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Colorado allows an unlimited deduction, up to total taxable income, but only for contributions to its own college plans.
updated 8/10/2007 12:53:32 PM ET 2007-08-10T16:53:32

Parents and grandparents have already stashed more than $100 billion in 529 state college saving and prepaid tuition plans. And since Congress last year made the federal tax benefits of these plans permanent, interest in them has grown.

But picking a plan can be daunting — and not just because of the variety of investment choices offered by dozens of different plans and the layers of not-so-easy-to-compare fees the plans charge. State income tax breaks further complicate the choice.

There's no federal income tax deduction for contributions to a 529, but withdrawals, if used for eligible college expenses, are not federally taxed. Nearly all the states conform to the federal treatment of distributions — meaning they don't include eligible distributions from any 529 plan in a resident's taxable income.

But here's where it gets complicated: 29 states and Washington, D.C., now grant income tax deductions for contributions to their own state savings plans, but not to other states' plans, reports Joseph Hurley, a certified public accountant who tracks and rates 529 plans on his Web site, Moreover, most of these states claw back the tax deduction if a resident later rolls the account to a plan in another state, he says.

Only Pennsylvania, Kansas and Maine allow residents to deduct investments in other states' plans, with Pennsylvania's break — new for 2006 — the most generous.

Is it legal for states to use taxes to promote their own plans? Maybe not. The Supreme Court recently agreed to decide whether states violate the constitution's commerce clause when they exempt interest on their own municipal bonds from tax, but tax interest earned on other states' bonds.

If the Supreme Court rules against the states on bonds, it would likely lead to legal challenges of discriminatory treatment of 529 plans, too. "The issues are fairly similar,'' says Leonard Weiser-Varon, a partner at law firm Mintz Levin in Boston. "The state is using tax inducements to have its residents invest in its own programs rather than some other states' programs."

Note that while many 529 plans are built around mutual fund offerings from the likes of Fidelity, Vanguard, T. Rowe Price, TIAA-CREF, JPMorgan Chase and Merrill Lynch, all but one of these plans are technically sponsored by an individual state. (The exception is the Independent 529 Plan, sponsored by more than 250 private colleges.)

State tax breaks alone shouldn't decide which plan you chose — but they can make a big difference. For example, South Carolina allows an unlimited deduction against its state income tax, which is 7 percent for income over $12,850 this year; a wealthy couple could save $7,000 in tax on $100,000 plopped into a child's or grandchild's account. Indiana this year began giving state residents a 20 percent credit on the first $5,000 they contribute to one of the state's plans, for an annual tax savings of $1,000.

Last November, the NASD levied fines of $500,000 each on MetLife Securities and JPMorgan Chase affiliate Chase Investment Services of Chicago because the firms didn't have procedures in place to make sure their registered reps figured local tax breaks into their recommendations to buyers of 529 plans. The firms also agreed to pay $376,000 and $288,5000, respectively, into the college accounts of customers who were disadvantaged by the failure. (Some plans use no-load funds and are sold directly to investors, while others are sold through brokers who get commissions.)

© 2012


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