Even in bad stock market years, families may still want to contribute to 529 plans.

Understand the Federal Tax Benefits of 529 Plans

Parents can avoid paying taxes on withdrawals when their kids start college.

Even in bad stock market years, families may still want to contribute to 529 plans.

Even in bad stock market years, families may still want to contribute to 529 plans.

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Mark Berg, a certified financial planner, knows he has two years of college savings for each of his three kids, partly because taxes aren't charged on withdrawals from their 529 plan accounts. 

Unlike other investment accounts, earnings from savings account interest, bond interest, and stock and mutual fund value increases aren't taxed at time of sale or withdrawal, he notes. By saving within a 529 plan, families don't have to worry about paying taxes on withdrawals when their children start college

[Learn more about the advantages of 529 plans.] 

Here's what every parent should do to maximize federal tax benefits. 

1. Schedule regular contributions: If a couple with two children saved $100 monthly per child for 10 years, they would accumulate $24,000 before investment earnings. If the account grew in value by 5 percent per year, they would add another $7,100 to their savings without paying taxes on the account's growth. 

The exact tax savings would depend on whether the investments are in savings accounts and bonds or stocks and stock-based mutual funds, Berg says. Savings account and bond interest earned outside of 529 plans are taxed at the couple's income tax rate, while stock-market based investment growth would be taxed at the capital gains rate, a special tax rate for investment sales, he notes.

For example, a middle class family makes between $70,000 and $142,000 and withdraws half of the funds to pay for college in 2012. The investments are split between bonds and stock-based mutual funds. The taxes charged if the money was withdrawn this year is $1,400. 

[See how to ask others for contributions to college savings plans.] 

2. Combine federal tax benefits with state tax deductions: Many states offer income tax deductions for 529 plan contributions. For instance, Berg's home state of Illinois charges 5 percent income tax, but the state allows tax deductions for 529 plan contributions of up to $10,000 per individual tax payer, or $20,000 per couple. 

A $10,000 contribution in a single year would save an Illinois resident $500 in taxes. If the same couple mentioned above contributed $2,400 this year, they would save $120 off their annual tax bill. 

And if tax rates stay the same, this adds up to $1,200 of tax savings over a 10-year period. Combined with federal tax savings, that amounts to $2,600. 

3. Don't limit investments during bad stock market years: Avoiding contributing to 529 plans when the stock market dips could prevent investment growth. Berg says he was able to average 5 percent annual growth because he bought stock-based mutual funds at low prices when his other stock-based mutual funds were falling in price during the 2008 financial crisis. 

"There was no special trick to finding the funds, because generally stock prices fall in weak economies and rise again when the economy recovers," Berg says. But he cautions, "Reinvesting in stocks should only be done if you have time before your kids enter college." 

His kids were 6, 9, and 10 in 2008. The total tax savings is based on when parents withdraw the funds to pay for their children's education, and not when they're earning it, he says. Continual investing averages out in long-term investment plans, Berg notes. 

[Follow four steps for choosing age-based 529 plans.] 

4. Before investing outside of 529 plans, consider what happens if taxes increase: "There is talk that capital gains could increase significantly, which would make 529 plans more attractive since they grow tax free," says Fred Amrein, a Pennsylvania-based chartered financial consultant. 

For example, a couple earned $5,000 in 10 years of investing in stock-based mutual funds within a 529 plan account. If taxes on earnings from stock-based investments rise from 15 percent to 20 percent, investing in a college savings plan saved $250 more than if the tax rate remains at 15 percent. Check with your financial adviser once per year about tax rates, Amrein says. 

Reyna Gobel, frequently quoted as an expert on student loans and college costs, is the author of "Graduation Debt: How To Manage Student Loans And Live Your Life" and "How Smart Students Pay for School: The Best Way to Save for College, Get the Right Loans, and Repay Debt." She has appeared on PBS's Nightly Business Report and speaks regularly at CollegeWeekLive.