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Take a lesson on state tax breaks for 529 plans

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in Small Business Tax,Small Business Tax Deduction Strategies

If you contribute to a Section 529 plan to help fund a child’s college education, you can secure valuable income tax breaks on the federal level. But what about state income taxes?  

Strategy: Consider investing in your home state’s plan. Most states provide a state income tax benefit to resident investors. If your child will be attending college soon, you might “park” funds in an in-state plan for the short term.

Here’s the whole story: A Section 529 plan is an educational savings plan generally operated by the individual states. If certain requirements are met, there’s no federal gift tax on contributions to the plans, no federal income tax on the accumulation of earnings and no federal income tax on distributions when the funds are finally paid out.

There are two types of Section 529 plans: the prepaid tuition plan and the college savings plan. With a prepaid tuition plan, you can lock in rates at an in-state public college. A college savings plan provides greater flexibility, but no guarantees.  

Every state offers at least one type of Section 529 plan. You can join a plan in an outside state, but you may do better tax-wise by staying at home. If you stick some money in your state’s plan, you might get a state income tax write-off or credit, even if you later withdraw the cash.    

This strategy only works for college savings plans; it isn’t allowed for prepaid tuition plans. Also, a few states restrict the right to withdraw funds during the first year. While some other state officials frown on this practice, they don’t prohibit it.

How much can you save? It depends on the state and the size of your contribution.

Online resource: For a listing of the limits, on state income tax deductions and credits for Section 529 plan contributions, see www.finaid.org/savings/state529deductions. If a deduction is limited, the state may allow you to carry forward the excess to future state income tax returns.

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{ 1 comment… read it below or add one }

Mary Anne Busse March 8, 2012 at 10:43 am

On behalf of the College Savings Plans Network, an organization working to improve 529 plans at the federal and state level and serving as a clearinghouse for information among existing programs, you can find extensive comparative information regarding 529 plans at collegesavings.org. Thanks!

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