Setting up your children for a successful future is a wonderful goal for parents. Many of us think of a 529 plan as a savings tool for college, but what if we have enough money saved in another investment account? Is a 529 plan still a good idea? Here we discuss the benefits of a 529 plan, how it compares to a traditional investment account as an education savings tool, and what happens if you don’t use the funds for a qualified education expense.
Benefits of a 529 Plan
Tax-free and tax-deferred growth – The funds in your 529 plan will grow tax-deferred, meaning you won’t owe any taxes until the money is withdrawn from the account. The growth will be tax-free if you use the funds for qualified education expenses.
Yearly tax deduction – There is no federal tax deduction for contributing to a 529 plan. However, various state plans may have tax deductions. For example, in Maryland, account holders or contributors who choose to invest in the Maryland 529 College Investment Plan can receive a $2,500 annual state income tax deduction ($5,000 for couples filing jointly).
Other states and types of 529 plans may offer different tax deductions – talk to your financial advisor to find the best option for you.
Gift tax benefits – For 2022, you can gift up to $16,000 tax-free ($32,000 if you’re a married couple) to any beneficiary. If you gift more than the annual limit, the amount over the limit is deducted from your overall lifetime gift tax exemption. The 2022 lifetime gift tax exemption is $12.06 million – this means you can give up to $12.06 million in gifts over your lifetime without having to pay gift tax.
529 plans are unique in that they allow contributors to gift up to five years of annual gifting at once. For 2022, that would equal a lump sum of $160,000 for a married couple ($32,000 X 5) that can be gifted to a 529 plan. This strategy not only benefits the 529 plan beneficiary, but also may benefit the contributors by removing money from their estate to potentially lower estate taxes.
What if you already have enough saved? Should you still utilize a 529 plan? What if you use a traditional investment account?
While a traditional investment account can be a great savings tool for many financial goals, a 529 plan is designed specifically for education expenses. Although a traditional investment account can offer more flexibility, it will not have the same tax benefits as a 529 plan. Even if you have enough saved, placing some of your money into a 529 plan could offer additional benefits.
What happens if your child doesn’t attend college or receives a scholarship?
A 529 plan can be used for much more than just college tuition. It can be used for two-year programs, trade schools, up to $10,000 per year for private primary or secondary school, and related expenses such as books and housing. If your child truly has no qualified education expenses, you can choose to change the beneficiary on the account to a family member without penalty.
If you don’t end up using the funds for qualified education expenses, you will incur a 10% penalty and owe taxes on the growth of your account upon withdrawing funds.
If your child receives a scholarship, you can avoid the 10% penalty on non-qualified withdrawals up to the amount of the tax-free scholarship, however you will have to pay tax on the earnings.
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