Three case studies demonstrate that the benefits are greatest to higher-income families who live in states with generous 529 tax deductions.
Many families want to save for college, but untangling the tax benefits associated with 529 college-savings plans can be difficult. Families might have an especially hard time weighing 529 investments' higher expense ratios with their tax-free investment gains and state income tax benefits.
Of course, every family saving for college is slightly different: Families save varying amounts, invest in different ways, and are subject to different levels of federal and state taxation. Nonetheless, we sought to determine when the federal and state income tax benefits of saving for college through a 529 plan outweigh the higher costs often associated with 529s. Thus, we thought it might be useful to create case studies of three fictional families with different income levels.
Federal Tax Benefits
Before we get into the case studies, let's briefly review the tax benefits associated with investing in a 529, first at the federal level.
529 investments carry two layers of federal tax benefits. The first is tax-deferred compounding: Similar to investments held in IRA and 401(k) accounts, investors don't pay taxes on investment income as long as they hold the account--whether it be in the form of dividends, capital gains, or bond income. This is in contrast to income and gains from investments held in taxable accounts, which investors must pay taxes on each year. The tax rate on long-term capital gains and qualified dividends held in taxable accounts ranges from 0% to 20%, depending on income level. Meanwhile, the tax rate on short-term capital gains and bond income held in a taxable account is taxed at the investor's ordinary income tax rate, which can be as high as 39.6%.
Tax-free withdrawals for qualified college expenses are the second federal tax benefit of investing in a 529 plan. Thus, investors in 529s avoid having to pay taxes on appreciation in their investments when they begin pulling the money out of their accounts to pay for college.
The value of 529 plans' federal tax benefits depends on household income and the type of investments used for college savings (for example, how much of the portfolio is allocated to stocks and how much to bonds). Investors in low tax brackets who buy and hold capital-gains-producing assets such as equities will see less of a federal tax benefit from investing in a 529 plan than those in higher tax brackets and who therefore will owe more in taxes. Likewise, a family in a high tax bracket that invests primarily in tax-inefficient assets (such as bonds) within a taxable account will derive a much greater benefit from investing in a 529 than will a family from a lower tax bracket.
State Tax Benefits
Usually, investors in 529 plans can deduct at least a portion of their contribution amounts from their state income taxes if they invest in their own state's plan. Naturally, state tax benefits associated with 529 plans depend on where the investor lives. Some states offer quite generous 529-related tax benefits, while others offer no benefits at all.
To help quantify the value of state and federal tax breaks for 529 savers with different financial and tax pictures, consider the following case studies. In all three situations, we compared the costs and benefits of investing within a 529 with investing in a taxable account for college savings. We made slightly different assumptions to measure federal tax benefits and state tax benefits.