some better descriptive names for this fantastic little account:
The Tax-Deferred College Savings Account
The No-Brainer Account
The How to Save $1,000 on your New York State Tax Return Account
So what IS a 529 Plan?
It’s a special type of brokerage account that can hold stocks and bonds that is specifically designed to incentivize parents to save for their children’s college education. Think of it like an extra 401(k), but instead of saving for retirement, you’re saving for the expense of college that can add up to high six figures. The reason it’s special is that dollars you invest in a 529 (just like a 401(k) or an IRA) grow tax-free. In other words, a dollar put into a 529 plan will be worth more than a dollar put into a regular old brokerage account because the dividends and interest are not taxed annually and are allowed to grow without “Uncle Sam” taking some off the top each year. Dollars saved into a 529 can then be withdrawn tax-free to pay for “qualified education expenses” like tuition and laptops.
529 plans are run by individual states and have different benefits. At Brooklyn FI, we LOVE the New York State 529 plan because of its fantastic tax benefit in the year of the contribution (this is in addition to the tax-free growth mentioned above). Like 401(k)s, there are often convenient options for investors to simply select an inexpensive age-based portfolio (often called a Target Date Fund with a year attached to it - like 2035) without having to buy and sell funds all the time.
Each taxpayer can receive a deduction of up to $5,000 on their New York tax return for a 529 contribution. For a married couple, that’s a $10,000 deduction from taxable income which can be incredibly valuable for high-income NYC residents paying as high as 14% income tax in New York state. Make a $10,000 contribution as a couple and receive a tax break as high as $1,300.
California taxpayers will not receive a tax benefit for making a contribution, but their funds will grow tax-free. Here’s how to look up your state benefits and how to open a plan in your state.
What can you spend 529 money on?
Anything that falls into the IRS category of “qualified education expense” is eligible. Currently, this list includes tuition, room and board for full-time students, laptops for school, books, and much more. The complete list is here. The funds must be used at an accredited university and can be used for both undergrad and graduate education. You can use 529 dollars at many foreign institutions as well. Here’s a great search tool to see if your school is eligible.
Should I open one?
Yes! If you’ve already filled up the 401(k) savings bucket and the IRA bucket, the next logical step in the savings order of operations is the 529 plan. Generally, in New York, we recommend going with a $5,000 annual contribution for the tax benefit and up to $15,000 annually which is the current amount you can gift to another individual without filing a gift tax return.
What if I don’t have kids or my genius kids get a scholarship and don’t need the money? And what if I don’t use the money for qualified education expenses?
Well, yes of course there could be a scenario where you never need to use the money. Then you’ll pay a 10% fee on withdrawals, plus ordinary income taxes. BUT BUT BUT, the benefits could still outweigh the negatives. First of all, there are nifty laws in place where you can actually withdraw the money tax-free up to the amount of the scholarship. Also! You can change the beneficiary at any time to a close relative. We often encourage our clients who are just thinking about having kids to open an account with themselves as the beneficiary. Then, when the baby is born, the beneficiary can be changed. If you aren’t planning on having children, this is still a fantastic way to gift money to your nieces and nephews, and cousins. You still get the tax benefit (in some states, remember) in the year of the contribution. Even if you never, ever have children, the tax benefits can FAR outweigh the penalties and taxes.
Here’s one of our favorite charts that shows the benefits of investing in a tax-deferred account vs a regular brokerage account.
