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Is It Better to Stick With the Home-State 529 Plan or Go Outside?

Families have many variables to consider, including plan quality, state income tax deductions, and contribution amounts.

Kailin Liu, 08/29/2013

Investing in a 529 college-savings plan allows you a significant break on your federal taxes: tax-free compounding and withdrawals, provided the money is used for qualified college expenses. Most 529 plans also offer some sort of a state tax break on contributions by in-state residents, usually a deduction but sometimes a credit.

There are no one-size-fits-all answers about whether to stay with your home state's plan or pursue one of the best plans available nationally. To reach a good decision, you'll need to weigh how much you're saving in taxes by staying in-state alongside the potential costs you'll incur if you invest in a subpar plan.

Understanding Your State Tax Break
To reach a sound decision, the starting point is to find out just what kind of a tax break your state offers 529 savers--or doesn't.

Usually, investors in 529 plans can deduct at least a portion of their contribution amount from their state income taxes if they invest in their own state's plan. Naturally, state tax benefits associated with 529 plans depend on where the investor lives. Some states offer quite generous 529-related tax benefits, while others offer no benefits at all.

In general, state tax benefits for 529s can be aggregated into a few different buckets, listed below. Some states don't follow these patterns (for instance, they offer a tax credit instead of a deduction), but these cases are few and far between. (Note: Utah residents can claim a credit for their 529 contributions, up to $184 per beneficiary for a married couple filing jointly. Indiana residents can claim a 20% tax credit on contributions, up to a maximum credit of $1,000.)

No tax benefits: Some states offer no tax benefits for investing in a 529 plan. This can either mean that the state offers no tax deductions for 529 savings or that the state does not collect any income tax at all. The following states offer no tax benefits for investing in a 529 plan.

States with No Tax Benefits

 States With No Tax Benefits
Alaska
California
Delaware
Florida
Hawaii
Kentucky
Massachusetts
Minnesota
Nevada
New Hampshire
New Jersey
South Dakota
Tennessee
Texas
Source: Morningstar


Tax parity: 
Tax parity is an interesting inversion of a state having no tax benefits. In this instance, the states are aiming to give their residents the incentive to save for college, period, rather than the incentive to invest in their home state's 529 plan. States that offer tax parity provide state income tax benefits for resident 529 savers regardless of which state's 529 they use. This means that a resident of Missouri (one of the tax parity states) can invest in a 529 plan in Virginia while still collecting Missouri's state income tax deductions for 529 savers.

States With Tax Parity

 States With Tax Parity
Arizona
Kansas
Maine
Missouri
Montana
Pennsylvania
 
Source: Morningstar


Low tax benefits:
A few states offer income tax deductions for 529 savings but cap those deductions at $1,000 or less. This means investors can deduct only the first $1,000 they invest in their state's 529 plan. Any contribution higher than that amount is not tax-deductible.

Low tax benefits:

 Low Tax Benefits
State
State Tax-Deduction Limit (Joint Filing)*
State Tax-Deduction Limit (Individual Filing)*
State Income Cap for Deduction (Joint)*
State Income Cap for Deduction (Individual)*
State Tax-Deduction Basis
Maine
250
250
200,000
100,000 Per Beneficiary
Vermont
500
250
--
-- Per Beneficiary
Rhode Island
1,000
500
--
-- Per Taxpayer
Source: Morningstar
* Numbers in dollars


Medium tax benefits:
These states offer income tax deductions of between $1,000 and $10,000.

Medium tax benefits:

 Medium Tax Benefits
State
State Tax-Deduction Limit (Joint Filing)*
State Tax-Deduction Limit (Individual Filing)*
State Income Cap for Deduction (Joint)*
State Income Cap for Deduction (Individual)*
State Tax-Deduction Basis
Arizona
1,500
750
--
-- Per Taxpayer
Ohio
2,000
2,000
--
-- Per Beneficiary
Georgia
2,000
2,000
--
-- Per Beneficiary
Maryland
2,500
2,500
--
-- Per Beneficiary
Wisconsin
3,000
3,000
--
-- Per Beneficiary
Virginia
4,000
4,000
--
-- Per Account
Oregon
4,345
2,170
--
-- Per Taxpayer
Louisiana
4,800
2,400
--
-- Per Beneficiary
Nebraska
5,000
5,000
--
-- Per Taxpayer
North Carolina
5,000
2,500
--
-- Per Taxpayer
Montana
6,000
3,000
--
-- Per Taxpayer
Kansas
6,000
3,000
--
-- Per Beneficiary
Iowa
6,090
3,045
--
-- Per Beneficiary
Dist. of Columbia
8,000
4,000
--
-- Per Taxpayer
Source: Morningstar
* Numbers in dollars


High tax benefits: 
These states offer income tax deductions of $10,000 and higher (generally the plan's contribution limit).

High tax benefits: 

 High Tax Benefits
State
State Tax-Deduction Limit (Joint Filing)*
State Tax-Deduction Limit (Individual Filing)*
State Income Cap for Deduction (Joint)
State Income Cap for Deduction (Individual)
State Tax-Deduction Basis
Arkansas
10,000
5,000
--
-- Per Taxpayer
Alabama
10,000
5,000
--
-- Per Taxpayer
Michigan
10,000
5,000
--
-- Per Taxpayer
North Dakota
10,000
5,000
--
-- Per Taxpayer
Connecticut
10,000
5,000
--
-- Per Taxpayer
New York
10,000
5,000
--
-- Per Taxpayer
Missouri
16,000
8,000
--
-- Per Taxpayer
Illinois
20,000
10,000
--
-- Per Taxpayer
Oklahoma
20,000
10,000
--
-- Per Taxpayer
Mississippi
20,000
10,000
--
-- Per Taxpayer
Pennsylvania
28,000
14,000
--
-- Per Beneficiary
West Virginia
265,620
265,620
--
-- Per Beneficiary
New Mexico
294,000
294,000
--
-- Per Beneficiary
South Carolina
318,000
318,000
--
-- Per Taxpayer
Colorado
350,000
350,000
--
-- Per Taxpayer
Source: Morningstar
* Numbers in dollars


Case Study: The Buchanans
To help model the trade-offs of staying with a home-state 529 versus pursuing an out-of-state plan, we'll use one family, the Buchanans, as an example. Let's assume that Daisy and Tom Buchanan have a combined household income of $500,000 and a state income tax rate of 10%. They will save $25,000 in their 529 account this year. We also assume that the Buchanans invested in an age-based option and that the best-performing age-based options did not outperform the worst-performing age-based options by more than 5 percentage points.

First, the no brainer: If the Buchanans' state has no state tax benefits for 529 investors or offers tax parity--meaning that they can obtain a tax benefit even if they invest outside of their home state's plan--they are free to pick from the best 529 plans in the country. (Click here for a list of top-rated 529 plans. )

If their state does offer tax benefits for investing in-state, before investing elsewhere it's important for them to quantify the magnitude of forgone tax benefits against potentially better performance in another plan. The amount of forgone tax benefits depends on a household's state income tax level, the amount they intend to invest, and their state's income-tax-deduction limit. (See charts above.) Those who would leave a substantial chunk of change (relative to their total assets) on the table may want to stay put, while those who won't lose much money by going out of state may find a better deal elsewhere. It's important to note that if the in-state option is of average or better quality, it becomes very difficult to make up the lost tax savings by pursuing another plan.

For instance, if the Buchanans live in a state with a $10,000 deduction limit, they would leave at least $1,000 (their 10% state income tax rate times $10,000) on the table by investing out of state. Given their $25,000 investment, passing on $1,000 is like waving goodbye to an automatic 4% boost to returns, which will be difficult to make up even in the strongest plan available nationwide. (Note that the performance differential between the top and bottom deciles of age-based options up to age 18 has been around 2 to 5 percentage points during the trailing three-year period). However, if the Buchanans live in a state with only a $1,000 deduction limit, they would only forgo $100 in tax savings (10% of the $1,000 limit) by investing outside of their state's plan, which adds up to only 0.40% of their $25,000 asset base. It's much more likely that they can make up 0.40% in one of the nation's strongest plans via better performance or lower fees. Individual households can follow this framework to crunch the numbers for their unique situations.

Visit Morningstar.com's 529 Plan Center here

Kailin Liu is a Mutual Fund Analyst with Morningstar.

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