Don't Forget the State-Tax Breaks on 529 Plans

When it comes to college savings, investing in a 529 plan is almost always the way to go. After all, these plans offer federally tax-free — and in most cases state-tax-free — withdrawals for qualified college expenses. And with tuition costs soaring (public-school costs increased by 9.6% this year while costs at private schools increased by 5.8%, according to The College Board), families need all the perks they can get.

Unfortunately, the federal government doesn't offer any tax savings on 529 contributions — but 24 states do. Of course, that's only for those who invest in their own state's plan.

Before we address how to determine whether you'll be eligible for a state-tax break, bear with us as we go over some 529-plan basics. For those who aren't familiar, 529 plans come in two varieties. A prepaid-tuition plan essentially allows families to pay today's tuition rate for future attendance of in-state schools, while a savings plan enables families to save and invest on a tax-deferred basis, and can ultimately be used toward any college or university. Given the flexibility in both school choice and investment selection, we prefer the latter.

Contributions to 529 plans aren't restricted based on age or income. The owner of the account, usually a parent or grandparent, simply needs to name a beneficiary, which is typically the child or grandchild (although it can be anyone). Once the account is opened, the owner can contribute $200,000 or more per beneficiary (this varies by plan). On an annual basis, however, an owner can contribute only up to $11,000 tax-free or $55,000 as a one-time payment without tax implications, provided no additional contributions are made in that year or in the following four years. (For more on this, click here.)

Once the youngster is ready for college, the funds can be withdrawn from the account and used for qualified education expenses without the owner or the beneficiary paying any federal taxes on the investment gains. (This law is in effect until 2010, and there's a bill in Congress to extend it.) If the money is used for nonqualified expenses, federal taxes are due, and a 10% penalty is levied. Most states, like Colorado, Georgia and Indiana, also offer tax-free withdrawals on qualified expenses. But in some states, such as Pennsylvania and Arkansas, the state-tax break on withdrawals is only for those who invest in an in-state plan. (Some states also require taxpayers to give back any tax deductions they received if the money is withdrawn for nonqualified expenses.)

State-tax deductions vary widely. Some states, like Pennsylvania and Arizona, offer no upfront tax breaks whatsoever, while others, like Colorado, Illinois, West Virginia, New Mexico and South Carolina, allow in-state investors to deduct their entire contribution. Some states, like Nebraska and Rhode Island, restrict the deductions to just $500 annually for single tax payers and $1,000 for joint filers. A few other states, including Minnesota, Michigan and Louisiana, will match a portion of contributions for families with lower income. You can check out the rules for each state on Savingforcollege.com, a Web site offering a wealth of helpful information on these plans.

As we mentioned earlier, in order to qualify for a deduction the owner must live in that state and invest in its plan. Unfortunately, while some state-sponsored plans are excellent, others are not. (Click here for a list of SmartMoney's favorite plans.) And this entire discussion of tax benefits could be moot if the owner plans to, say, escape the harsh Chicago winters for the 85-degree weather in Florida. Unbelievably, some states require an owner to give back the tax deduction if that person leaves the state and rolls over the account to another state before the beneficiary graduates from college. While only a handful of states are recapturing the deduction now, more are thinking about it, says Joseph Hurley, founder of Savingsforcollege.com. Thankfully, if you do decide to move out of state, you can leave your money in the original plan and just open another account in your new state to qualify for the tax deduction, he says.

With all of these variations, it's no surprise that college planning experts are more impressed with some plans than with others. The tax deduction alone isn't reason enough to invest in your home state's plan, they say. Since people are allowed to invest in any plan they choose, there are plenty of other things to consider — things like fee structure, plan investment options and overall performance.

For more on 529 plans, see On the Agenda, which includes several worksheets and articles to help you find the best plan