IF YOU'VE GOT college-bound kids in your life, then you've probably gotten word that one of the best ways to save is through a tax-free 529 college-savings plan. These plans, which typically allow you to invest in a pool of mutual funds, offer federal-tax-free savings for any college or university in the country. And in most cases, you get a break on your state taxes to boot.
But is a 529 plan really the way to go? Our calculator will help you decide. By comparing what you think you could earn in a regular taxable account with what you'd earn with a 529 college-savings plan, you can figure out the best way to save. We'll give you a hint: Assuming your time horizon is long enough, you're nearly always going to come out ahead with a 529 plan. The question is, by how much?
Weighing Your Options
Before you plug in your numbers below, there are a few things you should know. First, our calculator only works with college-savings plans. If you're considering a prepaid tuition plan (which allows you to pay today's tuition rates for specific schools), figuring out whether your investment is a wise decision should be based more on your certitude that the beneficiary will attend the participating schools. (Withdrawals from pre-paid tuition plans are indeed tax-free, but your earnings rate is limited to the tuition inflation rate of the participating schools.)
You should also be aware that while the withdrawals from a 529 plan are federally tax-free (and often state-tax free) when beneficiaries use them for college expenses, contributions are treated as gifts for federal-tax purposes. But as long as you don't make annual contributions greater than $13,000 per account (or $26,000 if you're married and make joint gifts), you don't need to worry about this. You should also know that these plans allow you to accelerate five years' worth of gift-tax exclusions upfront. So during one year, you could make a lump-sum contribution of up to $65,000 ($130,000 if you and your spouse contribute jointly) without any adverse gift or estate tax consequences, provided you don't make any additional contributions to that account for the next five years. Also, if you have several children or grandchildren, you can set up separate Section 529 plan accounts for each. The limits described above would then apply separately to each account.
Once you start plugging in your numbers, you'll see that we've asked you to estimate at what rate you think investments in a taxable account would be taxed. This, of course, isn't easy, but it's obviously necessary for this calculator, so do your best and try a few different scenarios. We suggest 20% as a good starting point.
Keep in mind that gains from investments held for more than a year are typically subject to the lower capital-gains rate, which is a maximum of 15% for 2012. (The capital gains rates for 2013 and beyond are up in the air). Ditto for qualified dividends. But short-term gains and interest are taxed at your regular federal-tax rate. The current federal-tax rates are 10%, 15%, 25%, 28%, 33% and 35%.