How valuable are the tax advantages associated with 529 plans? And how do they work?
April 13, 2021
Although most 529 account holders are aware that their college savings plan is tax-advantaged, it’s often confusing how valuable the tax benefits may be. With tax season in full swing, a simple hypothetical example might help illustrate how the tax advantages of a 529 plan help a family’s savings go further.
College is expensive; saving for it is important
In today’s economy, some form of post-secondary education—be it an apprenticeship, technical school, vocational school, two-year school, four-year school, or graduate school—is necessary to access most well-paying jobs. Understanding this, young people are enrolling in post-secondary education in increasing numbers. In 1980, approximately 50% of high school graduates went on to enroll in a two-year or four-year college. Today, 70% of American children who finished high school in 2016 have since enrolled in a two- or four-year college.
Postsecondary education is important and valuable. Unfortunately, it can also be expensive. Grants from the federal government, states, and educational institutions can help lower the costs, but they are rarely sufficient to cover all expenses. For the 2020 – 21 academic year, the average full-time community college student received $3,990 in grant aid, but the average cost for community college tuition, fees, books, and supplies totaled $5,230. The average full-time undergraduate at a public four-year school received $7,330 in grant aid but the total cost of tuition, fees, room, board, and books was $23,420. At four-year nonprofit private schools, the average student received $21,660 in grant aid but the full cost of attendance—room, board, books, and supplies—was $52,010. No matter the type of school, the average student has thousands of dollars of expenses that must be covered by the student and the student’s family through some combination of savings, income, student loans, and tax credits.
How 529 plans help families save on federal taxes
Through the federal tax code, the federal government helps families save for a wide variety of life’s major expenses – including retirement, health care, homes, and education. To help families save for college, the federal government allows families to save in tax-advantaged vehicles called 529 college savings plans. The goal of 529 plans is to make each dollar saved for college more valuable through tax-deferred compounding and tax-free withdrawals when used for qualified expenses.
To better understand how valuable these federal tax benefits may be, let’s work through a hypothetical example. Let’s imagine a family that, upon the birth of their child, opens a 529 College Savings account and invests $1000. Although there’s no guarantee, the family’s $1000 initial savings could realize investment earnings. For our hypothetical example, let’s assume the average annual earnings are 5% over 18 years.
Earning 5% a year, after 18 years, the family’s initial investment of $1000 would have grown to approximately $2400: consisting of a $1000 initial investment and a total of $1400 in tax-deferred compounded investment earnings. If the family withdraws the money from their 529 account and spends it on qualified expenses for their child’s education, the $1400 in investment earnings is free from federal tax.
How valuable is that tax benefit? By using a 529 plan, savers avoid capital gains taxes—taxes charged on the growth in value of investments such as stocks and bonds. The type of capital gains tax depends on the price at which a saver purchased an investment, the price at which they sold an investment, and for how long they owned it before selling. The rate of capital gains tax depends on the family’s income, filing status, and other factors. To understand how a 529 plan may help a family save in capital gains taxes, let’s take a very simple, hypothetical example. Let’s assume our family earns $80,000 in taxable income, meaning they would pay a long-term capital gains tax rate of 15%. By investing $1,000 in a 529 account and withdrawing it 18 years later to pay qualified education expenses, our family would avoid paying $210 in capital gains taxes on $1,400 of investment earnings during the life of the account.
How States Help Families Save
Over 30 states and the District of Columbia help further boost the value of college savings by offering state-level tax benefits for investing in a 529 plan. These benefits vary from state to state and, like federal tax benefits, will ultimately depend on each family’s income, filing status, and other factors.
As an example, in my home state of Illinois, taxpayers filing single may deduct up to $10,000 in Illinois 529 contributions from their Illinois taxable income; taxpayers married filing jointly may deduct up to $20,000. This state-level benefit helps our hypothetical family save even more. The Illinois state income tax rate is 4.95%, meaning, in our example, when the family invested the original $1,000, they saved approximately $50 in state income tax through their Illinois income tax deduction.
The Full Savings Boost
Our hypothetical family, recognizing that college is important and expensive, wisely put away $1,000 for college when their child was born. When they contributed $1,000, they saved $50 in state income taxes. Through the power of tax-deferred compound earnings, their $1,000 earned an additional $1,400. Through the 529 savings plan’s federal tax advantages, the family saved $210 in capital gains taxes.
In our hypothetical example, the final ledger is:
Initial investment: $1,000
Total Savings + Earnings: $2,400
Federal tax savings: $ 210
State tax deduction savings: $ 50
Total Tax Savings: $ 260
I offer this hypothetical example for illustration purposes only. It’s not intended as a guarantee of future performance or as tax advice for any specific family.
Nonetheless, this hypothetical example illustrates the power of saving in a tax-advantaged Illinois 529 College Savings account. Higher education is expensive, and, with a 529 College Savings account, federal and state-level tax advantages can help boost the power of a family’s savings.
About the Author: Michael Frerichs is the Treasurer of the State of Illinois and Chair of the College Savings Plans Network (CSPN). First elected in 2014 and reelected in 2018, Treasurer Frerichs serves as Illinois’ Chief Investment and Banking Officer, with a portfolio of approximately $35 billion. Frerichs serves as Trustee and Administrator of the Illinois 529 College Savings Plans: Bright Start and Bright Directions. Treasurer Frerichs also launched the Achieving a Better Life Experience (ABLE) program and the Secure Choice retirement savings program. Born and raised in the small farming community of Gifford, IL, Frerichs attended Yale University, served in the Illinois State Senate from 2006 – 2014, and currently lives in Champaign, IL, with his young daughter, Ella.
 US Department of Education, National Center for Education Statistics, Digest of Education Statistics, “Recent high school completers and their enrollment in college”