Permanent Value

Week in Review 11/11/13

Bruce Doole
November 11th, 2013

529 Savers – Should You Stay or Should You Go?

Morningstar recently released its annual Analyst Ratings for 529 College Savings Plans (see this article). These ratings can help guide investors toward the highest-quality plans, but there are good reasons–often tax-related–why a lower-rated plan may be a perfect fit for you. In many states, for example, you give up generous local benefits if you leave your home-based plan for another. Below we take a look at the myriad of ways states provide incentives for residents, which you can use to aid in choosing a plan.

Tax Benefits: Immediate Gratification
To compare the value of state 529 tax benefits, Morningstar crunched some numbers to evaluate the dollar-value benefit of a hypothetical investment. We used the following assumptions:

  • We looked at the state tax benefits as of October 2013 for one year’s worth of contributions, excluding any rollover benefits from previous years.
  •  We used the marginal state income tax rate for couples earning $50,000 per year.
  •  We assumed a couple made contributions of $1,200 for the year, or $100 per month, to a single beneficiary’s account.

Actual income levels and contribution amounts can have an impact on the state income tax benefits, and benefits can vary significantly from state to state. Indiana residents receive a state income tax credit on 20% of their contributions, providing a $240 savings in our example. Vermont also offers a 10% tax credit on contributions of up to $2,500 per year, per beneficiary. For families with multiple children, that last detail holds particular appeal. Idaho offers couples a state income tax deduction on contributions of up to $8,000. With a 7.4% marginal personal income tax for couples earning $50,000 a year, a couple socking away $1,200 per year into the IDEAL – Idaho College Savings Program would save roughly $89 on their state income tax bill.
These tax benefits enhance the appeal of the strong investment options offered by these states and make investing in the plans an easy decision for in-state residents. College savers can think of the benefits as lowering their investment costs or boosting returns. For example, the tax savings for Idaho investors is equivalent to a 7.4% return, more than compensating for the relatively hefty price tag of the state’s direct-sold plan. And the credit from Indiana is effectively like receiving a 20% return on your investment.

Not every state offers generous savings levels. For example, Maine caps deductions at $250 for couples, limiting the state income tax benefits (although there are other private and public matching grants, discussed below, that are worth considering). And North Dakota has a relatively low state income tax rate, leading to a smaller benefit for residents who invest in that state’s 529 plan.

As Kailin Liu summarized in this article, there are several layers of tax benefits for investing in a 529 plan, including at the federal level. Some states, including Alaska, Florida, Hawaii, New Hampshire, Nevada, South Dakota, Tennessee, and Texas, do not charge income tax and therefore don’t have state-level benefits. Other states’ income tax benefits are portable to other states’ plans. For example, Arizona, Kansas, Maine, Missouri, Montana, and Pennsylvania have tax parity, allowing investors to take deductions on 529 contributions regardless of which state’s plan they choose. In either case, investors have all the more reason to shop around for the highest-quality, and least-expensive, plan.

A Free Lunch for 529 Savers
In addition to potentially saving on this year’s state income tax bill, 529 beneficiaries may also be eligible for a scholarship or matching grant for contributing to the state’s plan. Roughly one third of 529 plans offer some type of matching contribution or grant benefit, mostly targeted toward low-income families.


Source: MorningstarAdvisor