Get a Break on Education

I am young and do not yet plan on having children anytime soon (much less am I thinking about how to pay for their college education).  Nonetheless, I am already setting up a 529 Plan.  But the plan is for me, as I intend on going to graduate school in the near- to medium-term future and figured I could use a tax break.

A 529 Plan (legally, a “qualified tuition plan”) works similarly to a Roth IRA account, but for education purposes rather than retirement.  You contribute post-tax dollars into the account, but then its earnings are not subject to federal, and often state, taxes.  But of course, if you do not use the 529 to cover eligible educational expenses (generally, tuition, room, board, and books), there is a penalty, which includes having to pay income tax plus a 10% federal tax on the earnings.  529 Plans can be used to pay for any college, university, vocational school, or other postsecondary educational institution, and can be transferred to family members if you do not use all of it or decide not to pursue further education (for more information and a list of eligible family members, visit the IRS website).

Most states have their own 529 Plans and you can enroll in any of them even if you are not a resident.  But make sure to weigh the benefits carefully, as some states also allow residents to deduct contributions when filing income tax returns, but only when they are made to its own 529 Plan.  DC taxpayers, for example, can get a deduction of up to $4,000 ($8,000 for couples filing jointly when both have 529 account and made contributions) on their contribution to a DC 529 Plan when filing state taxes.  There is no income limit, but no deductions are allowed for investment in   other states’ 529 Plans.  In contrast, since 2006, Pennsylvania taxpayers have been allowed a deduction of up to $12,000 in contributions (per taxpayer, per beneficiary) to 529 Plans from any state.  For a current list on the benefits offered in each state, click here.

While now may not be the best time to aggressively invest your money, most 529 Plans offer an investment option that protects your principal (just like a Roth IRA, which you could technically put in a money market savings or CD account).  The potential returns on your investment will probably be lower, but since the lifespan of a 529 Plan will likely be much shorter than a retirement account (i.e., it will be left to grow for fewer years) and you may not have enough time to regain any losses, you should see a 529 as way to get a tax break on your savings for education rather than as an investment device.  If you are single and have a taxable income between $8,350 and $33,950 in 2009, for instance, and set aside $3,000 this year for education, you will have save $450 in federal taxes (plus taxes on the interest earned) if you put it in a 529 rather than in a regular savings account.  With a taxable income between $33,950 and $82,250, you potential tax savings are $750!  And if you have to pay state taxes, you can save even more provided you invest in a 529 Plan for which contributions can be deducted.

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