Is It Better to Stick With the Home-State 529 Plan or Go Outside? / Families have many variables to consider, including plan quality, state income tax deductions, and contribution amounts.

Kailin Liu for Morningstar writes: Investing in a 529 college-savings plan allows you a significant break on your federal taxes: tax-free compounding and withdrawals, provided the money is used for qualified college expenses. Most 529 plans also offer some sort of a state tax break on contributions by in-state residents, usually a deduction but sometimes a credit. 

There are no one-size-fits-all answers about whether to stay with your home state's plan or pursue one of the best plans available nationally. To reach a good decision, you'll need to weigh how much you're saving in taxes by staying in-state alongside the potential costs you'll incur if you invest in a subpar plan. 

Understanding Your State Tax Break
To reach a sound decision, the starting point is to find out just what kind of a tax break your state offers 529 savers--or doesn't.
Usually, investors in 529 plans can deduct at least a portion of their contribution amount from their state income taxes if they invest in their own state's plan. Naturally, state tax benefits associated with 529 plans depend on where the investor lives. Some states offer quite generous 529-related tax benefits, while others offer no benefits at all.
In general, state tax benefits for 529s can be aggregated into a few different buckets, listed below. Some states don't follow these patterns (for instance, they offer a tax credit instead of a deduction), but these cases are few and far between.

No tax benefits: Some states offer no tax benefits for investing in a 529 plan. This can either mean that the state offers no tax deductions for 529 savings or that the state does not collect any income tax at all. The following states offer no tax benefits for investing in a 529 plan. 

States With No Tax Benefits

Alaska

California

Delaware

Florida

Hawaii

Indiana

Kentucky

Massachusetts

Minnesota

Nevada

New Hampshire

New Jersey

South Dakota

Tennessee

Texas

Utah

Source: Morningstar

Tax parity: Tax parity is an interesting inversion of a state having no tax benefits. In this instance, the states are aiming to give their residents the incentive to save for college, period, rather than the incentive to invest in their home state's 529 plan. States that offer tax parity provide state income tax benefits for resident 529 savers regardless of which state's 529 they use. This means that a resident of Missouri (one of the tax parity states) can invest in a 529 plan in Virginia while still collecting Missouri's state income tax deductions for 529 savers.

States With Tax Parity

Arizona

Kansas

Maine

Missouri

Pennsylvania

Source: Morningstar

Low tax benefits: A few states offer income tax deductions for 529 savings but cap those deductions at $1,000 or less. This means investors can deduct only the first $1,000 they invest in their state's 529 plan. Any contribution higher than that amount is not tax-deductible.

Low Tax Benefits
State	State Tax-Deduction Limit (Joint Filing)*	State Tax-Deduction Limit (Individual Filing)*	State Income Cap for Deduction (Joint)*	State Income Cap for Deduction (Individual)*	State Tax-Deduction Basis
Maine	250	250	200,000	100,000	Per Beneficiary
Vermont	500	250	--	--	Per Beneficiary
Rhode Island	1,000	500	--	--	Per Taxpayer
Source: Morningstar * Numbers in dollars

Medium tax benefits: These states offer income tax deductions of between $1,000 and $10,000.

Medium Tax Benefits
State	State Tax-Deduction Limit (Joint Filing)*	State Tax-Deduction Limit (Individual Filing)*	State Income Cap for Deduction (Joint)*	State Income Cap for Deduction (Individual)*	State Tax-Deduction Basis
Arizona	1,500	750	--	--	Per Taxpayer
Ohio	2,000	2,000	--	--	Per Beneficiary
Georgia	2,000	2,000	--	--	Per Beneficiary
Maryland	2,500	2,500	--	--	Per Beneficiary
Wisconsin	3,000	3,000	--	--	Per Beneficiary
Virginia	4,000	4,000	--	--	Per Account
Oregon	4,345	2,170	--	--	Per Taxpayer
Louisiana	4,800	2,400	--	--	Per Beneficiary
Nebraska	5,000	5,000	--	--	Per Taxpayer
North Carolina	5,000	2,500	100,000	60,000	Per Taxpayer
Montana	6,000	3,000	--	--	Per Taxpayer
Kansas	6,000	3,000	--	--	Per Beneficiary
Iowa	6,090	3,045	--	--	Per Beneficiary
Dist. of Columbia	8,000	4,000	--	--	Per Taxpayer
Source: Morningstar * Numbers in dollars

High tax benefits: These states offer income tax deductions of $10,000 and higher (generally the plan's contribution limit).

High Tax Benefits
State	State Tax-Deduction Limit (Joint Filing)*	State Tax-Deduction Limit (Individual Filing)*	State Income Cap for Deduction (Joint)	State Income Cap for Deduction (Individual)	State Tax-Deduction Basis
Arkansas	10,000	5,000	--	--	Per Taxpayer
Alabama	10,000	5,000	--	--	Per Taxpayer
Michigan	10,000	5,000	--	--	Per Taxpayer
North Dakota	10,000	5,000	--	--	Per Taxpayer
Connecticut	10,000	5,000	--	--	Per Taxpayer
New York	10,000	5,000	--	--	Per Taxpayer
Missouri	16,000	8,000	--	--	Per Taxpayer
Illinois	20,000	10,000	--	--	Per Taxpayer
Oklahoma	20,000	10,000	--	--	Per Taxpayer
Mississippi	20,000	10,000	--	--	Per Taxpayer
Pennsylvania	28,000	14,000	--	--	Per Beneficiary
West Virginia	265,620	265,620	--	--	Per Beneficiary
New Mexico	294,000	294,000	--	--	Per Beneficiary
South Carolina	318,000	318,000	--	--	Per Taxpayer
Colorado	350,000	350,000	--	--	Per Taxpayer
Source: Morningstar * Numbers in dollars

Case Study: The Buchanans
To help model the trade-offs of staying with a home-state 529 versus pursuing an out-of-state plan, we'll use one family, the Buchanans, as an example. Let's assume that Daisy and Tom Buchanan have a combined household income of $500,000 and a state income tax rate of 10%. They will save $25,000 in their 529 account this year. We also assume that the Buchanans invested in an age-based option and that the best-performing age-based options did not outperform the worst-performing age-based options by more than 5 percentage points.

First, the no brainer: If the Buchanans' state has no state tax benefits for 529 investors or offers tax parity--meaning that they can obtain a tax benefit even if they invest outside of their home state's plan--they are free to pick from the best 529 plans in the country. ( Click here for a list of top-rated 529 plans. )

If their state does offer tax benefits for investing in-state, before investing elsewhere it's important for them to quantify the magnitude of forgone tax benefits against potentially better performance in another plan. The amount of forgone tax benefits depends on a household's state income tax level, the amount they intend to invest, and their state's income-tax-deduction limit. (See charts above.) Those who would leave a substantial chunk of change (relative to their total assets) on the table may want to stay put, while those who won't lose much money by going out of state may find a better deal elsewhere. It's important to note that if the in-state option is of average or better quality, it becomes very difficult to make up the lost tax savings by pursuing another plan.

For instance, if the Buchanans live in a state with a $10,000 deduction limit, they would leave at least $1,000 (their 10% state income tax rate times $10,000) on the table by investing out of state. Given their $25,000 investment, passing on $1,000 is like waving goodbye to an automatic 4% boost to returns, which will be difficult to make up even in the strongest plan available nationwide. (Note that the performance differential between the top and bottom deciles of age-based options up to age 18 has been around 2 to 5 percentage points during the trailing three-year period). However, if the Buchanans live in a state with only a $1,000 deduction limit, they would only forgo $100 in tax savings (10% of the $1,000 limit) by investing outside of their state's plan, which adds up to only 0.40% of their $25,000 asset base. It's much more likely that they can make up 0.40% in one of the nation's strongest plans via better performance or lower fees. Individual households can follow this framework to crunch the numbers for their unique situations.

"The government policies designed to make college more affordable could be creating market frictions which enable investment firms to charge excess fees," Bogan said, adding that federal regulation may be needed "to preclude financial management companies from appropriating the benefits intended for individuals."
Bogan's analysis will appear in a forthcoming issue of the journal Contemporary Economic Policy.
In the early 2000s, Section 529 of the Internal Revenue Code was amended to create investment plans that would encourage parents to save for their children's education. As a result almost every state offers "529 plans" that allow parents to deduct contributions from their state income tax. Like 401(k) retirement plans, 529 plans usually invest in a group of mutual funds.
Analyzing data from 2002 to 2006, Bogan found that the greater the tax advantage a state offered, the higher the fees charged by investment managers, even after controlling for such factors as the amount of competition in a state and the administrative structure of the plan. The statistics support an assertion that investment management companies set their fees based on the amount of tax saving offered by the state, she said. And if the state is receiving a share of the fees charged by plan administrators, Bogan added, it has an incentive not to regulate those fees, creating a "moral hazard risk."
Bogan offers the example of parents investing $10,000 a year in a typical plan, starting when a child is born. Tax savings will amount to around $500 a year, depending on the investor's federal tax bracket, and the parents would invest that money back in the plan. But fees – based on the growing value of the fund – will quickly reach $585 a year. "By year four or five…the annual asset-based fees completely cannibalize the state taxable income benefit," Bogan reported. At the end of 18 years, the 529 fund could be worth thousands less than an ordinary mutual fund, depending on the fees charged.
"Households would be well advised to educate themselves about each specific educational savings plan prior to investing," Bogan concluded.


Read more at: http://phys.org/news/2013-08-fees-cancel-tax-advantage-college.html#jCp

"The government policies designed to make college more affordable could be creating market frictions which enable investment firms to charge excess fees," Bogan said, adding that federal regulation may be needed "to preclude financial management companies from appropriating the benefits intended for individuals."
Bogan's analysis will appear in a forthcoming issue of the journal Contemporary Economic Policy.
In the early 2000s, Section 529 of the Internal Revenue Code was amended to create investment plans that would encourage parents to save for their children's education. As a result almost every state offers "529 plans" that allow parents to deduct contributions from their state income tax. Like 401(k) retirement plans, 529 plans usually invest in a group of mutual funds.
Analyzing data from 2002 to 2006, Bogan found that the greater the tax advantage a state offered, the higher the fees charged by investment managers, even after controlling for such factors as the amount of competition in a state and the administrative structure of the plan. The statistics support an assertion that investment management companies set their fees based on the amount of tax saving offered by the state, she said. And if the state is receiving a share of the fees charged by plan administrators, Bogan added, it has an incentive not to regulate those fees, creating a "moral hazard risk."
Bogan offers the example of parents investing $10,000 a year in a typical plan, starting when a child is born. Tax savings will amount to around $500 a year, depending on the investor's federal tax bracket, and the parents would invest that money back in the plan. But fees – based on the growing value of the fund – will quickly reach $585 a year. "By year four or five…the annual asset-based fees completely cannibalize the state taxable income benefit," Bogan reported. At the end of 18 years, the 529 fund could be worth thousands less than an ordinary mutual fund, depending on the fees charged.
"Households would be well advised to educate themselves about each specific educational savings plan prior to investing," Bogan concluded.


Read more at: http://phys.org/news/2013-08-fees-cancel-tax-advantage-college.html#jCp

"The government policies designed to make college more affordable could be creating market frictions which enable investment firms to charge excess fees," Bogan said, adding that federal regulation may be needed "to preclude financial management companies from appropriating the benefits intended for individuals."
Bogan's analysis will appear in a forthcoming issue of the journal Contemporary Economic Policy.
In the early 2000s, Section 529 of the Internal Revenue Code was amended to create investment plans that would encourage parents to save for their children's education. As a result almost every state offers "529 plans" that allow parents to deduct contributions from their state income tax. Like 401(k) retirement plans, 529 plans usually invest in a group of mutual funds.
Analyzing data from 2002 to 2006, Bogan found that the greater the tax advantage a state offered, the higher the fees charged by investment managers, even after controlling for such factors as the amount of competition in a state and the administrative structure of the plan. The statistics support an assertion that investment management companies set their fees based on the amount of tax saving offered by the state, she said. And if the state is receiving a share of the fees charged by plan administrators, Bogan added, it has an incentive not to regulate those fees, creating a "moral hazard risk."
Bogan offers the example of parents investing $10,000 a year in a typical plan, starting when a child is born. Tax savings will amount to around $500 a year, depending on the investor's federal tax bracket, and the parents would invest that money back in the plan. But fees – based on the growing value of the fund – will quickly reach $585 a year. "By year four or five…the annual asset-based fees completely cannibalize the state taxable income benefit," Bogan reported. At the end of 18 years, the 529 fund could be worth thousands less than an ordinary mutual fund, depending on the fees charged.
"Households would be well advised to educate themselves about each specific educational savings plan prior to investing," Bogan concluded.


Read more at: http://phys.org/news/2013-08-fees-cancel-tax-advantage-college.html#jCp

e

The final value of a college savings plan depends on management fees. Parents purchasing a mutual fund portfolio for a newborn child and investing $10,000 each year until the child starts college (18 years) would finally have almost $415,000 …more

(Phys.org) —Government efforts to make it easier to save for college have unintended consequences, according to a Cornell economist. When you get a tax deduction for contributing to a college savings plan, your savings may be more than consumed by higher fees charged by plan administrators, according to research by Vicki Bogan, associate professor in the Charles H. Dyson School of Applied Economics and Management. Parents may be better off putting their money in ordinary, non-tax-exempt investments, she suggested.

Read more at: http://phys.org/news/2013-08-fees-cancel-tax-advantage-college.html#jCp

"The government policies designed to make college more affordable could be creating market frictions which enable investment firms to charge excess fees," Bogan said, adding that federal regulation may be needed "to preclude financial management companies from appropriating the benefits intended for individuals."
Bogan's analysis will appear in a forthcoming issue of the journal Contemporary Economic Policy.
In the early 2000s, Section 529 of the Internal Revenue Code was amended to create investment plans that would encourage parents to save for their children's education. As a result almost every state offers "529 plans" that allow parents to deduct contributions from their state income tax. Like 401(k) retirement plans, 529 plans usually invest in a group of mutual funds.
Analyzing data from 2002 to 2006, Bogan found that the greater the tax advantage a state offered, the higher the fees charged by investment managers, even after controlling for such factors as the amount of competition in a state and the administrative structure of the plan. The statistics support an assertion that investment management companies set their fees based on the amount of tax saving offered by the state, she said. And if the state is receiving a share of the fees charged by plan administrators, Bogan added, it has an incentive not to regulate those fees, creating a "moral hazard risk."
Bogan offers the example of parents investing $10,000 a year in a typical plan, starting when a child is born. Tax savings will amount to around $500 a year, depending on the investor's federal tax bracket, and the parents would invest that money back in the plan. But fees – based on the growing value of the fund – will quickly reach $585 a year. "By year four or five…the annual asset-based fees completely cannibalize the state taxable income benefit," Bogan reported. At the end of 18 years, the 529 fund could be worth thousands less than an ordinary mutual fund, depending on the fees charged.
"Households would be well advised to educate themselves about each specific educational savings plan prior to investing," Bogan concluded.


Read more at: http://phys.org/news/2013-08-fees-cancel-tax-advantage-college.html#jCp

"The government policies designed to make college more affordable could be creating market frictions which enable investment firms to charge excess fees," Bogan said, adding that federal regulation may be needed "to preclude financial management companies from appropriating the benefits intended for individuals."
Bogan's analysis will appear in a forthcoming issue of the journal Contemporary Economic Policy.
In the early 2000s, Section 529 of the Internal Revenue Code was amended to create investment plans that would encourage parents to save for their children's education. As a result almost every state offers "529 plans" that allow parents to deduct contributions from their state income tax. Like 401(k) retirement plans, 529 plans usually invest in a group of mutual funds.
Analyzing data from 2002 to 2006, Bogan found that the greater the tax advantage a state offered, the higher the fees charged by investment managers, even after controlling for such factors as the amount of competition in a state and the administrative structure of the plan. The statistics support an assertion that investment management companies set their fees based on the amount of tax saving offered by the state, she said. And if the state is receiving a share of the fees charged by plan administrators, Bogan added, it has an incentive not to regulate those fees, creating a "moral hazard risk."
Bogan offers the example of parents investing $10,000 a year in a typical plan, starting when a child is born. Tax savings will amount to around $500 a year, depending on the investor's federal tax bracket, and the parents would invest that money back in the plan. But fees – based on the growing value of the fund – will quickly reach $585 a year. "By year four or five…the annual asset-based fees completely cannibalize the state taxable income benefit," Bogan reported. At the end of 18 years, the 529 fund could be worth thousands less than an ordinary mutual fund, depending on the fees charged.
"Households would be well advised to educate themselves about each specific educational savings plan prior to investing," Bogan concluded.


Read more at: http://phys.org/news/2013-08-fees-cancel-tax-advantage-college.html#jCp

Government efforts to make it easier to save for college have unintended consequences, according to a Cornell economist. When you get a tax deduction for contributing to a college savings plan, your savings may be more than consumed by higher fees charged by plan administrators, according to research by Vicki Bogan, associate professor in the Charles H. Dyson School of Applied Economics and Management. Parents may be better off putting their money in ordinary, non-tax-exempt investments, she suggested.

Read more at: http://phys.org/news/2013-08-fees-cancel-tax-advantage-college.html#jCp

Government efforts to make it easier to save for college have unintended consequences, according to a Cornell economist. When you get a tax deduction for contributing to a college savings plan, your savings may be more than consumed by higher fees charged by plan administrators, according to research by Vicki Bogan, associate professor in the Charles H. Dyson School of Applied Economics and Management. Parents may be better off putting their money in ordinary, non-tax-exempt investments, she suggested.

Read more at: http://phys.org/news/2013-08-fees-cancel-tax-advantage-college.html#jCp

Government efforts to make it easier to save for college have unintended consequences, according to a Cornell economist. When you get a tax deduction for contributing to a college savings plan, your savings may be more than consumed by higher fees charged by plan administrators, according to research by Vicki Bogan, associate professor in the Charles H. Dyson School of Applied Economics and Management. Parents may be better off putting their money in ordinary, non-tax-exempt investments, she suggested.

Read more at: http://phys.org/news/2013-08-fees-cancel-tax-advantage-college.html#jCp

Government efforts to make it easier to save for college have unintended consequences, according to a Cornell economist. When you get a tax deduction for contributing to a college savings plan, your savings may be more than consumed by higher fees charged by plan administrators, according to research by Vicki Bogan, associate professor in the Charles H. Dyson School of Applied Economics and Management. Parents may be better off putting their money in ordinary, non-tax-exempt investments, she suggested.

Read more at: http://phys.org/news/2013-08-fees-cancel-tax-advantage-college.html#jCp