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. For the full list of tax benefits by plan, please see Table 1.
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.
For example, Colorado's sky-high state tax deduction limit (up to $350,000) may appeal to higher earners, but the state also offers a compelling grant program to benefit lower-income investors. The state matches contributions dollar-for-dollar on up to $500 per calendar year, dependent on a family's adjusted gross income. In addition, college students with an account that is at least two years old may be eligible for a $2,000 scholarship, renewable for up to four years, also dependent on family income levels.
Other states with matching grants include Arkansas, Kansas, Louisiana, Missouri, Nevada, North Dakota, Utah, and West Virginia, each with various family income limits. For example, Missouri families with a household income less than $75,000 are eligible to receive dollar-for-dollar matching on contributions of up to $500 per calendar year. That benefit goes away, however, if Missourians take their tax parity and invest elsewhere, so the matching grant makes the local plan more appealing for families that qualify. Nevada's SSgA Upromise 529 Plan and USAA 529 College Savings Plan both offer matching grants with a lifetime maximum of $1,500, although the latter plan requires a specific connection to the U.S. military. Louisiana takes a slightly different approach and matches contributions based on a sliding family income scale: 2% of contributions for higher-income families and up to 14% for low-income families.
For new parents, Rhode Island and Maine offer one-time grants for new babies born in the state. Families receiving these grants early on benefit from the effects of compounding returns for the maximum lifetime of the investment. Rhode Island offers a $100 grant through its direct-sold program to new account owners and also provides a match of up to $500 on contributions to both its direct- and advisor-sold programs. Meanwhile, Maine babies are eligible for a $500 grant, made possible by a legacy gift from the estate of local philanthropist Harold Alfond. (For residents with older children who may have missed the beneficiary's first birthday deadline, Maine offers a separate initial matching grant of up to $200 per beneficiary.) The benefits don't stop there: Maine also offers a 50% match on contributions up to $100 per year, as well as an additional grant of $50 for making automatic contributions. These are admirable incentives and help instill the habit of saving regularly for college. Unlike many states' matching grant programs that are targeted to low-income families, there is no family income limit for the Maine programs.
Investors with beneficiaries in their midteens may also be attracted to programs that reward soon-to-be college students, especially because at this point, families know with more certainty whether the beneficiary will indeed be using the funds from the 529 account for qualified higher education expenses. One example of such a program is the NJBEST Scholarship offered by the state of New Jersey, which awards up to $1,500 for a student's freshman year of college. The final amount is based on meeting contribution levels and participating in the plan for at least four years. Still, the scholarship is available only to those attending an in-state school. Since there is no guarantee the beneficiary will apply and be accepted to an in-state school, this benefit may hold less appeal to families with younger children.
Other states occasionally offer sweepstakes or contests and provide winners with extra 529 account contributions. These awards vary in amount and are generally not as widely accessible as the above-mentioned grants. In addition, it's worthwhile to take advantage of 529 benefits when they are available, as there is no promise that grants and scholarships will be available for the long haul. Indeed, Michigan and Minnesota discounted their matching grant programs in 2010 and 2011, respectively.
Read the Fine Print
Saving for college is an important financial goal, and 529 college savings plans provide some compelling benefits. A helpful starting place when choosing a plan is to take a look at your home state's offerings. Look at the quality of investment options and management of the plan and be sure to consider the other potential in-state benefits, as occasionally these can outweigh middling performance or a less-than-stellar price tag.
Morningstar's 529 Plan Ratings
To find out more about your 529 investments, visit the Real Life Finance tab of Morningstar.com. The Save for College tab features Morningstar's 2013 ratings on more than 60 529 plans.
- Personal Finance - Career & Education
- 529 College Savings Plans
- state income tax
- personal income tax