If you have (or expect to have) kids you plan to send to college someday, chances are you’ve heard about 529 savings plans.
Created in 1996 and named for the IRS Code section that houses them, 529s are state- (and sometimes institution-) run investment programs that help you cover “qualified higher education expenses” — tuition, fees and often room, board and more — while taking advantage of two key tax benefits: Your account grows tax deferred, and withdrawals are federal tax free if you use them to meet those costs.
And while you’re not limited to investing through a plan run by your state, many plans also enable residents to snag state-tax-free withdrawals, tax deductions or credits on contributions, and other state tax benefits. (A Prudential advisor can help you find a 529 plan that makes sense for you.)
Making the grades
In December 2017, Congress helped 529s celebrate their 18th birthday by adding K-12 education to the mix: Besides paying for college, you can use 529 plan savings to fund up to $10,000 a year in tuition (but not room or board) for public, private or religious elementary, middle or high school.
Even so, the state tax benefits that could come from using 529s are all over the map. For starters, many states simply don’t impose personal income taxes — so their plans offer no extra benefits for residents. But over 20 states and the District of Columbia Opens in a new window now let residents write off at least some 529 contributions for K-12 tuition. Another five enable income tax-free withdrawals. And at least two (Kentucky and Louisiana) have special 529s whose investment options are geared toward K-12 savers.
In general, 529 benefits alone shouldn’t justify sending your child to a tuition-based school. But if paying their way is already part of your plan (or your life), 529s are worth a look. Here are some pros cons to consider about when considering 529 saving.
There’s usually a longer road to college bills.
When saving for college, 529s can take advantage of compounding (the earnings on your investment earnings). This means the more time you have to invest — even if you don’t contribute a lot at a time — the bigger your tax-favored college fund can become.
But with K-12 tuition, time for growth may not be on your side. That’s because you might need the money in a couple years — or even months. So, you generally can’t afford to take as much investment risk (to seek greater rewards) as someone who has more time to recover from possible losses.
Here today, gone tomorrow?
The more money you pull from a 529 to cover shorter-term K-12 costs, the less that will be working toward longer-term college expenses. And make no mistake, these days college really costs — and prices aren’t likely to fall anytime soon (if ever).
Pro tip: To avoid tapping your college fund to cover K-12 costs, consider opening a separate 529 account for each. This way you can take a more conservative investment approach to the money you’ll need sooner — and watch compounding work its magic toward your longer-term goal.
No double dipping allowed.
States that give you tax benefits when you contribute don’t want you to also take one when you withdraw (or vice versa). In fact, chances are they’ll hit you for back taxes or penalties if you try.
Pro tip: If your state’s 529 doesn’t offer a tax break, a Coverdell Education Savings Account (ESA) could help. Coverdell ESAs offer similar tax benefits — federal and state — as 529s and can cover most K-12 and college expenses. But you can save only up to $2,000 a year per child — no matter who contributes — depending on your income.
More income, more breaks.
The higher your income — and state income tax bracket — the more you could benefit from a 529. For example, if you’re in your state's 5.75% tax bracket, a $10,000 investment in a 529 could save you $575 a year in state taxes when it’s used to pay K-12 tuition. But for to a family in a 2% bracket, that same investment would snag only a $200 state tax break. And if your income is low enough to result in a nonrefundable tax credit, a 529 you wouldn’t see any state tax benefit from a 529.
There are all kinds of rules around 529s. For example, if you don’t end up using your account balance for one child, you can change the beneficiary to a sibling. And if you withdraw money to cover nonqualified college expenses Opens in a new window or K-12 costs other than tuition, you’ll owe a 10% federal tax penalty on the earnings—and one state (we’re looking at you, California) dings residents another 2.5% for that. Indeed, some states that impose income taxes won’t give you a break on 529 earnings you use for K-12 tuition at all. But every state’s approach — to rules, investments and fees — is different. So, it pays to educate yourself before you choose a plan.