How to take advantage of a state income tax reduction with a 529 College Savings plan
With 529 education savings plans offered by most states, how do you take advantage of the income tax benefits of these plans? If you are fortunate enough to be in one of the over 30 states that offer a state income tax reduction or credit for a 529 plan, you should closely consider these plans.
Remember that money contributed to a 529 plan is after-tax, so you do not get a federal income tax reduction on the contribution, but you get tax-free distributions if used for qualified educational expenses. Because this can represent a significant saving, it is the preferred investment vehicle to save for college, which many families are unaware of or don’t fully maximize its use.
The taxpayer must contribute to their state plan to reduce the income tax in most states. However, seven tax parity states offer a state income tax reduction, regardless of your state plan (Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania). The tax parity states provide the best of both worlds, the ultimate choice in a 529 plan and the added benefit of reducing state income taxes.
When shopping around for a plan, you should first consider your state plan. Ask yourself whether it offers a state income benefit. If it does, then research the plan. A good source is Morningstar’s 2021 ratings of 529 plans. Check that the plan is highly rated; silver or gold is preferred. Having both an income tax reduction and a highly rated plan should be a good plan.
Always review the fees for the plans. Typically this is called the expense ratio. There also will be a modest fee collected by the state either as a percent or flat fee. The fees can be low at around .10 percent or up to 1 percent. However, research shows that higher fees and more active management don’t translate into better returns. So consider the fees carefully, as high fees will provide a drag on your investment returns over time.
If your state does not have an income tax or no income tax benefit, you can choose any plan. Similarly to the above, select a plan that is at least silver or gold rating from Morningstar. Of these highly-rated plans, there is no one best plan. Most of the plans use the same funds and are typically low-cost. Focus on other factors such as customer service and talk to a financial planner to get an idea of the popular plans. The market for 529 plans has become very competitive and, as a result, has lower fees overall than in the past.
In summary, what to look for in 529 plans is the ability to get good low-cost investment options and excellent customer service. It is not just investing the money. It is how the plan handles the distribution when you need the money for college. It is a big decision to invest in a 529 plan. But what I’ve found is that parents spend too much time thinking about doing it and don’t act! Opening the plan is easy, but being disciplined and making regular monthly contributions are more important. Many investment calculators are available online to help you estimate the cost of college. Or work with a financial planner to help you estimate the cost of college and how this goal fits within other goals such as retirement.
Saving for college is the most significant investment besides your home. Therefore, it is an important decision that must be worked on and thought through. Contact me, and I can guide you through different strategies for saving for college.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on to avoid federal tax penalties. Individuals are encouraged to seek advice from their tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.