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A 529 plan, also known as a qualified tuition plan, is a financial account that enables saving for college with tax-advantaged growth. Contributions are not tax-deductible for federal income tax returns. However, states serve as sponsors for most 529 plans, and many of them offer state income tax deductions for contributions to their plans.
You do not get a federal tax deduction for 529 plan contributions, but the accounts yield other major federal tax benefits. The money in 529 plans grows without incurring state or federal taxes, and you pay no taxes on the earnings when you withdraw funds for qualified college expenses. However, earnings used for non-qualified expenses are taxed as ordinary income and receive an additional 10 percent tax penalty.
Each of the 50 states sponsors at least one 529 plan. Some are open to state residents only, while others are open to any U.S. resident. According to the FinAid, website, many states provide some form of state income tax deduction for contributions to the plans. Most states limit the deductions to the plans that they sponsor. The size of the allowed deduction can vary widely. For example, Colorado and New Mexico allow a state deduction for the full size of the contribution. Most other states place a cap on the contribution. For example, Arkansas limits deductions to $5,000 for a single filer and $10,000 for joint filers.
Seven states do not provide deductions on state income taxes for 529 contributions. Another nine do not have state income taxes, so there is no need to offer a deduction. The majority of the states that do provide tax deductions offer them only for contributions by state residents to the plans offered by that particular state. However, at the time of publication, Arizona, Kansas, Maine, Missouri and Pennsylvania offer income tax deductions to their residents for contributions to any state's plan.
Although receiving a state income tax deduction has obvious benefits, it may not be worth choosing a plan based solely on that factor. It's also important to take into account the annual fees that a plan carries, and where your beneficiary intends to go to school. Some states also offer a matching grant program for low-income families, which can add tremendous value to a plan. As with any investment, it's important to look at the big picture.
- female college student image by Matthew Antonino from Fotolia.com