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529 E-ditorials

04-3: Don't let the sun go down on me
Joe Hurley
Tuesday, June 29th 2004

Residents in twenty-five states and the District of Columbia face an unpleasant tax surprise on January 1, 2011. Those who have invested in out-of-state 529 plans will wake up that morning to find that qualified withdrawals from their out-of-state 529 accounts, which would have been state tax-free the day before, are now subject to state income tax. For these investors, only the in-state 529 plan will offer shelter from state income tax on post-2010 withdrawals.*

You already know that the federal tax exclusion for qualified 529 withdrawals is scheduled to expire on December 31, 2010. The "sunset" problem has been covered extensively in the media and in 529 program disclosures. But the impact of the sunset on residents of states that piggyback on the federal rules for determining taxable income has received scant attention.

It's altogether possible that the tax cost of the sunset will be greater on your child's state tax return than it is on his or her federal tax return. For many taxpayers, the federal education tax credits (Hope and Lifetime Learning credits) will offset most or all of the beneficiary's federal tax liability arising from a qualified 529 withdrawal after 2010. Most states have no such credits, and the beneficiary will bear the full brunt of any state tax on 529 withdrawals.

I see three actions that should be taken to address this unfortunate situation:

First, our government in Washington should make permanent the federal tax exclusion on 529 withdrawals. The sunset problem will then be fixed automatically in most of the states that piggyback on the federal tax code. I believe it is poor public policy to tax a family on investment gains needed to merely keep up with college cost increases. In fact, the current tuition spiral makes it difficult, if not impossible, to invest successfully enough to keep pace with these increases, never mind Uncle Sam extracting a chunk of account growth. Congress needs to make permanency happen, and sooner rather than later.

Second, every state with an income tax should take the necessary legislative steps to ensure that qualified withdrawals from ANY state's 529 plan remain state tax-free, regardless of the federal rules. In other words, states should not wait for the feds to fix the sunset problem. My argument is no different than what I have already stated: it is not right for states to tax their residents on moneys used for college. Several states-Arizona, Arkansas, Colorado, Massachusetts, New Jersey, New Hampshire, and Tennessee-have stepped up to the plate and have already enacted legislation making qualified withdrawals from ANY 529 plan exempt from state tax. Every other state should follow suit.

Third, you, the investor, should become familiar with the tax policies in your own state (and the state where the beneficiary resides, if different). Just as an upfront state tax deduction for contributions to the in-state 529 plan will influence your choice of 529 plan, so should the back-end state treatment of withdrawals. Please understand, however, that state tax conformity laws are notoriously tricky. While we do our best to summarize this information on our web site at www.savingforcollege.com, you must ultimately rely on your own tax adviser. You may conclude that a timely rollover from an out-of-state 529 plan to the in-state 529 plan will allow you to avoid the problem, but some states may label this strategy a "loophole" and attempt to plug it in the future.

We should demand that our state legislators support full exemption of all qualified 529 withdrawals so that no one is forced into tax-motivated rollovers, or is caught by surprise in a state tax trap.

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*Here are the twenty-five states (including DC) that begin taxing withdrawals from out-of-state 529 plans on January 1, 2011 while maintaining exemption for withdrawals from their in-state 529 plans: California, Connecticut, District of Columbia. Georgia, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Missouri, Montana, Nebraska, New Mexico, New York, North Carolina, Ohio, Oregon, Rhode Island, South Carolina, Utah, Vermont, Virginia, and Wisconsin.

In eight states, the federal tax sunset will cause post-2010 withdrawals from both out-of-state and in-state 529 plans to become subject to state income tax:
Delaware, Hawaii, Idaho, Kansas, Minnesota, North Dakota, Oklahoma, and West Virginia.

Seven states have enacted legislation exempting qualified withdrawals from any 529 plan, regardless of federal tax treatment: Arizona, Arkansas, Colorado, Massachusetts, New Hampshire, New Jersey, and Tennessee.

Three states currently permit state tax exclusion only on withdrawals from the in-state 529 plan and are not impacted by the federal sunset: Illinois, Mississippi, and Pennsylvania.

Alabama is the only state that currently subjects residents to state tax on qualified withdrawals from both in-state and out-of-state 529 plans (proposed legislation to provide exemption has not yet been enacted).

Seven states have no income tax or interest/dividends tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.

Important notes:
- Typically, the state where the beneficiary resides in the year of withdrawal will determine state tax treatment of withdrawals.
- State taxes are complex and subject to change. The information summarized here may contain inaccuracies and/or inadequate detail. If incorrect information comes to our attention, we will announce the corrections in a future article. Rely on your own tax adviser in understanding how you and your beneficiary may be impacted by state taxes related to your 529 accounts.

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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