The Benefits of Using Your Home State's
529 College Savings Plan

Even though the 529 College Savings Plan is a creation of federal tax law each states operates their own 529 Plan. Since the state generally receives compensation from the 529 Plan Manager based upon amounts contributed to the 529 Plan, the states are placed in competition with each other. To distinguish themselves, the various states have begun including features and benefits to their 529 Plans to attract investors.

The group likely to receive the most benefit of a particular state's 529 Plan features and designs is the resident of that particular state. These features are designed to attract the resident of the state to use their "home state's" 529 Plan. The following is a summary of features and benefits currently being designed into various 529 College Savings Plans:

Tax Benefits

To attract their residents to use the home state's 529 Plan tax benefits are being offered to the state resident to invest in the home state's 529 Plan. Generally there are 2 types of tax benefits that many states are offering their citizens to use the home state plan. They are:

State Tax Deductions for Contributions

Some states have enacted laws that allow for a partial or complete deduction against the state income tax for contributions to a state's home plan. That means that for someone living in a state that allows for a deduction, the contribution to a 529 College Savings Plan will reduce their state income tax amount.

In trying to decide which of the available 529 Plans to use, the consumer must calculate the real benefit of the state income tax benefit they will get from using the home state plan. Some states limit the deduction to a specific amount (i.e. total deduction cannot exceed $1,000 per year). Other states have very low income tax rates, so the real benefit of the deduction might be relatively small.

A word of caution Recently several state's have been adding new laws to "recapture" a state income tax deduction that was given to a state resident, if that person moves the 529 Plan account to another state's Plan. states are growing concerned that deductions are being given when the account is owned, but then consumers are moving the accounts to another state some time later. Not only is the deduction that was given when the account was opened being "recaptured" but in some cases, all of the earnings on the account are being taxed when the account is moved to another state.

It is important then to understand the state income tax benefit, if any, of each particular state. When a state provides a tax benefit to use the state's own Plan, then the consumer needs to determine the actual economic value/benefit of doing so and the potential "recapture" cost is the consumer elects to move the account to another state. As with any investment decision, all factors should be considered in selecting an appropriate 529 College Savings Plan thought must be given to issues of state income tax deductibility for contributions, investment performance among the plans, fees and loads on plan assets and state tax issues at the time of withdrawing assets from the plan.

State Taxation on Withdrawals from a College Savings Plan

The federal law is clear, withdrawals from a College Savings Plan for use in paying "qualified higher education expenses" is tax-free for federal income tax purposes. The same may not be true about taxes that must be paid to state you reside in. Remember, the 529 College Savings Plan is administered by each state under their own set of rules. As long as the rules they adopt don't conflict with federal laws, they can establish any rules they like.

There are many different approaches to the state taxation of the Plan income at the time of a withdrawal from a 529 College Savings Plan. A number of states offer a tax break at the time of withdrawal, including tax-free withdrawal in some cases, if you use the plan sponsored by your home state. Other states have adopted the federal law, thereby making all distributions from the state's 529 Plan tax-free for anyone, regardless of state residency. There are still other states that have adopted both their own tax-free legislation and have adopted the federal legislation. This may become important in 2011 when the federal law "sunsets". Those states that have their own tax-free legislation will continue to allow tax-free withdrawals. states that have only adopted the federal law may become taxable withdrawal states when and if the federal law sunsets.

Other state plans afford no tax break at all. Then, of course, there are the state's that have no income tax, and so residents of that state will receive tax-free treatment on withdrawal, automatically.

Fees and Expenses

Another benefit of using the home state's 529 Plan is the ability to invest in the Plan incurring lower fees and expenses then an out of state investor would. Often the home state's plan, even if it is an advisor sold Plan, can be obtained directly from the state Treasurer's office without incurring any sales charge.

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