There are many common misconceptions about 529s, but the ones I hear most often is with regards to their tax benefits. While it is true that most states offer an income tax deduction, you should know that deduction only applies to your state income tax, not Federal. Where 529s do help you with regards to Federal taxes is that the capital gains are not taxed when the funds are used for qualified expenses. 

Let’s do a simple example for my home state of Virginia: 

• Joe and Stacey are married and have a daughter, Julia, who is 5. They plan to contribute $3k per year every year until she heads off to college at age 18. They have taxable income of $150k per year. 
• Virginia’s top marginal bracket is 5.75%, and that bracket begins at only $17,001 of income. 

The value of the state income tax deduction for contributing $3k this year is $172.50 ($3k x 5.75%). Doesn’t seem like a lot, right? Over 13yrs (age 5 to 18) that’s $2,242. Not nothing, but not an eye-popping figure, either. 

Now let’s assess the capital gain tax savings:

• In the 13 years we contribute, we’ll have put in $39k total into the plan. If we assume a 6% rate of return over that investment period, that gives us a balance of $56,646 
• The capital gain will be $17,646 ($56,646 – 39,000). At $150k taxable income, your Federal capital gains rate is 15% and your state rate remains the same at 5.75%
• The resulting tax bill dodged on capital gains is $3,662 ($17,646 x 20.75%)

So all told, Joe and Stacey get an actual dollar benefit of $5,904. 

Tax rates, deductions on contributions, and plan options vary greatly state by state. There are also alternative strategies and vehicles for college savings that you can consider. Be sure to run the numbers yourself to determine if 529s make sense for you.