529 College Savings Plans provide incentive for saving for college through favorable federal and state income tax treatment. Gains in 529 Plans accumulate tax-free.  529 account withdrawals are tax-free provided the money is used for qualified educational expenses.  An IRS 529 college savings plan Q&A is available here.  It is much less expensive to pre-pay education expenses in a 529 Plan while the money grows tax-free versus paying interest on student debt later.  Think of it this way.  Interest earned on a 529 account works for you.  Interest paid on student loans works against you.

Types of 529 College Savings Plans

Two types of 529 College Savings Plans are investment college savings plans and pre-paid tuition plans.  A 529 investment type plan can be sponsored by a state or obtained through a brokerage firm or financial institution.  Pre-paid tuition plans are established by states as pre-payment of tuition or tuition credits to be used at the sponsoring state’s schools. Pre-paid tuition plans are a hedge against tuition cost increases.  You are buying tuition credits at current rates with pre-paid tuition plans.

Additional State Tax Savings on Deposits

More than half the states offer a state income tax deduction or state tax credit on deposits in their state 529 plans.  Let’s take a closer look at how a 529 college savings plan deposit can impact the state income tax return.

Example of 529 Plan Tax Savings on Deposits in Michigan

Michigan gives a state tax break on up to $10,000 annually on deposits into the Michigan-sponsored 529 plan.  A Michigan resident makes a 529 deposit into a Michigan-sponsored 529 Plan.  The taxable income on the Michigan Income Tax Return is reduced in the year the 529 deposit is made.  Deposits into a 529 Plan do not impact federal income taxes.

529 College Savings Plan gains are passive income

Suppose you open a 529 account with a $5,000 deposit.  The value of the account rises to $10,000.  The $10,000 balance pays for college expenses like tuition and books.  The $5,000 gain upon withdrawal is tax-free.  Sweet!  529 Plan gains are passive income.  The owner didn’t have to actively work for that money.  It accumulated on its own.  Not paying income taxes on 529 account gains is huge benefit.

When Circumstances Change

You select a pre-paid tuition plan and Junior goes to an out-of-state school. Converting pre-paid tuition plan money can be a little sticky.  The return of a pre-paid tuition plan generally lags behind market returns for the same time period.  If you are uncertain which type of 529 Plan to choose, the investment type is more flexible.

What if Junior doesn’t go to college?  One option is to transfer 529 account money to an immediate family member.  Another option is to cash out of the account and pay a penalty.

• Investigate the 529 plan options in your state.
• Select an investment or a pre-paid tuition college savings plan.
• If the state plan does not offer state tax advantages, open a 529 investment account through a discount brokerage firm.  The fees are usually lower.  Adding a 529 Account to an existing portfolio simplifies the paperwork.

A 529 College Savings Plan is a way to pre-pay for college.  Research your state’s 529 plan options to select the right product to meet your needs.  The income tax savings makes the 529 investment a winner.

• It is less expensive to pre-pay future education expenses in a 529 Account while the money grows tax-free versus paying interest on student debt later.
• Two types of 529 Accounts are investment and pre-paid tuition college savings plans.
• More than half the states offer a state income tax deduction or state tax credit on deposits in their state 529 plans.
• If the state plan does not offer state tax advantages, open a 529 investment account through a discount brokerage firm because the fees are usually lower.