Effective Strategies to Save for Education and Retirement
Summary
Section 529 plans are tax-advantaged savings plans designed to encourage saving for future education costs.
In this post, we’ll cover tricks how to use these accounts effectively, including, for New York State taxpayers:
How contributions can get you state income-tax deductions of up to $5,000,
How you can start saving for your child’s future education costs even before they’re born and still reap those deductions,
Saving $5,000 each year before your child is born could reduce the amount you need to save after by $35/month,
Saving 5 years ahead of your child’s birth could be optimal: you’ll have met your savings target, and every dollar you contributed will have been deducted off your NY state taxes,
Saving past the time of their education needs, you could net yourself an extra $97,000 tax-free in retirement,
How, even if you don’t anticipate future education costs for you or a child, you could use it to save up to $300,000 tax-free at retirement,
How you might be able to take advantage of these strategies even if you’re not a New York State taxpayer.
Disclaimers
This post is for informational purposes only and does not constitute financial or investment advice. It is not intended to recommend any specific investment or provide a basis for making investment decisions. As the author, I am not a financial advisor, and my opinions should not be taken as financial advice. Investments carry risks and can fluctuate in value; past performance is not indicative of future results. Readers should conduct their own research or consult with a professional financial advisor before making any investment decisions. By reading this post, you agree that neither the author nor any affiliated entities shall be liable for any losses, damages, or claims that may arise from actions taken based on the information provided.
The tax benefits of using a Section 529 Plan vary state to state. This post discusses the potential such benefits for individuals filing New York State income taxes. Please consult your state’s applicable laws and regulations.
If you’re already familiar with the basics of Section 529 plans and are just interested in the tricks, skip ahead to the section, Section 529 Tricks.
Introduction
Section 529 plans, named after Section 529 of the Internal Revenue Code, are tax-advantaged savings plans designed to encourage saving for future education costs. In New York State, like in many others, these plans offer families a way to save for their children's education in a tax-efficient manner. Understanding how these plans work and how to use them effectively can provide significant benefits. Here's an overview of New York's 529 College Savings Program and tips on maximizing its potential.
Overview of New York's 529 Plans
New York offers two types of 529 plans: the Direct Plan and the Advisor-Guided Plan. Both are designed to help save for a beneficiary's education expenses, including tuition, room and board, books, and other qualified expenses. Contributions to these plans grow tax-deferred, and withdrawals for qualified education expenses are tax-free at the federal and state level.
Direct Plan
The New York 529 Direct Plan is available to any U.S. resident, not just those in New York. It allows you to invest in a variety of portfolios directly and has no sales charges, which makes it a cost-effective option for many savers. You manage your investments directly with the plan, without the need to go through a financial advisor.
Advisor-Guided Plan
The Advisor-Guided Plan is available through financial advisors. It may offer additional investment options and personalized investment advice but typically comes with higher fees due to the advisory services provided.
Benefits of Using New York's 529 Plans
Tax Advantages: Contributions grow tax-deferred, and withdrawals for qualified education expenses are tax-free. Additionally, New York taxpayers can deduct up to $5,000 ($10,000 for married couples filing jointly) per year on their state income taxes for contributions to the plan.
High Contribution Limits: New York's 529 plans allow high total contribution limits per beneficiary, accommodating substantial savings for future education expenses.
Investment Options: Both plans offer a range of investment options, from conservative to aggressive, allowing savers to choose based on their risk tolerance and time horizon.
Flexibility: Funds can be used at any accredited college, university, vocational, or technical school in the United States and even some international institutions. Additionally, up to $10,000 per year can be withdrawn tax-free for tuition at elementary or secondary public, private, or religious schools.
Section 529 Tricks
Trick #1: Start Early - Even Before Your Child is Born, and Still Get the Tax Benefits
It’s well-known that in general, the sooner you start saving, the more time your money has to grow through compounded interest.
With a Section 529 Plan - these gains are tax-free for qualified education expenses, and contributions up to $5,000 are deductible from your NY state income-taxes.
But did you know you could start saving for your child years before they’re born so you can lower the amount you need to put away for them and still reap those tax breaks?
The Basics of Starting Early
If you wait to start saving until your child is born, you’ll have to save $570 a month for a $200,000 college education at current rates, as the below simulation illustrates.
Remember you can only deduct up to $5,000 on your New York State tax returns in a Section 529 Plan. $570 a month adds up to $6,840 a year, so there will be $1,840 you won’t be able to deduct each year.
Saving Ahead for Your Unborn Child
Suppose on the other hand, you know you’re going to have a child, you just don’t know when. In the same hypothetical situation before,
For each year you save the $5,000 before your child is born, you could shave off $35 a month in saving for their higher education after they’re born.
This is additive for each year you do it, and you could get the deduction for that year.
So, if you save 2 years in advance, you could have deducted $10,000 off your NY state taxes, and might start out with $10,000 when your child is born. After that, you could shave off $70 a month saving for their education expenses.
In general, starting balances might be a bit different than $5,000 for each year you save since they’ll include capital gains/losses and interest that accrue up until your child is born.
Saving 5 years ahead is nearly optimal
If you save 5 years in advance, you could have deducted $25,000 off your NY state taxes, and might start out with $25,000 when your child is born. After that, you could shave off $175 a month saving for their education expenses.
Remember, contributions up to $5,000 are tax deductible on your New York State taxes. $570 - $175 = $395 a month adds up to $4,740 a year, so you could actually contribute an additional $260 to get the full deduction.
Regardless if you decide to max it out, you could have met your savings target, and every dollar you contributed could have been deducted off your NY state taxes.
Not bad.
This is Too Good to be True?
Surely most folks do this…right?
Not exactly - there’s a trick.
Schedule a session to find out what it is today.
Strategies that Generalize to Other Savings Goals
Tax implications and education objectives aside, the above examples illustrate,
How powerful saving over time can be to reach your financial goals,
How powerful front-loading it can be to reduce monthly contributions.
Sign-up for sessions today and learn techniques to reach your financial goals.
Trick #2: Extra Savings for Retirement
The SECURE 2.0 Act of 2022 was signed into law in December 2022. Along with other retirement account changes, the law introduces another use for excess 529 funds: retirement.
“Section 126 amends the Internal Revenue Code to allow for tax and penalty free rollovers from 529 accounts to Roth IRAs, under certain conditions. Beneficiaries of 529 college savings accounts would be permitted to rollover up to $35,000 over the course of their lifetime from any 529 account in their name to their Roth IRA. These rollovers are also subject to Roth IRA annual contribution limits, and the 529 account must have been open for more than 15 years.”
This is a great way to sneak some extra money into your Roth IRA. Remember: contributions and earnings grow tax-free in your Roth IRA. All withdrawals can be taken out tax-free and penalty free, provided you're age 59½ or older and you have met the minimum account holding period (currently five years).
The below simulation illustrates hypothetical savings under 4 scenarios that are a consequence of this. In each scenario, you contribute the maximum annual deductible amount of $5,000 to your Section 529 Plan, and roll it into your Roth IRA. You do it for 7 years to hit the $35,000 limit.
Notice there’s a kink at 7 years. That’s when the $35,000 cap hits - but contributions still continue to grow in your Roth after that.
Scenario 1 (Red): You have children at 30, save 18 years for them, and keep saving thereafter from 48 to when you retire at 59.5. You’ll have saved $52,000 extra, tax-free.
Scenario 2 (Green): You have children at 30, save 18 years for them, and keep saving thereafter from 48 to when you retire at 72. You’ll have saved $97,000 extra, tax-free.
Scenario 3 (Yellow): You don’t have children, start the strategy at 25 to when you retire at 59.5. You’ll have saved $164,000 extra, tax-free.
Scenario 4 (Blue): You don’t have children, start the strategy at 25 to when you retire at 72. You’ll have saved $306,000 extra, tax-free.
Trick #3: Start Today
We’re going through the biggest interest rate hikes in the last 40 years as the Federal Reserve tries to cool down inflation. Current interest rates can yield as high as 5%.
That means you could lock in those 5% rates of return we used in the above simulations today using debt securities today.
There’s also inverse relationship between rates and prices for those debt securities, so when rates go up, prices go down and vice versa.
This means when the Fed does start to cut rates from 5%, you could get a tax free capital gain on investments in those debt securities realizing those current 5% rates.
When rate cuts do begin, future contributions using just debt securities will yield less than 5%, so you’ll have to rebalance your portfolio using both equity and debt securities to maintain the growth rate of 5% rate.
Sign-up for sessions today to learn more.
Trick #4: Trick #1 - 3 Could Still Apply Saving for Yourself or You’re Not a New York State Taxpayer
If you’re saving for yourself - trick #1 - 3 still work for you.
If you’re not a New York State taxpayer, you won’t be eligible for the $5,000 state income tax deduction since policies vary from state to state. Be sure to check your local laws and regulations for how your state’s 529 plans work.
For example, Massachusetts allows up to $1,000 deductions, and California doesn’t allow any as of 2024.
Conclusions
By leveraging these strategies, New York's 529 plans can be a powerful tool in your education savings arsenal. Whether you're saving for your child's future college expenses or planning ahead for your own education, understanding and utilizing these plans effectively can lead to significant savings and financial benefits.
Other things to consider:
Understand Investment Options: Choose an investment strategy that matches your risk tolerance and time horizon. As the beneficiary gets closer to college age, consider shifting to more conservative investments to protect against market volatility.
Take Advantage of Tax Benefits: Make sure to contribute enough to maximize state tax deductions if you're a New York taxpayer.
Use for a Broad Range of Education Expenses: Remember that funds from 529 plans can be used not just for tuition, but also for other qualified expenses, including room and board, books, and supplies.
Plan Contributions Around Gift Tax Limits: Contributions to 529 plans are considered gifts for tax purposes. In 2023, you can contribute up to $16,000 per year ($32,000 for married couples) without triggering the federal gift tax, and you can even front-load five years' worth of contributions in a single year.
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