Paying for College this Year? Lower Your State Income Taxes with this Little Known 529 Tactic

Let’s say you have a kid who will likely attend college in 10 or more years, and you have enough to start saving money toward her education.

I call this an “ideal” situation because, personally, when my kids were that age, my income wasn’t high enough to set aside any realistic amounts after covering expenses.

Back to your situation, though, you start investing through a so-called 529 plan. Such contributions don’t reduce your federal income tax. However, like contributions to a Roth IRA, withdrawals are tax-free if you use plan money as intended. 

In this case, rather than for retirement, it’s to cover educational expenses. These include, e.g., tuition and fees; books, supplies, and equipment needed for enrollment or attendance; room and board (if attending at least half-time); up to $10k paid toward qualified student loans; etc.

Further, in a majority of states, you’ll qualify for a state income tax benefit.

Most states let you deduct all or some of your 529 plan contributions from state income taxes. Seven states will even afford you that benefit for any other state’s 529 plans: Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, and Pennsylvania.

Indiana, Utah, and Vermont offer a tax credit, and Minnesota offers either a deduction or, usually the better deal, a non-refundable tax credit.

Only five states have state income tax and don’t offer a deduction for 529 plan contributions: California, Hawaii, Kentucky, Maine, and North Carolina.

Nine other states have no personal income taxes or have them but not on wages: Alaska, Florida, Nevada, New Hampshire (no tax on wages), South Dakota, Tennessee, Washington, and Wyoming.

Save Thousands of Dollars in Taxes Without Investing in a 529 Plan Ahead of Time

One unexpected wrinkle in how Maryland treats 529 plans allowed us to save thousands of dollars in income taxes.

The surprising detail is that there’s no requirement as to how long 529 contributions have to stay in the plan. Here’s what that means…

Your kid is already in college, and you have no 529 plan.

You open a 529 plan, and instead of paying tuition directly, you move the money from your checking account to the 529 plan, then pay tuition, and then take the money back out of the 529 plan. This totally legal financial shell game lets you claim the 529 contributions in your state income tax return, reducing your state income tax.

In Maryland, a couple can claim a deduction for up to $5000 per year contributed to a 529 plan. With a state income tax rate of (more or less) 8 percent, that’s worth $400 a year. Further, you can even bunch up five years’ worth of contributions into a single year without paying gift taxes.

Finally, if your 529 plan withdrawals are higher than the $5000 annual limit, you can carry them over for up to 10 years. This last means that if your kid starts college in September 2023 and graduates in June 2027, you can claim the deductions for the five calendar years in which she attends school (2023, 2024, 2025, 2026, and 2027), plus continue claiming carryover benefits for the following 10 years (2028-2037).

All told, that’s 15 years’ worth of a $400 annual tax reduction for a total of $6000 tax reduction.

Have more than one kid?

A friend of ours has four kids, so I advised him to do the above. I’m not sure if he ended up following my advice, but if he did, it would save him $24,000!

The Bottom Line

If you have kids who will (or already) attend college, and you plan to (or already) help them cover the cost, using a 529 plan to save for that expense is a great way to save a nice chunk of change on your taxes.

If your state isn’t in the handful that don’t have a state income tax or in the other handful that do but offers no 529-plan tax benefit, you can save thousands more, even if you can’t set aside any money for education ahead of time.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.