A lot of financial planning and advice can start to seem pretty routine over time: maximize contributions to tax-advantaged savings vehicles, invest in a basket of diversified, low-cost assets, and periodically (but not too often!) rebalance.
I’m always interested in identifying places where that kind of routine advice breaks down, and the other day, I got to thinking: many states allow certain state income tax deductions for 529 college savings plan contributions, but only when contributions are made to plans sponsored by the state where you take the deduction. Since the fees and expenses of 529 plans can vary considerably, I wondered if there are states where the costs of using the in-state plan instead of a cheaper alternative exceed the value of the state income tax benefits.
Deductions, credits, and rates
To investigate this question, I had to isolate several different dimensions:
- Does a state offer a tax deduction or a tax credit? Four of the 35 states offering state income tax benefits offer a tax credit for contributions: Indiana, Utah, Vermont, and Minnesota. The rest allow for contributions to be deducted from state income instead.
- What are the limits on the state tax benefit? Colorado, New Mexico, and West Virginia allow taxpayers to completely eliminate their state income tax liability through 529 contributions. The remaining states place a cap on the amount that can be deducted.
- What are the state income tax rates? A deduction is more valuable in a state with high income tax rates than in a state with low ones. I used the lowest and highest non-zero income tax brackets for each state to identify the range of potential values of a state income tax deduction.
- Does the state only allow deductions for in-state plan contributions? Seven states allow income tax deductions for contributions to out-of-state plans: Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania.
- And finally, what is the cheapest appropriate investment option in each plan? For this comparison, I selected the lowest-cost broad US equity option in each plan, which was typically a US large cap, S&P 500, or total stock market fund.
Whether or not you’re interested in my particular research question, you might find the resulting spreadsheet useful on its own, and you can find it here.
Reminder: state tax benefits are worth less to federal itemizers
Before I go on, I want to remind folks who choose to itemize their federal deductions that state tax credits and deductions are worth less to them, since reducing their state income taxes mechanically reduces their state and local tax deduction and increases their federal income taxes.
Take, for example, a South Carolina resident in the 7% state income tax bracket who owed exactly $10,000 in state income tax and no other state or local taxes in 2018. If they chose to itemize their federal deductions, for example due to a large deductible charitable contribution in 2018, then the $10,000 is also deductible from their taxable federal income.
Since South Carolina allows 529 plan contributions to be deducted against an unlimited amount of state income, the taxpayer can save $10,000 in state taxes by contributing a bit over $100,000 to a South Carolina 529 plan. But this will reduce their state and local tax deduction by the same $10,000, increasing their federal income tax liability by up to $3,700.
Such corner cases cover only a tiny number of taxpayers, but it’s something to be aware of in case you happen to be one of them.
Taking a look at the spreadsheet, the first thing that should jump out at you is that these plans are all over the place. Investment costs start as low as 0.035% (for Rhode Island residents to invest the “U.S. Stock Portfolio”), and run as high as 0.65% (for Mississippi’s “U.S. Large-Cap Stock Index Fund Option”). Note that these are the lowest-cost equity investment options in each plan — fees for other investment options can run much, much higher than this.
The second noteworthy observation is that some of these supposed tax benefits are trifling. Rhode Island will give a married couple with over $145,600 in taxable income a deduction worth a little less than $60 for contributing $1,000 to their in-state plan. For a low-income single filer, the deduction is worth less than $20. What exactly is the point supposed to be?
At the high end, the state tax benefits can be considerable. In addition to the states with unlimited deductions I mentioned above, high-income married taxpayers in Alabama, Connecticut, Idaho, Illinois, Indiana, Iowa, Mississippi, Nebraska, New York, Oklahoma, and Vermont can all save $500 or more by making contributions to in-state plans. Single filers have it tougher, but can still save more $500 or more in Mississippi and Oklahoma state income taxes.
If you’re just maximizing state tax benefits, don’t diversify!
This is a corollary of what I wrote above: since I chose the lowest-cost equity option in each plan as my benchmark, if you don’t use that option, you will likely end up paying more in fees. For your primary 529 account, you should have an appropriately diversified portfolio that scales back risk as your beneficiary nears enrollment. For your tax-scam 529 account, just put however much money you need to maximize the state tax benefits into the cheapest equity fund and forget about it.
If you’re lucky enough that your primary account is also your tax-scam account (Utah, I’m looking at you), then feel free to disregard this warning.
It’s almost always worthwhile for non-zero rate payers to maximize their in-state tax benefits
Remember the original question we started with: are there states where the cheapest investment option is so expensive it outweighs the state income tax benefits?
And the answer, to a first approximation, is no. What I was looking for is a state with a very low income tax benefit, like Rhode Island, and very high investment costs, like Mississippi or North Dakota. But those states mostly don’t exist: for taxpayers with any state income tax liability at all, making the maximum deductible contribution to the cheapest in-state 529 investment option will almost always create a greater reduction in state income taxes than the increased expenses compared to the cheapest 529 plans available.
There are two exceptions: in states with fixed account maintenance fees in addition to investment costs, low balances may incur much higher proportional expenses, in the same way that fixed fees on origination can increase a loan’s APR far above the stated interest rate.
The second exception is folks without state income tax liability. If you aren’t taking advantage of your state’s tax benefits for in-state plan contributions, don’t feel compelled to make in-state plan contributions: find the cheapest plan with the best investment options and use that instead.