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Joe's blog

The '529 Guru' offers his random thoughts.

09/30/2009: At last count, 34 of the 41 states with a personal income tax—plus the District of Columbia—offered some type of state income-tax deduction or tax credit for money contributed into the home-state 529 plan. Five of those states allow the deduction for contributions to an out-of-state 529 plan as well. Millions of families have taken advantage of these deductions over the years, reducing state tax bills by billions of dollars.

The U.S. Treasury Department, in a recent report for President Obama’s Middle-Class Task Force, called for the elimination of “home-state bias” in 529 plans, essentially saying that all states should follow the example of the five states that grant tax benefits to 529-plan participants regardless of which 529 plan they use. But most people agree that the federal government would be over-reaching in any attempt to dictate such a result to the states.

Rather than seeing the federal government attempt to force state tax parity, I have a different suggestion: Every state should simply eliminate its income-tax deduction for 529 contributions. Here are the reasons why:


  • It’s unnecessary.

  • States cannot afford it.

  • It doesn’t help low-income families.

  • It’s unfair.

  • It creates confusion and complexity.

  • It creates loopholes.

  • It leads to bad investment decisions.



A state income-tax deduction is no longer necessary.

The quickest and easiest way to attract contributions to a 529 plan is to offer an income-tax deduction. Back in the “old” days (pre-2002), a state income tax deduction made sense as 529 plans were federally tax-deferred and not tax-free. But 529 plans now act more like Roth IRAs, and, to my knowledge, no state gives their residents a state income-tax deduction for contributions to their Roth IRAs. In fact, I know of no other investment program that combines a deduction on the front end with tax exclusion on the back end. It’s been a tremendously successful way for states to attract contributions and encourage college savings, but most 529 plans have now achieved scale and do not need the boost a state tax deduction provides.

Many states cannot afford to be giving away tax dollars.

My home state of New York has a huge budget mess on its hands, as do many other states. To fill the gap in New York, personal income-tax rates are being hiked, which in turn causes taxpaying citizens to move out of the state, which leads to lower tax collections and eventually even higher tax rates on those who cannot leave. Unless state government can curb its spending—and New York is a dismal failure in this regard—I would rather the state remove this tax subsidy for personal investing and use the extra dollars to keep a lid on income-tax rates.

A state income-tax deduction provides little incentive for low-income families to save for college.

In public-policy parlance, income-tax deductions are regressive. They only help those with enough income to pay taxes, and in states employing tax brackets they help high-income taxpayers more than low-income families. Congress and the U.S. Treasury Department have made it clear that Section 529 of the Code was not intended to cater only to the wealthy and they have been asking the states for proof that their plans are helping lower-income groups. A better alternative is for a state to offer a matching contribution program tied to family income level, which will encourage low-income families to save for college. Approximately one dozen states now offer this incentive, and all other states should consider similar programs.

A tax deduction for college savers is not fair to everyone else.

Keeping 529 plan distributions tax-free makes all the sense in the world—after all, the money must be spent on education and all you are trying to do is keep pace with college cost increases—but an upfront deduction for your contributions is a giveaway that benefits only those in position to save for college. I find it difficult to justify a state deduction to those who ask “Why should my tax dollars be used to boost your college savings fund?” Of course, one could make the same argument against tax dollars going to support public universities, or against programs to help low-income families afford college, but with those issues you have much larger societal considerations.

State tax deductions inject confusion and complexity.

It would be one thing if all you had to do was claim everything you contributed to your 529 plan as a deduction on your state income tax return. But in reality, states think up all sorts of rules surrounding the deduction, and sometimes don’t come up with any rules that are needed to answer the questions you have. For example, many states have mind-numbing “recapture” rules designed to wrest back your state tax savings in some future year if your 529 money is not used for qualified expenses. In completing our own 2008 New York tax returns on TurboTax, I swear it took me (a CPA) more than an hour to understand and fill out the input form tracking our history of New York 529 contributions and distributions.

Of course, there are always loopholes.

States might try to keep things simple by having few rules, but that approach opens the door to people wanting to take advantage of unintended opportunities: ways to take the tax deduction and avoid recapture; to contribute to the home-state plan for the deduction but roll over to another state’s plan soon thereafter; to make a deductible contribution to a 529 plan a couple of weeks before it is withdrawn to pay for college costs. Even in plans with a lot of rules, loopholes still exist.

The deduction can lead to bad investment decisions.

A state deduction restricted to the home-state 529 plan may cause you to choose that particular plan since using another state’s 529 plan means forgoing a guaranteed return on your investment. But just how big is that guaranteed return? In some cases, it can be a few hundred dollars of state tax savings. In most cases, it will be well under a hundred dollars. Is that enough? Perhaps not, especially if your state offers essentially the same investment options in its 529 plan as another state, but at higher cost. Or if another state’s 529 plan offers investment portfolios with better performance and risk characteristics. In other words, it is possible to be misled by the state income-tax deduction and end up in the wrong 529 plan.

Is there a better way?

Yes, there is. Next month I will reveal a way that virtually guarantees any state a hugely successful 529 plan WITHOUT offering a state income-tax deduction or credit. And it will help all Americans with their college savings—a primary goal here at Savingforcollege.com. I still need to put the finishing touches on this idea but look forward to sharing it with everyone soon.

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