529 College Savings Plans: The Tax-Advantaged Way to Pay for Higher Education

A college degree could be one of the best investments you make for yourself or your children. However, higher education is getting more expensive. On average, a four-year college program costs over $10,000, and that can balloon into six figures for graduate programs. This is where 529 savings plans come in. Is there a tax deduction for these plans?

A 529, a tax-advantaged savings plan (or “qualified tuition plan”), encourages saving for future education costs. The plans are sponsored by states, state agencies, or educational institutions, and are authorized by the Internal Revenue Code's Section 529, which was added in 1996 as an incentive for parents to save for college.

Your contributions to a 529 plan aren't tax-deductible on a federal level but might be on the state level. Many states offer tax deductions for 529 plans.

Also, whereas most states require you to contribute to their home plan to be eligible for tax savings, seven offer a state tax deduction whether you invest in its sponsored 529 plan or a 529 plan in a different state. These states are Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania. In some cases, though, a state may offer incentives to use its plan. Arkansas, for example, offers a larger deduction for contributors to its Gift529 program.

Earnings in a 529 savings plan grow tax-free, meaning the longer your money is invested, the more time it has to grow and the greater your tax benefits. However, you won't benefit if you withdraw your money from a 529 plan account shortly after putting it in.

As long as withdrawals are for qualified higher education expenses (such as tuition, room and board, books and supplies, or a computer) or tuition for elementary or secondary schools, earnings in 529 accounts aren't subject to federal income tax or, in many cases, state income tax. If these withdrawals are used for any other purpose, however, they'll be subject to state and federal income taxes and an additional 10 percent federal tax penalty.

Another advantage of 529 plans is that they're considered a parent asset on FAFSA and CSS Profile forms, the two financial aid forms used by most colleges. (Parent assets are assessed at a much lower rate than student assets in needs methodologies.)

It's best to make regular payments over a long period of time, even if your contributions are small to begin with. This lets you take advantage of compounding interest.