Does California Allow You to Deduct Contributions to a 529 on a State Tax Return?

State-sponsored 529 plans are a better way to save for college.

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With college tuition constantly rising, more and more parents are looking ahead at ways to save for that future expense. So-called 529 plans have grown in popularity to become the biggest form of savings for higher education. These are state-sponsored programs, which vary in details and investment options. California's plan offers 19 investment options and allows you to use saved funds at any eligible higher education institution in the country.

No Tax Deduction

While California's 529 plan is a good one, California is one of seven states with an income tax system that does not allow tax deductions for contributions. There's no limit on contributions, however, and you can contribute as much as $350,000 to a plan for a specific beneficiary. Parents, grandparents or other relatives also can contribute.

Withdrawals and Interest Aren't Taxed

California does afford a small tax break for 529 plans. Funds that are withdrawn to pay for qualified educational expenses won't be taxed as income. That also applies to earnings on the contributions. So if a grandparent contributed $50,000 to a 529 and it earned $10,000 in interest, you can take out $60,000 for qualified college expenses for your child without counting it as income.

Out of State Plans

You don't have to invest in California's plan if you live in that state. You're free to choose another state's plan, if that plan allows non-resident contributions. Fees vary by state, but California's plan is managed by TIIA-CREF, a company whose fees tend to be among the lowest nationwide. A plan with lower fees is usually a good investment, regardless of tax deductions.

Estate Taxes

While you won't get an immediate tax break for 529 contributions in California, those contributions will reduce the size of your estate (or that of other contributors) and qualify for federal gift tax exclusion if they are less than $13,000 a year. That means the beneficiary of the 529 plan will not owe any tax upon receiving that money from an estate after the contributor's death. The contributor can even give a one-time gift of up to $65,000 and have it treated as five years of gifts for federal gift tax exclusion.