One popular method of saving for college is the 529 plan, with most states offering at least one option. With a 529 plan, your college savings grow tax-deferred, and you pay no federal tax on withdrawals for qualified higher education expenses.
In 2018, the Tax Cuts and Jobs Act took effect, expanding the definition of qualified higher education expenses to include tuition payments for private or religious school education from kindergarten through grade 12.
Here's what else you need to know about 529 plans and how they differ from state to state.
- 529 plans, or Qualified Education Programs (QEPs), are special savings accounts designed to help pay for a student's future higher education expenses.
- Contributions to 529 plans are subject to the federal gift tax thresholds, which may be set yearly.
- The tax treatment of 529 plans varies based on the state that offers the plan, whether via deductions, credits, a combination of the two, or none at all.
- It's important to remember that 529 plans are investment accounts that vary in performance and risk. Choose a plan with features that suit your needs.
Federal Deductions for 529 Plans
There is no federal deduction for contributions to a 529 account. At the federal level, contributors should keep in mind that contributions may be subject to the federal gift tax laws. In tax years 2022, you can give up to $16,000 to someone before the gift tax kicks in, or $32,000 for married couples combining gifts (up from $15,000 and $30,000 in 2021, respectively).
At the state level, many states offer a deduction, and a few states offer a credit. Deductions typically will only be relevant if they help the contributor bypass the state’s standard deduction level. Credits offer the greatest advantage as they are subtracted from the amount of tax a taxpayer owes overall.
The Best 529 Tax Advantages Offered
Over 30 states offer a tax parity that allows taxpayers to receive a state tax break on contributions to any 529 plan in the U.S. Three states offer tax credits. States with tax parity and tax credits make them obvious front-runners for the best advantages.
Tax Parity Deductions
Arizona and Kansas are the two states that offer their residents tax deductions in the 2021 tax year for contributions to any state’s 529 plan, not just their own. This gives residents of these states the freedom to pick and choose among state plans—seeking out those with the lowest fees and the best investment options—while still getting a state tax deduction.
Out of these seven states, the best may be Pennsylvania's 529 College and Career Savings Program (PA529). This plan allows a deduction equal to the annual federal gift tax exclusion.
Indiana, Utah, and Vermont are the three states offering a tax credit, which include the following:
- Indiana: Any contributor can claim a 20% tax credit on contributions up to $5,000 for a maximum credit of $1,000.
- Utah: The contributor can claim a 5% tax credit per beneficiary on contributions up to $2,040 (for individual filers) or $4,080 (for those filing jointly) for a maximum credit of $102 (individual) or $204 (joint).
- Vermont: The contributor can claim a 10% tax credit per beneficiary on contributions up to $2,500 (for individual filers) or $5,000 (for those filing jointly) for a maximum credit of $250 (individual) or $500 (joint).
Other States That Offer Deductions
As for the rest of the states with tax savings, you can only deduct amounts contributed to a state plan where deductions are available. Therefore, the best states from a tax perspective will be those that offer the biggest deductions.
While most states have dollar limits on 529 deductions, Colorado, New Mexico, South Carolina, and West Virginia allow you to deduct the full amount of contributions to their respective 529 plans. However, Colorado limits deduction amounts to the taxpayer's total taxable income.
States with No Tax Savings
Some states have no deduction or credit for 529 plan contributions. If you are a resident of one of these states, there are still plenty of 529 plan options but no tax breaks for utilizing them.
If you live in one of these states, your best option is to choose a state plan that has low fees and offers the type of investment options you want. In most cases, you do not need to be a resident of a state to invest in its plan.
Even if you don't get upfront tax breaks from your state for contributing to a 529 plan, you will still get federal tax benefits down the road as long as you withdraw from them properly.
Which State Plan to Choose
Tax deductions and credits are great, but they may not add up to much if your state’s 529 plan charges high fees. Be sure to check on the fees for your state’s plan (and whether it waives those fees for in-state residents). Shop around, and compare those fees to those of other states. Other important considerations are investment performance and whether a plan includes investment options, such as target-date funds.
Frequently Asked Questions
Is there a federal tax break for contributing to 529 plans?
There is no credit or deduction at the federal level for contributing to a 529 plan, but this type of savings account is considered to be tax-favorable, as earnings that come from 529 plans are not subject to federal income tax when used for qualified educational expenses.
Are there any downsides to using a 529 plan?
As with any investment, there is always risk. 529 plans can be structured in a variety of ways, so you can minimize the risk of losing any of your initial investment by choosing an option that works with your financial situation, and with your student's future. If you end up using the earnings for something other than qualified higher educational expenses, then they will be subject to federal taxes.