Some Out-of-State 529 Plans Face Taxes

Parents confounded by the over abundance of ways to save for college may face a new hurdle as out-of-state College 529 Plans become subject to income taxes in some states. The 529 funds, often exempt from state taxes, have become a popular way to save for college since up to $250,000 can be put away for education-related expenses, with the earnings exempt from federal taxes.

A new trend shows that more states are levying income taxes on those who earn dividends on plans outside of their home states. With more than 40 of the 529 plans available nationwide, chances are investors shopping around could have found a better deal in a state other than their own. As state fiscal crises worsen, the sacred 529s are no longer exempt from taxation in some instances.

Joseph Hurley of SavingforCollege.com sees the taxes as penalizing parents who choose a higher performing plan in another state.

Tennessee let its investors know on April 1 that residents who earned interest and dividends on out-of-state 529 funds will be subjected to a 6 percent state income tax on the earnings and may potentially be taxed under the state’s gift tax as well. Tennessee, which has no state income tax, exempts taxation of interest and dividends residents earn through its own 529, but state law does not exempt what is earned in 529s offered by other states. However, since the state exempts up to $2,500 annually in interest and dividends for a married couple, only the wealthiest 529 investors would be affected by the out-of-state tax.

"I'll be steering clients to the Tennessee plan," says Bryan Howard, an attorney with Waller Lansden in Nashville. However small investors still need to be keeping good records of their earnings since most 529 plans don’t furnish their customers with regular statements, which could cause a problem at tax time.

In Maine, the 2003 budget calls for a 2 to 8.5 percent state income tax on any withdrawals from out-of-state 529s, but the revenue-generating requirement ends in three years, so investors would be wise to leave their money where it is until then.

New York investors this year will be penalized when they switch from New York’s 529 plan to an out-of-state plan, with residents required to pay state and capital gains taxes on their earnings as well as repaying previous state tax deductions.

Illinois instilled a 3 percent income tax on residents who withdrew funds from their out-of-state 529s.

Not all the news is bad. New Hampshire residents, who pay income tax on all income and dividends, may soon be free from paying any taxes on 529 gains if a law pending in the state legislature is successful.

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