How much is the 529 tax deduction worth?
The 529 Plan comes with an array of tax deductions which can yield huge savings when you pay for college. But how much are these deductions really worth? The answer can change based on many factors. How much you contribute, the number of years in which you contribute, and the state you’re in can all determine how much your deduction is worth. Let’s break down all of the relevant factors.
Read more: What is a 529 Plan?
How total contribution affects your 529 Plan deduction
Tax deductions lower your taxable income by excluding specific income or expenses from taxation. So, at a tax rate of 20%, a $1,000 deduction would save you $200. The 529 Plan is an opportunity to deduct educational expenses, which can make saving for college much easier.
529 Plan contributions are made from after-tax income. But depending on your state, you may be able to deduct these contributions from your state taxes. So, the more you contribute, the higher your deduction will be. 529 Plan earnings are also exempt from federal taxes. So even if your income is taxed, the earnings in the account will not be.
How annual limits affect your 529 Plan deduction
Each state has its own maximum annual deduction for 529 Plans. To maximize your state deduction, try to spread your 529 Plan contributions out over many years. If you make a few large contributions instead of pacing them, some of them will not be deductible from your state taxes.
529 contributions made by a family member run the risk of being taxed by the government. However, 529 Plan contributors can use the gift and estate tax exemption to circumvent this. The gift and estate tax exemption has an annual limit of $15,000. Therefore, it’s wise to space out your contributions to a 529 Plan.
It’s also possible to make more than $15,000 of 529 Plan contributions per year. You can choose to “superfund” your 529 Plan by making one large contribution which counts against your limits for future years. You can also deduct contributions over $15,000 against your lifetime gifts and estate contribution limit. This limit is set at over $11 million, so very few people exceed it.
For more information: How much can I contribute to a 529 Plan?
How your state of residence affects your 529 Plan deduction
Each state has its own policy for taxable income deductions. Some states don’t have a 529 Plan deduction, so you won’t be able to deduct any of your state income. Others will allow you to deduct up to $15,000 per year.
If you live in a state with a low 529 Plan deduction, make sure to start contributing early so you can space out your contributions. This will maximize your deduction and save you the most money. It’s a good idea to try to deduct as much of your college fund as possible from state taxes.
Also read: What are the 529 Plan rules?
Don’t forget interest
Remember, if you start investing in a 529 plan early, your savings will compound as time goes on. The money that you saved in tax deductions will compound every year and your savings will continue to grow. Your tax deductions will be worth more the sooner they land in the bank. And on top of that, they will not be subject to federal taxes. So start saving early to get the most out of your 529 plan!
Related: How to choose a 529 Plan