529 Tax Credit or Deduction: Which Is More Valuable? / The answer is more complicated than you might think.

Adam Zoll for Morningstar writes:  Question: My state offers a tax deduction for 529 contributions made to our state's plan, but my sister's state offers a tax credit for 529 contributions. Which is better and why?

Answer: Typically an income tax credit of any type is better--meaning that it saves the taxpayer more money--than an income tax deduction. That's because a tax credit is an off-the-top reduction in the amount of taxes paid whereas a tax deduction is a reduction in the amount of income subject to taxes.
For example, someone who receives a $500 tax credit pays $500 less in taxes than they otherwise would have, whereas someone who gets a $500 tax deduction merely avoids paying taxes on that amount. So if the person receiving the deduction lives in a state with a 5% income tax rate, he saves an amount equal to 5% of $500, or $25, in taxes (assuming no other state tax breaks are affected by taking the deduction). That's obviously a far cry from the $500 he or she would save with a tax credit. Thus, the short answer is that a tax credit is generally more valuable.

However, given the way tax breaks for 529 contributions are structured by the states, not to mention the broad range of state income tax rates, merely looking at whether a state offers a credit or a deduction doesn't tell the whole story. For one thing, states typically impose limits on the amount of 529 contributions subject to a tax credit or deduction. The limit is often imposed on a per-taxpayer basis, but some states impose limits per 529 beneficiary. (Some states also allow deductions or credits for funds transferred from out-of-state 529 plans.) Residents of states with generous deduction limits can pocket significant tax savings by making very large contributions to 529s, but it's a different story for states with tax credits. 

Giving Tax Credits Where Credits Are Due
Only Indiana, Vermont, and Utah currently offer tax credits for 529 contributions. Indiana offers a 20% tax credit per year on the first $5,000 contributed to its plans, for a maximum credit of $1,000 per account owner. Vermont's tax credit covers 10% of contributions up to $2,500 for a maximum credit of $250 per beneficiary for single filers or $500 per beneficiary for taxpayers filing jointly. Utah's tax credit covers 5% of contributions up to $1,840, or $92 per beneficiary for single filers or $184 per beneficiary for taxpayers filing jointly.

Eligible contributions in the three states that offer credits are capped at fairly low levels, so generally speaking, tax credits are most beneficial to people who aren't making significant 529 contributions. Although these tax credits amount to a nice bonus for families saving for college, residents of some states that offer tax deductions on 529 contributions can potentially save even more because their states have higher limits on the amounts subject to tax breaks.

For example, Colorado essentially places no limit on the amount of contributions a 529 account owner can deduct in a year as long as it's not more than the account owner's taxable income. (However, the annual federal gift tax exclusion of $14,000 may apply, and the state does limit the amount of contributions that can be made to a single beneficiary's 529 account to $350,000). Given the state's 4.63% income tax rate, a 529 account holder who contributes $50,000 in a given year to the state's plan might receive a $2,315 break on state income taxes. 


Another interesting example is Pennsylvania, which is one of a handful of states that allows residents to deduct contributions to any 529 plan, even out-of-state plans. (It's a good thing, too, given that their state's plan receives only a Neutral rating from Morningstar's 529 analyst team because of its high fees.) The state's relatively generous 529 deduction limit of $14,000 for single taxpayers or $28,000 for couples filing jointly, and the state's flat income tax rate of 3.07%, means that a couple that contributes the full $28,000 to any 529 plan could come out $860 ahead on their taxes.
 
Income Tax Rates Also Come Into Play
Tax deductions for 529 contributions also tend to be slightly more valuable for high earners in states with graduated income tax structures. For example, New York allows couples filing jointly to deduct up to $10,000 in contributions to its state 529 plans. A couple making $100,000 a year, and thus falling in the 6.65% tax bracket, would save $665 in taxes if they hit the full deduction amount. But for a couple paying the top rate of 8.82% (starting at more than $2 million in income) the tax savings on the same size contribution would amount to $882.

Not all states offer tax incentives for families saving for college. In fact, more than a dozen don't. However, for residents of those that do, tax savings can be among the biggest advantages of using a 529 as a way to save to send a family member to college.