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529 Rollover Can Have Tax Impact--For Good or Bad

Some states offer tax incentives for transferring funds to in-state plans, and tax penalties for leaving them.

Adam Zoll, 11/30/2012

Question: I own a 529 college-savings account in another state but would like to take advantage of the tax break I can get on contributions to my home state's plan. If I roll over the funds from my out-of-state plan to an in-state one, is the rollover tax-deductible?

Answer: While saving for a child's future college costs is its own reward, the income tax break offered by many states is an added bonus your clients can take advantage of now. Thirty-four states offer some sort of tax deduction or tax credit for contributions made to a 529 plan, according to data from the College Savings Plans Network (seven states have no state income tax). But in all but five of those 34 states, the tax break is available only for contributions made to an in-state plan (Arizona, Kansas, Maine, Missouri, and Pennsylvania give residents a tax break for contributing to any state's plan).

So what happens if your client decides to switch plans, and is it worth rolling an out-of-state plan to an in-state one just for the tax break?

Do Your Homework Before Deciding
There's no question that the tax break can be a real plus, especially for parents trying to scrape together as much money as possible to save for college. But it shouldn't be the only consideration. The quality of the 529 plan--its investment options and fees, in particular--is important, too. If a client has already opened an out-of-state 529 plan--perhaps because his in-state plan was poorly rated when he did the research years ago--he may think there's no point in revisiting that decision. But 529 plans can change over time, and the in-state plan might have improved.

Morningstar's 529 research team recently unveiled updates to its ratings of dozens of state-sponsored 529 plans. Laura Lutton, Morningstar's head of 529 plan research, discusses this year's ratings and how they were compiled in this video. This year's ratings reflect improvements in some plans, and if your client is an investor with an out-of-state plan that doesn't qualify for a state income tax break, he might want to check out the latest ratings to see how his state's plan compares. You can find details on state plans by visiting Morningstar's 529 Plan Center and clicking on the interactive map. There you'll find information on plan options as well as details on available tax breaks. Morningstar.com Premium members also can read plan analyses by Morningstar's team of experts.

A Potential Tax Break on Inbound Funds
Once you've determined whether the state offers a quality plan, check with the plan to see if there are tax advantages to rolling funds over from your out-of-state 529 account(s). Many states do not provide a tax break for inbound 529 rollovers, but some do. States that do may limit deductions to just the contribution portion of the out-of-state 529 or let you deduct the entire amount including earnings. For example, a taxpayer in Illinois, which has a 5% income tax rate, who rolls $10,000 worth of contributions from an out-of-state 529 to an in-state plan, stands to save $500 in state taxes from the rollover. (For taxpayers who deduct state taxes on their federal returns, this could result in slightly higher federal taxes paid.) That's a nice bonus that can be used to contribute even more to the college account if he or she so chooses.

You can roll 529 funds into another state's plan once every 12 months per beneficiary, and fund transfers may be made directly from plan to plan or indirectly, with the old plan sending the money to the investor and the investor depositing it in the new 529 account within 60 days (to avoid paying taxes on the distribution). There might be fees associated with transferring 529 funds between state plans, so make sure to ask about these before sending in the rollover paperwork.

Outbound Rolling Could Cost You
So what happens if your research finds that the in-state 529 plan where your client already has money invested is a lousy one? You may well be tempted to roll those funds into a better plan in a different state, but be careful. Many states have recapture provisions that allow them to reclaim any tax deductions you've taken for in-state 529 contributions. Many times this information will be posted on the plan's website, but if you're not sure about your state's policy, contact the plan to find out. Finding a quality 529 plan is important, but if rolling funds out of state will cost your client dearly come tax time, you should think twice, especially if the client will only need the 529 for a few more years.

Adam Zoll is an assistant site editor with Morningstar.com


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