529 Essentials: State Tax Benefits

By Paul Curley | paul.curley@strategic-i.com | July 15, 2016

This week’s article focuses on the state tax advantages that 529s offer to 12.8 million families investing $258 billion in assets as of March 2016.

A 529 Plan is a federal and state tax advantaged education savings plan operated by a state or educational institution. This week’s article focuses on the state tax advantages that 529s offer to 12.8 million families investing $258 billion in assets as of March 2016.

State Tax Benefit on Account Value Appreciation – Families invest after-tax money into 529 accounts, and the assets in those accounts grow federal and state tax free. Unlike taxable accounts such as money market accounts or taxable brokerage accounts, taxes are not paid on gains or reported as losses to the account as part of filing taxes in April ever year. Also, changes in the value of the account do not need to be reported or filed for taxes on an annual basis, though a bank statement reporting the balance will be received in the mail after year-end. When the money in the account is used for qualified higher educational expenses, the qualified distributions are made federal and state tax free as well.

State Tax Benefits on Contributions into the Account – You can invest in any state’s 529 savings plan, and use the assets to attend any accredited college in the U.S. and many abroad as well so long as the foreign colleges and universities are eligible for financial aid from the U.S. Government. For residents in over 30 states plus D.C., accountholders also receive a state tax deduction or credit for contributions into a 529 plan in addition to other benefits. Four of those states as of publication of this article provide an unlimited deduction against taxable income for state tax returns including (in alphabetical order) Colorado, New Mexico, South Carolina and West Virginia. Also, while some states provide a tax deduction or credit only on contributions to their own state’s 529 plan(s), five states currently as of publication of this article provide “tax parity”, which provides a tax deduction or credit on contributions to any state’s 529 plans: Arizona, Kansas, Missouri, Montana and Pennsylvania. Despite the benefits in those states, there are still 17 tax-neutral states that either do not have a state income tax or other state tax benefit for investing in a 529 plan. Despite the lack of a state tax benefit, do remember that investors still receive federal tax benefits. While state tax incentives are important and increase the return on investment to varying degrees from one state to the next, there are many factors to consider in selecting a 529 plan such as overall investment performance, investment fees, account maintenance fees, diversification of investment line-up, experience of investment management, asset allocation, target-date glide path, operational efficiency, platform efficiency, call center support, marketing materials and advisor support to name a few. Also, it is worth noting that the whether the contributor to the account or the accountowner of the account receives the state tax deduction or credit varies from state to state. Therefore, you can provide value to your client as an advisor by reviewing these other features and benefits to help clients choose the right plan for their specific situation.

Therefore, 529 plans provide all families with federal and state tax-deferred growth, and federal and state tax-free distributions if used for qualified higher education expenses, and the majority of states also provide a state tax incentive for making contributions into a 529 account. Advisors should note this benefit in comparison to other investment vehicles potentially used to save and pay for higher education expenses. Have the college financial planning discussion with your clients today.

Next week, we will compare and contrast 529 savings plans and 529 prepaid plans, and please feel free to contact the editor of the 529 Dash for topics of interest in future issues as well. Please Read, Engage and Share.