The U.S. government wants to encourage citizens to save for retirement and for advanced education, and one of the best incentives for saving is a tax break. These plans work differently in how the investor ultimately gets the tax break. In a traditional IRA or 401(k), the tax break comes at the beginning on the contributions the saver makes that year.
For example, assume you contribute $5,000 to a traditional IRA or 401(k) plan in 2017 and you make $50,000 in wages and other income that year. When you do your taxes prior to the April 15, 2018, deadline, you will be taxed only on $45,000 of income because you deferred $5,000 that year into your qualified retirement account. Roth IRAs and Roth 401(k) plans have a different tax treatment.
The 529 plan offers a different kind of tax break. In this account, the money that is contributed to the plan in a particular year is before-tax money that does not reduce your taxable income. In other words, if you contribute $5,000 to your child’s 529 plan in 2017 and you make $50,000 in wages and other income that year, your taxable income for 2017 is still $50,000.
When you do your taxes in the early part of 2018, you will still be taxed on $50,000 of income because the $5,000 did not reduce your taxes in 2017. For a 529 plan, the tax break comes years later, when your child heads to college. Assume that over 12 years of his or her growing up, you contributed $30,000 to your child’s 529 plan. The $30,000 you invested earned $5,000 in capital gains. When you start to take the money out of the 529 plan to pay for qualified college costs, that $5,000 of gains comes out without incurring tax.