Do the Tax Benefits of 529 Plans Outweigh Their Higher Costs?

Note: This article is part of Morningstar's October 2013 College-Savings Boot Camp special report. This article originally appeared Aug. 27.

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.

Case Studies
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.

To find federal tax benefits, we assumed the following:

• Each family contributed to one member's 529 account each year for 18 years without any changes to their income level over time.
• They make no withdrawals during the 18-year period.
• Their 529 investments gained exactly 6% per year.
• Their 529 investments were no more than 35 basis points more expensive than a comparable open-end mutual fund. (We used a 35-basis-point differential because Morningstar's 2013 529 College-Savings Plans Industry Survey found that, on average, the difference in price between 529 funds and comparable mutual funds did not exceed 35 basis points.)
• Each family has a different household income and subsequently different long-term capital gains tax rates, which we note for each family.

To find state tax benefits, we assumed the following:

• Each family contributed 5% of its household income to its 529 account. State income tax rates vary for each family based on income and are noted.

Note that we did not make any assumptions about financial aid in this article.

Family Finances: The Wilsons
Myrtle and George Wilson have a combined household income of $50,000 and a state income tax rate of 3%. They will save $2,500 in their 529 account this year.

Federal Tax Benefits: The Wilsons' combined household income of $50,000 puts them in the 0% tax bracket for long-term capital gains. That means that if they bought and held investments in a taxable brokerage account, they'd owe no tax at the time of the sale when they sold the holdings to pay for college. However, any bond income, nonqualified dividends, or short-term capital gains would be taxable at their ordinary income tax rate of 15% (assuming they file jointly) in the year in which they receive them. Because 529 investments frequently have higher total expense ratios than comparable mutual funds, investing in lower-cost mutual funds held in a taxable account may make more sense from a price perspective. However, the case for the Wilsons investing in a 529 rather than a taxable account becomes stronger if they were to shift their taxable investment portfolio toward bonds and cash as college draws near, as is typically recommended. In that case, the income distributions from their investments would be added to their household's taxable income, and the federal tax benefits of the 529 would increase.

State Tax Benefits: If the Wilsons live in a state that offers a state income tax deduction for investing in their home 529 plan, the state tax savings could tip the balance in favor of using a 529 plan. Even in a state with a relatively low deduction cap of $1,000, the Wilsons would receive at least $30 (3% of $1,000) off their state income tax for their $2,500 investment. $30 back for a $2,500 investment is like a 1.2% boost to returns. Thus, that benefit outweighs the 529's higher costs.

The Short Answer for the Wilsons: The Wilsons' household income is too low to see any clear federal tax benefits from investing in a 529 plan, but state tax benefits could easily make 529 plans worth the extra cost if they choose to invest in their home state's plan.

Family Finances: The McKees
Lucy and Chester McKee have a combined household income of $150,000 and a state income tax rate of 8%. They will save $7,500 in their 529 account this year.

Federal Tax Benefits: The McKees' combined household income of $150,000 subjects them to a 15% long-term capital gains tax rate. To measure the effect of this tax on their investment, suppose that they invest $1,000 per year for 18 years in a 529 account and enjoy a 6% return each year. (For the sake of this example, we'll set aside the fact that the McKees are actually contributing at a much higher level than this.) At the end of the 18 years, their ending balance is $32,760 and their investment gain is $14,760. Their withdrawals would be tax-free, assuming they used the 529 money for qualified college expenses. If they held their college savings in a taxable brokerage account that generated an identical gain, they'd owe long-term capital gains of $2,214 (their $14,760 gain taxed at their long-term capital gains tax rate of 15%), lowering their effective net balance to $30,546. This is roughly equivalent to the McKees paying 67-68 additional basis points per year in annual expenses. The McKees may also incur additional tax costs by saving for college in a taxable account if their investments kick off ordinary income, dividends, or capital gains while they're in accumulation mode. At a minimum, their total savings from the federal tax benefits would exceed 67-68 basis points per year total. Because the price differential between a mutual fund available outside a 529 and comparable funds within a 529 tends to be around 35 basis points or less, the McKees come out ahead by investing in a 529 plan.

State Tax Benefits: Because the McKees clearly get enough federal tax benefits from using a 529 plan to make it a sound choice for college savings, any additional state tax benefits are the proverbial icing on the cake. The dollar amount of the McKees' state tax benefits increases with state deduction limits. To illustrate, for their $7,500 investment they would receive at least $80 back under a $1,000 deduction limit (assuming an 8% tax rate) and at least $600 back under a $10,000 deduction limit, which add up to a performance boost of 1.07% and 8%, respectively, versus saving in a taxable account.

The Short Answer for the McKees: The McKees' household income is high enough that their savings from avoiding federal capital gains and income tax bills clearly tips the scales in favor of a 529 plan. Any state tax benefits are an added bonus.

Family Finances: The Buchanans
Daisy and Tom Buchanan have a combined household income of $500,000 and a state income tax rate of 10%. They will save $25,000 in their 529 account this year.

Federal Tax Benefits: The Buchanans have the highest household income of our three families, and they also pay the highest capital gains tax rate of 20%. The Buchanans, like the McKees, are contributing more than $1,000 per year. But let's assume for illustration purposes that they invest $1,000 per year with the same 6% return as the McKees and end up with the same ending balance of $32,760. Like the McKees, they gained $14,760 from their $18,000 investment. If they held the money in a taxable account and that $14,760 were taxed at 20%, they would pay $2,952 in capital gains taxes, lowering their ending balance to $29,808. This is roughly equivalent to the Buchanans paying 91-92 extra basis points per year in annual expenses. Because the price differential between a mutual fund available outside a 529 and comparable funds within a 529 is almost never this high, the Buchanans definitely keep more of their money by investing in a 529 plan. To the extent that investments in a taxable account would subject them to additional income, dividend, and capital gains taxes on a year-to-year basis, investing in a 529 would be even more beneficial.

State Tax Benefits: Similar to the McKees' situation, any state tax benefits are an extra bonus for the Buchanans. Similarly, the dollar amount of the Buchanans' state tax benefits increases with state deduction limits. To illustrate, for their $25,000 529 contribution they would receive at least $100 back under a $1,000 deduction limit, at least $1,000 back under a $10,000 deduction limit, and at least a cool $2,500 back under a deduction limit of more than $25,000. (Only five states offer a deduction limit of $25,000 or more.)

The Short Answer for the Buchanans: The Buchanans' household income is high enough that investing in a 529 plan to avoid capital gains and income tax exposure definitely makes financial sense. Any state tax benefits are an added bonus.