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State Tax Perks and 529 Plans

Investors armed with the knowledge of their state’s tax benefits can readily narrow their 529 plan choices.

Morningstar recently released its 2015 ratings for 63 529 plans, along with a companion piece, Choosing a 529 Investment. The following article summarizes the first step for do-it-yourself investors in choosing a direct-sold 529 plan--determining whether state tax or other benefits make it worthwhile to stay in state, or if investors are better off searching nationwide for a 529 plan. Investors can open direct-sold plans through 529 plan managers without the aid of a financial advisor. College savers working with advisors presumably already have guidance on these issues, so while many of the same principles apply, this research does not go into detail on advisor-sold plans, which must be opened through an advisor.

Tax Benefits Drive the In-State or Out-of-State Investing Decision
Investors have their pick among the nation’s more than 50 state-sponsored, direct-sold 529 college-savings plans, and they have no obligation to stay with their state’s plan. All 529 investors skip federal taxes on growth and distributions to pay for beneficiaries’ higher education costs. About 45% of the U.S. population lives in states that offer their residents additional state-specific tax benefits for investing within the state’s 529 plan; 10% enjoy state tax benefits regardless of the state 529 plan used (these are commonly referred to as tax-parity states); and 45% reside in states that offer no additional tax benefits (either because the state has no state income tax or no 529-specific tax benefit). Exhibit 1 shows how states fall into the different scenarios.