529 Rollover Can Have Tax Impact--For Good or Bad

Question: I own a 529 college-savings account in another state but would like to take advantage of the tax break I can get on contributions to my home state's plan. If I roll over the funds from my out-of-state plan to an in-state one, is the rollover tax-deductible?

Answer: While saving for a child's future college costs is its own reward, the income tax break offered by many states is an added bonus you can take advantage of now. Thirty-four states offer some sort of tax deduction or tax credit for contributions made to a 529 plan, according to data from the College Savings Plans Network (seven states have no state income tax). But in all but five of those 34 states, the tax break is available only for contributions made to an in-state plan (Arizona, Kansas, Maine, Missouri, and Pennsylvania give residents a tax break for contributing to any state's plan).

So what happens if you decide to switch plans, and is it worth rolling an out-of-state plan to an in-state one just for the tax break?

Do Your Homework Before Deciding
There's no question that the tax break can be a real plus, especially for parents trying to scrape together as much money as possible to save for college. But it shouldn't be your only consideration. The quality of the 529 plan--its investment options and fees, in particular--is important, too. If you've already opened an out-of-state 529 plan--perhaps because your in-state plan was poorly rated when you did your research years ago--you may think there's no point in revisiting that decision. But 529 plans can change over time, and your in-state plan might have improved.

Morningstar's 529 research team recently unveiled updates to its ratings of dozens of state-sponsored 529 plans. Laura Lutton, Morningstar's head of 529 plan research, discusses this year's ratings and how they were compiled in this video. This year's ratings reflect improvements in some plans, and if you're an investor with an out-of-state plan that doesn't qualify for a state income tax break, you might want to check out the latest ratings to see how your state's plan compares. You can find details on your state's plan by visiting Morningstar's 529 Plan Center and clicking on the interactive map. There you'll find information on plan options as well as details on available tax breaks. Premium members also can read plan analyses by Morningstar's team of experts.

A Potential Tax Break on Inbound Funds
Once you've determined whether your state offers a quality plan, check with the plan or a tax professional to see if there are tax advantages to rolling funds over from your out-of-state 529 account(s). Many states do not provide a tax break for inbound 529 rollovers, but some do. States that do may limit deductions to just the contribution portion of the out-of-state 529 or let you deduct the entire amount including earnings. For example, a taxpayer in Illinois, which has a 5% income tax rate, who rolls $10,000 worth of contributions from an out-of-state 529 to an in-state plan, stands to save $500 in state taxes from the rollover. (For taxpayers who deduct state taxes on their federal returns, this could result in slightly higher federal taxes paid.) That's a nice bonus that can be used to contribute even more to the college account if he or she so chooses.

You can roll 529 funds into another state's plan once every 12 months per beneficiary, and fund transfers may be made directly from plan to plan or indirectly, with the old plan sending you the money and you depositing it in the new 529 account within 60 days (to avoid paying taxes on the distribution). There might be fees associated with transferring 529 funds between state plans, so make sure you ask about these before sending in the rollover paperwork.

Outbound Rolling Could Cost You
So what happens if your research finds that the in-state 529 plan where you already have money invested is a lousy one? You may well be tempted to roll those funds into a better plan in a different state, but be careful. Many states have recapture provisions that allow them to reclaim any tax deductions you've taken for in-state 529 contributions. Many times this information will be posted on the plan's website, but if you're not sure about your state's policy, contact the plan to find out. Finding a quality 529 plan is important, but if rolling funds out of state will cost you dearly come tax time, you should think twice, especially if you will only need the 529 for a few more years.

"With just a few exceptions, we've found that most college savers will be just fine with their in-state plan," Lutton says. "Very few plans have terrible investments or too-high costs, and many savers will find that in-state tax benefits and other local incentives are too valuable to give up by switching.”

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