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Making Dollars and Sense of College Savings' State Benefits

Some states' 529 plans offer better tax breaks and other savings.

Laura Pavlenko Lutton, 09/23/2011

Among the most attractive benefits of a 529 college-savings plan are the tax breaks college savers receive while building a nest egg to pay for a child's education expenses. All 529 plan participants can avoid paying federal taxes on their 529 savings' gains, but many states offer local benefits on the initial 529 contributions, as well.

Morningstar recently tallied the states' benefits to determine which states offered the most generous local tax breaks. By quantifying these benefits, college savers are better able to determine whether their home state's 529 plan is a good choice. Generous tax benefits and fee waivers may offset other shortcomings in a plan, like higher expense ratios or mediocre investments among the 529 plan's investment options. Likewise, if a state's tax benefits are little to none, college savers have little reason to stay with their state's plan and may instead seek a best-in-class plan elsewhere.

To determine a dollar value for the states' benefits, Morningstar's Ben Alpert made some assumptions. His calculations assume that a couple with $100,000 in income and two children made a $2,500 contribution to each child's 529 account over the course of a year. As such, the couple's total 529 plan savings for the year was $5,000.

Morningstar found a wide range of benefits. Eight states, including populous ones such as California and Massachusetts, tax their residents' income and offer no state tax benefits. Residents in these states often invest elsewhere and are actively targeted by other states' 529 plans. On the flip side are states that offer portable tax benefits. Residents of states such as Maine, Missouri and Pennsylvania receive benefits on their contributions to any 529 plan--not just the ones offered by their home state. For most 529 savers, however, their state's tax benefits are not portable, so if they choose another state's plan, they give up the local tax breaks.

The Hoosier Tax Credit
Topping Morningstar's list of the states with the most generous 529 benefits is Indiana. While most states with tax benefits allow their residents to subtract their 529 contributions from their taxable income, Hoosiers get something far better: A tax credit. This credit of 20% of the first $5,000 of 529 contributions allows Indiana residents to subtract $1,000 from their annual state tax bill. When you also include two $20 account-fee waivers, Indianans save $1,040 on $5,000 in annual 529 contribution by staying in-state. (Vermont and Utah also offer tax credits on 529 savings, but they're not as generous as Indiana's.)

Maine is another state with solid benefits, but much of them expire after the child's first birthday. Maine residents get a $500 grant from their state if they open a 529 account before their child's first birthday. From there, the Maine benefits are less generous. Residents may deduct from their taxable income just $250 per child in annual 529 contributions, saving them $21.25 in income taxes per contribution. In addition, they're eligible for a waiver on the Next Gen plan's annual $50 fee, saving a family with two beneficiaries $142.50 before the $500 matching grant. In Morningstar's example, which assumed one of the two 529 beneficiaries is less than one year old, the 529 benefits would be worth $642.50. For Mainers who leave the state and make similar contributions to another state's 529 plan, they'll receive $42.50 in benefits.

Beyond Indiana and Maine, six states offer benefits in the $400-$500 range, and more than a half dozen are $300-$400. The states with greater benefits, like Iowa and Oregon, often also have higher tax rates.

Click here to view all the data.

Laura Pavlenko Lutton is an editorial director in Morningstar's fund research group. She would love to hear from you, but she can't give portfolio advice.
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