Staying Local Benefits College Savers in These States

When Morningstar's analysts determine ratings for the nation's largest 529 college-savings plans, state-level perks set some plans apart from others. Certain tax and grant benefits or other local bonuses may make a lower-rated, home-state plan a better choice for some college savers. All 529 plans, regardless of state domicile, shelter college savers from paying federal capital gains taxes on their higher-education nest eggs.

Lowering Your Tax Bill
To make a state-by-state comparison of various tax benefits, Morningstar crunched the numbers and calculated the value a typical family could receive from sticking with its local plan. We selected a hypothetical family of four that earns $50,000, or close to the national median household income. In our scenario, the family has two children and contributes $100 per month to each child's 529 account, for a total contribution level of $2,400 per year. We looked at the state tax benefits as of October 2014 and calculated the dollar value for each plan. While the actual impact to each college savers' tax bill will depend on their family's income level and contribution amount, the results below demonstrate which states offer compelling tax benefits--good background to consider when selecting where to save.

In many cases, the dollar benefit of the plan's tax benefit can help college savers overcome a less-than-stellar investment lineup or relatively high fees. Indeed, Morningstar's analysts consider such tax benefits when assigning forward-looking Morningstar Analyst Ratings, which are expressed as Gold, Silver, Bronze, Neutral, and Negative. Substantial tax savings act like a return on one's investment and can help college savers overcome a drag on returns from elsewhere in the plan. For example, Indiana's CollegeChoice Advisor 529 Savings Plan and CollegeChoice 529 Direct Savings Plan charge a high levy compared with other predominantly index-based plans, but the state offers residents the highest dollar value in tax benefits, according to our study. The state's 20% tax credit lowers an investor's tax bill for every penny added to the state's 529 plans, on up to $5,000 in contributions per family. That allows our hypothetical family to save $480 per year; if they contributed up to the $5,000 maximum, the savings would increase to $1,000 per year. Although the plans may trail their peers in absolute returns, on an aftertax basis they should come out ahead, earning both plans an Analyst Rating of Bronze. Vermont and Utah also offer tax credits on residents' contributions, although at 10% and 5%, respectively, the benefit is proportionally less generous than Indiana's.

Most states have fairly high contribution limits that provide ample leeway for investors to take a tax deduction on a large chunk of their contributions. A handful of states even have no cap, allowing deductions on contributions up to a six-figure statute limit. For example, South Carolina caps contributions and allows deductions of up to $318,000, West Virginia up to $265,620, and Colorado up to $350,000. These states' plans have obvious appeal for families planning to make sizable contributions.

While some plans limit contributions to a certain threshold for each taxpayer, several have per-beneficiary limits. Such plans are particularly attractive for families with more than one child. For example, Georgia caps its state taxable income deduction at $2,000, but that's for each child. Our family of four could save $144 per year by contributing to two accounts. Ohio uses the same calculation for its contribution limit, although with a lower marginal tax bracket, the savings is smaller, only $90. Indeed, states with relatively low income tax rates provide a smaller dollar-value in tax savings. North Dakota, which charges a 2.82% marginal income tax rate for our hypothetical median-income family, offers $68 in annual tax benefits.

Seven states do not charge income tax (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, and Texas), and eight do not allow an income tax deduction of any kind (California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Jersey, and North Carolina), eliminating state-level benefits from consideration. In these cases, college savers can go with an out-of-state 529 plan without giving up any local tax perks.

Five states allow residents to deduct contributions to any state's 529 plan from their state taxable income. Arizona, Kansas, Maine, Missouri, and Pennsylvania all have "tax parity," which provides an incentive for in-staters to shop nationally for the most compelling plan.

It's important to note that state benefits can be improved--or taken away completely. In 2014, for example, North Carolina overhauled its tax code, adopting a flat rather than tiered personal income-tax rate and removing its college-savings deduction, among other changes.

Boosting Your Account Size
In addition, or, in some cases alternatively to tax benefits, several 529 plans and/or states offer grants for staying with a home-state plan. Maine offers investors a tax deduction regardless of the state's plan they choose, but the NextGen College Investing Plan Direct and NextGen College Investing Plan Select offer college savers a suite of matching grant programs if they stick with a Maine plan. The state makes an initial dollar-for-dollar matching grant of up to $200 when an account is first opened and continues to match 50% of contributions, up to $100 per year. The state gives incentives to families to save regularly, tacking on an additional $50 for account owners making consecutive contributions. A private foundation has also bequeathed each Maine-born child with $500 to kick-start their college-savings account, although the family does not need to contribute to a 529 plan to claim the gift.

Grant programs hold more appeal than tax benefits for most lower-income families, many of whom are typically in lower tax brackets. Louisiana takes this a step further, offering a tiered matching program of 2%-14% of contributions, depending on a household's income level. Our sample family would be eligible for a 9% match, for example, adding $216 in value to the accounts.

Other states with matching grants include Arkansas, Colorado, Kansas, Missouri, Nevada, North Dakota, Utah, and West Virginia, each with various family income limits. For example, Missouri families with an annual household income less than $75,000 are eligible to receive dollar-for-dollar matches on contributions of up to $500 per calendar year. Despite the tax parity offered by Missouri, investors eligible for the grant may want to stay with their home state. Nevada's SSgA Upromise 529 Plan and USAA 529 College Savings Plan both offer matching grants with a lifetime maximum of $1,500, although the latter plan requires a specific connection to the U.S. military.

As with tax benefits, there is no guarantee these programs will be in place for the 18-plus years a college saver may own a 529 plan. Several plans have folded their matching grants, or in some cases lowered the amount given. For example, in 2013, Rhode Island closed its matching grant program to new members, and in 2014, North Dakota lowered its grant level to $300 from $500. While residents in states with matching grant programs should still seek that benefit when selecting a plan, they should also check in regularly to make sure the benefits that drew them to a plan remain.

Other Perks
In addition to exploring possible tax and grant benefits, college savers should keep in mind their state may also offer additional benefits. New Jersey, for example, offers beneficiaries a scholarship of up to $1,500 if they attend an in-state college. Similarly, Pennsylvania's SAGE Scholars Tuition Rewards offers scholarship credits that can be more widely used, although at a still-limited set of participating schools. These types of benefits have their limits and thus may have less appeal than a contribution match, which can be used at any qualified school worldwide.

States also often offer sweepstakes or contests that can provide initial or extra contributions to a 529 account, so it's worth watching to see whether any are offered in your home state. Still, these are often limited to a single or small number of winners, and tax deductions and grants can be used by a wider set of college savers.

In all, families facing higher-education expenses have many savings options, and a 529 plan can be a great choice. College savers should evaluate home-state benefits first and then vet the quality of investments and their costs. Those without an incentive to stay local shouldn't be too discouraged; there is a wide range of capable choices nationwide. To find out more about 529 investments, visit the Real Life Finance tab of Morningstar.com. The Save for College tab features Morningstar's 2014 ratings on 64 of the largest 529 plans.