Originally created 07/18/04

Avoiding a state tax hit on 529 college savings plans



Q: I know that 529 college savings plans are exempt from federal taxes, but what about state taxes?

A: The increasingly popular 529 plans are some of the best ways to save for college. A 529 plan, named for the section of the U.S. tax code that outlines them, is a state-sponsored investment plan that allows parents to save for their children's future college education.

The plans allow for substantial federal tax benefits to protect your investment when it comes time to use the money for tuition. They are composed of mutual funds and other standard investments that have the potential for returns far better than money markets, savings bonds or other savings vehicles.

Anybody in the United States can invest in any 529 plan offered by any state, whether or not they live there. However, many states offer tax advantages when a state resident opts for an in-state 529 plan, while a few states even impose additional taxes on earnings from out-of-state plans.

"I think you need to assess your tax situation when you're shopping for a 529 plan because it can make a significant difference in some situations," said Joseph Hurley, CEO and founder of Savingforcollege.com, a Web site devoted to 529 plans. "There are also some cases where it won't make a significant difference."

The difference comes from whether or not your state offers tax benefits from investing with an in-state plan, and whether the in-state plan offers strong returns on your investments. Ideally, your state offers both tax breaks and a top-notch plan, but that's not always the case.

States offering tax breaks on in-state plans, similar to the federal tax break for all 529 plans, include: Colorado, the District of Columbia, Georgia, Iowa, Kansas, Louisiana, Maine, Maryland, Michigan, Minnesota, Mississippi, Missouri, Montana, Nebraska, New Mexico, New York, Ohio, Oklahoma, Oregon, Rhode Island, South Carolina, Utah, Vermont, Virginia, West Virginia and Wisconsin.

A few states sweeten the pot further by offering further incentives for their in-state 529 plans. Louisiana, Maine, Minnesota and Rhode Island all offer matching grants for qualified in-state residents, based on their income.

The returns and value of state-sponsored plans vary widely from state to state. But even if your state's 529 plans aren't among the best performing plans, the state tax incentives often make it worth staying in-state.

"In general, I would say it would be worth sticking with even a middling 529 plan if there are very advantageous state tax reasons for doing so," said Dan McNeela, senior research analyst at Morningstar and an expert on 529 plans. "There may be some cases where a quality fund might offset the tax break, but you really have to do your research."

Some states are also fairly restrictive when it comes to 529 investing. Residents of Alabama, Pennsylvania and Tennessee do not enjoy state tax benefits, but will incur state tax liability on earnings from out-of-state 529 plans.

"There are also times when your state's tax benefit is low, like a $500 or $1,000 deduction at most," Hurley said. "A strong out-of-state plan with great returns can make up for that."

The states not listed above do not offer state tax breaks. But while residents of those states miss out on state tax benefits, they're able to shop around for the best overall returns when choosing a 529 plan.

Would-be investors should look at whether a given state's 529 plan has a one-time setup or enrollment fee, an annual fee, and the plan's expense ratios. Expense ratios range from 0.25 percent to 2 percent of your assets under management.

And while some out-of-state plans are easy to enroll in, others require a financial adviser to invest in the plan for you, or have an additional sales charge for out-of-state participants. A number of books and Web sites offer side-by-side comparisons of 529 plans for research on which plan to choose.

"First off, find a plan that has low costs, then find a plan that has really high quality underlying funds," McNeela said. "And then, the third most important thing is flexibility with the investment options so you can manage your risk."

A good 529 fund will allow investors to select how they want their holdings balanced - whether they want more stock funds or more bonds - according to their own risk tolerance. Other plans offer age-based programs that will invest your money more conservatively as your child approaches college age.

"The quality of investment is the most important thing to look for," Hurley said. "Like anything else, you want to maximize your return under whatever level of risk you're comfortable with."

On the Net:

College Savings Plans Network: www.collegesavings.org

Morningstar 529 ratings: www.morningstar.com/centers/529.html?hsection 529

Savingforcollege.com LLC: www.savingforcollege.com