One reason why a 529 makes sense as a college-savings vehicle is because of its built-in federal tax treatment. The money inside a 529 grows without being hit with federal taxes and when money is withdrawn for eligible educational expenses, it avoids federal income taxes.
In addition, many savers will enjoy a state tax savings. More than 30 states, plus the District of Columbia, offer a state income tax deduction or tax credit for contributions to their 529 college savings plan.
The following seven states even provide a tax deduction or a tax credit for contributions made outside their own state plan:
In contrast, seven states, which have a state income tax system, provide no tax break, according to Savingforcollege.com. Here are states in this category:
In the majority of states offering a tax benefit, the full amount or a portion of a taxpayer’s 529 plan contribution is deductible on their state income taxes. According to Savingforcollege.com, Indiana, Utah and Vermont offer a state income tax credit for contributions.
Savers who live in states with a state tax benefit need to weigh whether the state benefit is worth staying put and investing in the 529 sponsored by their own state. In some cases it will be the right move, while in other cases, it will not especially if the mutual fund choices within the 529 plan are expensive.
According to Mark Kantrowitz, the publisher and vice president of research at SavingforCollege.com, lower fees generally matter more when a child is young and state income tax breaks matter more after the child enters high school.
The answer depends on the state’s marginal income tax rate, the difference in the fees and the number of years until the child enrolls in college.
Investors living in states like California and New Jersey, which don’t offer a tax carrot, can look for the best plan without regard to tax consequences.