Is a 529 Plan Tax-Free?

Parents spend an average of nearly $13,000 each year just to raise one child. And that’s without any special activities, private school, tutoring, or unexpected events. Multiply that by 18 years and you’re looking at spending over $230,000 per child to raise your kid. Obviously, then, it makes sense to look into a 529 plan.

Then, you’ve gotta start thinking about the costs of sending them to college. Why? You obviously want to set them up for their best and brightest future. Already struggling to save money each month? Saving for college costs can be a challenge, especially given how tuition has skyrocketed in recent years.

Currently, the average cost of attending university is about $41,000 per year for a private university. It's just over $11,000 for public universities. Thankfully, there’s a tax-advantage way of saving that money so you and your kids can all prosper.

529 plans are a flexible way of saving and building wealth for your child’s future. You put after-tax money into the account and it gets invested in bonds, mutual funds, and certain stocks. Yeah, we said after-tax money. So, is this college-savings account tax-free? And what makes these plans so popular? Let's have a look. 

What is a 529 Plan?

A 529 plan is a flexible and tax-advantaged savings plan. They allow parents to slowly save money for their child’s education. Initially, a 529 plan covered only post-secondary schooling costs (i.e. college). Recently ,it was expanded so that now you’re able to use it for K-12 education and apprenticeship programs, too.

There are two major types of 529 plans: prepaid tuition plans and savings plans

Prepaid tuition 529 plans allow you to pay your child's education costs in advance at designated universities and colleges while locking in the total cost at a specific rate. Basically, you’re purchasing credits or units at those universities. While this is a unique offer, you’ll want to be sure that your child will actually attend one of those participating universities or you’ll be wasting that money.

On the other hand, you have savings plans. These are tax-free when you make payments for qualified education costs. Plus, they are also tax-deferred. These are investment accounts, meaning that you’re putting money into the account and the cash gets invested for you so that you’re able to grow it more than you would in a savings account.

It’s important to keep in mind that you can only allocate $10,000 from a savings plan to pay for education costs from a 529 savings plan.

Why are 529 Plans so Popular?

There are two major reasons why 529 plans are gaining traction.

First, you’ve got the tax advantage, because who doesn’t love a good tax break, right?

529 plans do not only provide tax-free withdrawals and federal tax-free growth when paying for qualified tuition costs, some states in the US offer residents a deduction for contributions to their plan or a full or partial tax credit.  

According to the 2017 Tax Cuts and Jobs Act, account holders can use the funds to pay for tuition costs up to $10,000 per child annually from kindergarten through the 12th grade. However, there are some states that do not permit the funds to be spent on K-12 tuition expenses. Therefore, check with your state to determine the plan's rules so as not to pay for penalties or be subjected to the state's income tax. 

The second biggest reason why 529 plans are a good idea for those with children? They’re pretty freakin’ flexible.

After the beneficiary of a 529 plan has successfully earned an undergraduate degree, the remaining money in the account can still be used at any time to pursue vocational, trade, or graduate education. And, get this (if you’re looking to build generational wealth), the account holder can also channel the funds to any direct relative, including nieces, nephews, aunts, uncles, cousins, and even themselves.

So, What About 529 Plans and Taxes?

The short answer: 529 plans allow you to invest in your child’s future. They do so while allowing you to enjoy federal tax-free growth and tax-free withdrawals for education expenses. But keep reading because there’s more to this whole thing.

The earnings accrued through a 529 plan are exempted from both state and federal income taxes, provided the funds are used on qualified educational costs (more on what those qualifying costs are here). 

A non-qualified withdrawal will earn you a 10% penalty and is subject to taxes, so definitely don’t do that.

Generally, if you want a state tax deduction, you will need to invest in your state's plan. However, if you are comfortable forgoing a tax break, investing in other states' plans as a non-resident would be a no-brainer. 

Why Does This Matter?

Building and compounding your wealth is all about learning where to cut spending. It helps to also know how to grow your wealth in a way that’s passive, consistent, and in this case, tax-free. Finding ways in which you can put the same amount of cash in the right account instead of a savings account can be the difference between simply saving and actually building generational wealth.

A 529 plan is a tax-free way to do this. However, there are plenty of other ways to do it, too. They all start with you understanding your personal capital structure, the interest rates you’re working with when spending and saving, and a few other factors.

At Wealth Stack, we’re obsessed with being a force of change. That's why we've created an app that allows you to learn how to invest in yourself. We’ll teach you how to take the money you’re saving by investing in a 529 plan (or investing in stocks, yourself). Head over to our Learn section to see how.