State Tax Benefits for Contributions to
529 College Savings Plans

The 529 College Savings Plan is a creation of federal tax law, specifically Internal Revenue Code Section 529. The law provides for federal tax benefits when assets are growing in the 529 Plan portfolio, as well as when withdrawals are made, assuming the withdrawals are used for "qualified higher education expenses".

Many States (remember the States are the ones who actually run the different 529 Plans) provide a state tax incentive for residents of that State to "stay home" and use the home state's plan.

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.

To put this in perspective, consider the following examples of the value, or lack of value, in the deductibility of a contribution to a state's home plan:

Example #1: In 2002 Father establishes a 529 College Savings Plan Account under the 529 Plan run by his home state's Plan Manager. Under the State's income tax rules, there is an unlimited income tax deduction when contributions are made to the home State's 529 Plan (the "home state plan"). The state's flat income tax is a rate of 3.0%.

In this case, if Father contributed $20,000 to son's account there would be a tax savings of $600 ($20,000 times the state's flat income tax rate of 3.0%). If Father contributed only $2,000.00 to the home state's plan, the savings would be $60.

Example #2: In 2002 Mother establishes a 529 College Savings Account under the 529 Plan administered by her home state's Plan Manager. Under the state's income tax rules, there is no income tax deduction for contributions made to a 529 College Savings Account - whether you use the home state's plan or some other state's plan.

In this case, Mother would receive no state income tax benefit for contributions to the account.

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.

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