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Ar Gift Plan - If you've done a lot of research on how to save for your child's college education, you've probably heard of 529 plans. These plans, created as part of the Small Business Employment Protection Act of 1996, were originally intended to provide parents with a tax-saving way for college costs.
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Parents can receive federal income tax benefits as long as they use the money for certain qualified educational expenses, all at the post-secondary level. But the Tax Cuts and Jobs Act, passed in 2017, expanded the allowed uses of these accounts to include up to $10,000 in annual K-12 personal tuition expenses.
This may be useful for some parents who wish to send their children to private primary or secondary schools. However, these types of tax laws are extremely complex, so make sure you understand all the implications of using a 529 plan for K-12 expenses before going this route.
Anyone can open a 529 plan with another person as the beneficiary. Adults can even use them for continuing education expenses. But the most common use is for parents or other family members to open a 529 account with a child as the beneficiary. This means the money will be used for the child's education, but the parent or other custodian of the account actually controls the funds.
529 Plan Basics
As long as the money is used for the beneficiary's allowable educational expenses, including individual K-12 tuition costs or college-related tuition, fees and other expenses up to $10,000 per year, it is income tax-free . Contributions and growth can also carry state tax benefits, which we discuss below.
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However, the key is that the money must be used for the beneficiary's benefit and must be used for eligible educational expenses. If you use the money for a non-qualified expense, you'll pay taxes and a 10 percent penalty on the earnings you withdraw, not the original contribution.
That's why it's important to follow the rules when using 529 funds. Used correctly, the tax benefits of your 529 can be a powerful way to help save for your child's education. When you don't pay income taxes on growth, your account grows faster and gives you more money to work with when it comes time to pay for private education or college.
Not sure what it looks like? Here's an example: Let's say you pay a marginal tax rate of 32 percent. You start with $0 invested in a 529 when your child is born. Then invest $10,000 every year for 14 years, until you're ready to attend a private high school.
529 Plan Basics
With an average investment return of 8 percent and not taking into account any state tax benefits or payments, you'll get the following results, according to this calculator: At age 14, your child will have $261,521 available in a 529. If he kept the money in an account
taxable, he would only have $213,071. That's a difference of almost $50,000! For parents who are already planning and can save for their children's future private education, this makes the 529 a powerful tool. But before you rush out to open one, make sure you understand all the ins and outs of how a 529 works and its recent changes.
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Remember that 529 plans are run primarily by the federal government. So, regardless of your state's rules and regulations, you can get federal tax benefits when you use this account for K-12 expenses. You don't get a federal income tax benefit for contributing to a 529, because it pays after you've already paid federal income tax.
But you avoid paying federal income tax on the growth, as long as you use the money for qualified expenses. Exactly how much federal benefits will affect your family's bottom line varies. Fixed interest income and dividends are taxed at their ordinary marginal tax rate.
Why 529S Are Powerful: An Example
Capital gains from stocks and mutual funds are taxed at a lower rate and may not be taxed at all for low-income households. This means that households in the lowest tax brackets will receive less total federal income tax benefits than households in the highest tax brackets.
Let's look at another simplified example. (Note that this does not take into account interest income that pushes the family into the next tax bracket.) Family A is in the 24 percent marginal tax bracket, but Family B is in the 35 percent marginal tax bracket
Both families earned $2,000 in their 529 accounts this year. Family A will save $480 and Family B will save $700 because of the 529 rule. Either way, tax-free growth in a 529 account is lucrative. It only benefits high-income families slightly more than low-income families.
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Here things get complicated. For starters, not all states offer the same tax benefits to their state 529 accounts. And you can open a 529 in any state. However, the benefit of opening a 529 with your home state residency is that you can take advantage of state tax benefits.
Why 529S Are Powerful: An Example
Until the recent K-12 changes, most states mirrored federal 529 regulations. For example, in most states, you don't pay state income tax on interest growth in a 529 account, even if you open a 529 account out of state Additionally, many states give their residents additional state tax benefits for contributing to a 529. Some offer tax credits and some offer tax deductions.
Most states apply these additional benefits only to in-state 529s, but some allow credits or deductions based on contributions to out-of-state 529s. However, the new K-12 eligibility rules have caused some states to unload Many states are still debating how to incorporate this new rule into their 529 plans and tax benefits.
Although these changes apply to fiscal year 2018, which has already ended, experts are still approaching the issue with caution. Brown said that if states don't adopt federal amendments allowing these expenses, taxpayers will still be able to take advantage of the federal tax benefits in their accounts.
However, he said if a taxpayer used a 529 distribution to pay for K-12 expenses before their state adopted these changes, the distribution may not be considered eligible for state income tax. "If this is the case," he wrote, "the state taxpayer may be required to add the distribution to state taxable income."
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