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State Tax Benefits for Withdrawals from
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 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.
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