Breaking down the Minnesota 529 state tax benefit

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A few weeks ago, Minnesota introduced the most unique tax benefit in the 529 space: A progressive, tax-parity benefit for its constituents. Minnesota taxpayers now have the option of claiming either a tax credit or deduction for contributions to any state's 529 plan. Minnesotans can only claim one of the two benefits in any given tax year, and the benefit phases out as taxpayer income increases.

Minnesota taxpayers may:

• Take a deduction: Up to $3,000 for a married couple filing jointly or $1,500 for all other filers for contributions made to a qualified 529 account.
• Take a credit: A credit can be claimed on half of contributions up to $500, subject to phase-out starting at a federal adjusted gross income of $75,000. The credit is reduced by any withdrawals made by that taxpayer during the taxable year.

The tax deduction is pretty straightforward, and works much the same as deductions offered by other states like Missouri (who recently enacted tax parity legislation). The trouble comes in interpreting whether a taxpayer will benefit more from the deduction or credit when they fall in between the income brackets, because the language of the legislation is confusing, at best.

The tax credit for single filers

The exact language is, "For individual filers, the maximum credit is reduced by two percent of adjusted gross income in excess of $75,000." If you do the math, the benefit is reduced until it hits zero at a taxable income of $100,000. But what if their income is close to but not equal to $100,000?

For someone with less than $75,000 in taxable income, it's a no-brainer: You take the credit. And for those with over $100,000, they would take the deduction. But if a Minnesotan has $95,000 in taxable income, you can this State Tax Calculator to run multiple scenarios. In 99 percent of cases, however, they're going to be better off using the credit if they're under the $100,000 income threshold. A few example cases, for an individual taxpayer with $95,000 in taxable income:

1. The taxpayer contributes $600 to the account. This would give them a maximum tax benefit of $100, which is a net tax savings of $72 after accounting for the increase in federal tax. Taking the deduction would yield a net tax savings of only $34, by comparison.
2. If the taxpayer contributes $10,000 (hey, maybe they won the lottery), they get a maximum deduction benefit of $85. The benefit of the credit is still capped at $72.

So, if you or your client are in a situation where their income falls between these brackets, run the scenarios in the calculator to figure out the best option. Otherwise, it's safe to assume above and below the $75,000 and $100,000 income levels that they should take the credit or deduction, respectively.

RELATED: How much is each state's 529 tax benefit really worth?

The tax credit for married couples filing jointly

The single filer legislation language, while confusing, has nothing on the married-filing-jointly language. Minnesota law states, For married couples filing a joint return, the maximum credit is phased out as follows:

1. for married couples with adjusted gross income in excess of $75,000, but not more than $100,000, the maximum credit is reduced by one percent of adjusted gross income in excess of $75,000;
2. for married couples with adjusted gross income in excess of $100,000, but not more than $135,000, the maximum credit is $250; and
3. for married couples with adjusted gross income in excess of $135,000, the maximum credit is $250, reduced by one percent of adjusted gross income in excess of $135,000.

Married couples will find the tax credit begins to phase out at $75,000, with the benefit hitting zero at $160,000 in income due to the reduction, and after which it will be unilaterally better to take the deduction. In every case up to $135,000 the tax credit will offer superior tax benefits to the deduction. Like single filers, it is between $135,000 and $160,000 in taxable income that Minnesotans may need to run scenarios to determine which option is better based on their income bracket and contribution amount.

However, the benefit, while generous, carries some steep penalties in the event the owner takes non-qualified distributions. All prior year tax benefits are subject to recapture in the event of a non-qualified distribution. That could amount to thousands of dollars, depending on how many years a family has been saving.

Will we see more legislation like Minnesota in other states?

Despite some confusing language, the tax benefit for Minnesotans is actually quite elegant. Low-income savers get a significantly better tax incentive for contributions, phasing out for middle- and upper-income tax brackets. This makes it far less expensive for the state to offer these benefits to its constituents, while helping those families that need it most.

However, the legislation is so confusing and difficult to calculate for the average taxpayer, that Minnesotans may instead stand like a deer in the headlines, and default to whichever one gives them a better number in Turbotax. Or worse, they may forgo saving entirely because it's just too much work.

While it would be ideal to see more state tax benefits of this design, they need better guidance, plain language to accompany the legalese, and sample scenarios to help taxpayers and tax preparers interpret and act on the benefit. Still, Minnesota deserves praise for introducing a truly novel state tax benefit that adds value to its constituents.

Full details from the legislature are available from Minnesota HF 1, 1st Engrossment - 90th Legislature, 2017 1st Special Session.

RELATED: How to calculate your client's state tax benefit.