College Savings Plans and State Income Tax Deductions
My home state recently passed the New Jersey College Affordability Act, making it the 35th state that offers a tax benefit for contributions to an approved 529 college savings plan. With NJ’s change, there are only a handful of states with a state income tax that do not also offer a tax benefit for 529 plan contributions (CA,DE, HI, KY, ME and NC).
As a refresher, 529 college savings plans allow contributions to grow on a tax-deferred basis (like an IRA) and allow you to withdraw any earnings/growth accumulated tax-free (like a Roth IRA) as long as you use the withdrawals for qualified education expenses (i.e. tuition and related expenses defined by the IRS). Withdrawals can be used to pay for college, post-graduate programs, or even for K-12 tuition on a limited basis.
From an investment/savings perspective, 529 plans are more valuable if you can start saving early, when children are young, to allow for the benefit of many years of tax-deferred growth. And while they can be an important part of a college education savings plan, you may or may not want to plan to save for four years at a select private university that could cost $70,000 per year today, if you’re not really sure that this is where your child will eventually go.
If you’re scratching your head on this, then that’s good. As simple as 529 plans are in concept, everyone’s family and financial situation is different and the devil is in the details on how 529 plans work in your state, how valuable the state tax benefits may be and how they fit into your plan.
Starting in 2022, NJ allows a deduction of up to $10,000 for contributions to NJ’s 529 plan, “NJBEST”, for state income tax purposes, to taxpayers with household income of $200,000 or less. In addition, the law included a state income tax deduction of up to $10,000 for in-state tuition for taxpayers with household income of $200,000 or less.
If you make $200,000 or less in NJ, then you can take a deduction of up to $10,000, or a lesser amount that you contribute to NJBEST, off of your income for NJ state income tax purposes. And if the kids eventually attend an in-state school, then you’ll potentially be eligible for a tax deduction on the tuition you pay as well.
Keep in mind that the deductions in NJ are “in-state” only. You have to contribute to NJ’s approved 529 plan, NJBEST, for the deduction on contributions. And you only get the tuition deduction later on if your kids attend an in-state school.
The majority of states with a state income tax deduction on 529 plan contributions similarly require that you use that state’s sponsored 529 plan. There are a handful that offer a state income tax-deduction regardless of whether or not you use its in-state 529 plan (AZ, AR, KS, MN, MO, MT and PA).
The dollar amount of the deduction differs depending on the state. Depending on the state, the deduction may be “per beneficiary” or “per taxpayer” and some states allow you to pre-fund a 529 plan and carry forward the deduction by continuing to claim it on future state income tax returns over a period of years or even on an unlimited basis.
While there are no limits on the amount of a taxpayer’s total 529 plan contributions in a given year, almost all states limit the amount of contributions that qualify for a deduction.
The NJ deduction is not per beneficiary, but per taxpayer. So a taxpayer filing individually can deduct up to $10,000 and joint filers can deduct up to $20,000 ($10,000 each). This may come in handy in a state like NJ that has a high state income tax rate.
For comparison, the deduction limit for single/joint taxpayers in Rhode Island is only $500/$1,000, while in Colorado it’s a much more generous $20,000/$30,000 per taxpayer/per beneficiary. Colorado also allows anyone making the contribution to take the deduction (i.e. grandparents, aunts/uncles) which is allowed in many other states too, but there are ten states that limit the its tax benefit only for the account owner or the account owner’s spouse.Of course, there are nine states that have no state income tax (FL, AL, NV, SD, TN, TX, WA and WY) so there’s no need for any tax incentive on 529 plan contributions.
From a timing perspective, most states require that 529 plan contributions must be made by December 31 to qualify for their state tax benefit, but there are a few that give you until April and still qualify for a deduction for the prior tax year.
You also need to check to make sure that there is no requirement to hold funds in a 529 plan for a specified period of time before claiming the deduction. For most, you can contribute and immediately take a qualified distribution to pay for college and still qualify for the state income tax benefit. But there a few states who have blocked this ‘loophole’ and/or base the credit on annual contributions net of distributions. If there is no time requirement, then parents paying for K-12 education or adults paying for graduate school may get the equivalent of a tuition discount by funneling payments through a 529 plan and claiming the state income tax benefit each year.
If you live in a state with a tax benefit for 529 plan contributions, then this is great and it’s important to understand the details of how it works, but keep in mind that it’s not the only consideration when choosing a 529 plan. Plan fees, investment options and performance should also be considered.
Again, what seems pretty straightforward in concept gets a bit more complicated when considering the details of each state’s plan. If you have questions on this or how to incorporate 529 plans into your college savings plan, then reach out to ACM Wealth Advisor.
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