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Saving on state taxes with your 529 plan
Joe Hurley is the founder of Savingforcollege.com, and a certified public accountant.
Does your state offer a state income tax deduction (or tax credit) for 529 contributions? Thirty-four states and the District of Columbia currently do. All but five of them (Arizona, Kansas, Maine, Missouri and Pennsylvania) require that contributions be made to the state's own 529 plan to be eligible for the deduction. Although it may be too late to claim a state tax benefit for 2008, it's not too late (or too early) to plan for 2009. Here's a short guide on how to take best advantage of this particular benefit on your state tax return.
- Be sure you understand what your state offers and its requirements and restrictions. Visit your state's 529 plan website and download the official disclosure statement which will describe the special state tax benefits. You can also view our own description of the benefit on the plan description page at savingforcollege.com. Most states place an annual cap on the amount of the deduction but in some cases permit excess contributions to be carried over to future years. A couple of states impose income limits.
- Determine if your state's rules are changing and how those changes may impact the timing and amounts of your contributions.
- Consider the value of the state tax benefit in selecting a 529 plan. How much will you be losing by choosing an out-of-state 529 plan, and what level of investment performance in an out-of-state 529 plan will make up for the lost tax savings? The answer will depend on your state tax bracket, the amount of your contributions relative to the maximum deduction amount in your state, your ability to itemize deductions on your federal income tax return, and the number of years your money will stay invested in the 529 plan. We offer an easy and comprehensive calculator called the State Tax 529 Calculator for financial professionals under our premium subscription service.
- The state tax benefit is worth more for parents with older children than for those with young children. To demonstrate this concept, we plugged a set of assumptions into our State Tax 529 Calculator, using New York as our example state, and varied just one factor: the number of years invested in the 529 (based on the age of the child.) The annual return equivalent of the New York tax deduction for a 5-year old (13 years to withdrawal) was only 0.41%, but the annual return equivalent for a 15-year old (3 years to withdrawal) was 1.79%. A New Yorker with an investment horizon of just 6 months, for example, would find the value of the in-state deduction nearly impossible to beat through investment performance in a non-New York 529 plan.
- Many other factors beyond the state tax benefit can influence your choice of 529 plan. Some states also offer their residents matching contributions, state financial aid preferences, or special asset protections with the in-state 529 plan. On the other hand, out-of-state 529 plans may provide you with higher-returning investment options, lower expenses, and/or fewer restrictions. We've developed a 529 Plan Selection Checklist which you can get for free by clicking on any of the 529 plans participating in our "Get Started" enrollment and information service. (The checklist is partially completed for the plan you select.)
- Make your contribution on time if you are planning to claim a deduction on your state income tax return. Be sure you comply with the deadline mandated by your state. Some states allow contributions to be postmarked by December 31 while others require that contributions be received by the state on or before before the last business day of the year. A couple of states allow a deduction this year for contributions made by April 15 of next year.
- Rollovers require special attention. Some states permit a deduction for incoming 529 rollovers while others do not. Some states impose "recapture" tax on outgoing 529 rollovers while others do not. Depending on where you live, careful rollover planning may allow you to capture a state tax deduction even when your money spends most of its time in an out-of-state 529 plan.
Posted January 2, 2009