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Many states give the account owner a full or partial state income tax deductions for their contributions to the state's section 529 plans. So far a total of 34 states and the District of Columbia offer such a deduction.

California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Hampshire, New Jersey and Tennessee currently have state income taxes but do not offer a state income tax deduction or tax credit for contributions to the state's 529 college savings plan. Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming do not have state income taxes.

Contributions to other states' section 529 plans are generally not deductible in your home state. See the discussion of tax parity below.

Contributions in some states may be tax deductible on even a short-term basis, leading to a state income tax loophole.

See also Fastweb's article Free Money for College Savings for a list of grant programs that provide matching contributions to the college savings plans of low and moderate income families and grant programs that provide one-time college savings plan grants to newborn children.

Deductibility of State 529 Plan Contributions

The following table shows the limits, if any, on state income tax deductions for section 529 plan contributions. If there is a limit on the amount of the deduction, many states allow carry forward of excess contributions to future income tax returns.

State	529 Deduction
Alabama	$5,000 per parent ($10,000 joint)
Alaska	No state income tax
Arizona	$750 single or head of household/$1,500 joint (any state plan)
Arkansas	$5,000 per parent ($10,000 joint)
California	--
Colorado	Full amount of contribution
Connecticut	$5,000 per parent ($10,000 joint), 5 year carryforward on excess contributions
Delaware	--
Florida	No state income tax
Georgia	$2,000 per beneficiary
Hawaii	--
Idaho	$4,000 single/$8,000 joint
Illinois	$10,000 single/$20,000 joint per beneficiary (25% tax credit for employers for matching contributions up to $500 per employee)
Indiana	20% tax credit on contributions up to $5,000 ($1,000 maximum credit)
Iowa	$2,811 single/$5,622 joint per account
Kansas	$3,000 single/$6,000 joint per beneficiary (any state plan), above the line exclusion from income
Kentucky	--
Louisiana	$2,400 single/$4,800 joint per beneficiary, above the line exclusion from income, unlimited carryforward of unused deduction into subsequent years
Maine	$250 per beneficiary starting 2007 (any state plan), above the line exclusion from income, phaseout at $100,000 single/$200,000 joint
Maryland	$2,500 per account per beneficiary, 10 year carryforward
Massachusetts	--
Michigan	$5,000 single/$10,000 joint, above the line exclusion from income
Minnesota	--
Mississippi	$10,000 single/$20,000 joint, above the line exclusion from income
Missouri	$8,000 single/$16,000 joint, above the line exclusion from income
Montana	$3,000 single/$6,000 joint, above the line exclusion from income
Nebraska	$5,000 per tax return ($2,500 if filing separate), above the line exclusion from income
Nevada	No state income tax
New Hampshire	--
New Jersey	--
New Mexico	Full amount of contribution, above the line exclusion from income
New York	$5,000 single/$10,000 joint, above the line exclusion from income
North Carolina	$2,500 single/$5,000 joint, above the line exclusion from income
North Dakota	$5,000 single/$10,000 joint
Ohio	$2,000 per beneficiary per contributor or married couple, above the line exclusion from income, unlimited carryforward of excess contributions
Oklahoma	$10,000 single/$20,000 joint per beneficiary, above the line exclusion from income, five-year carryforward of excess contributions
Oregon	$2,090 single/$4,180 joint (i.e., $2,090 per contributor) per year, above the line exclusion from income, four-year carryforward of excess contributions
Pennsylvania	$13,000 per contributor per beneficiary (any state plan)
Rhode Island	$500 single/$1,000 joint, above the line exclusion from income, unlimited carryforward of excess contributions
South Carolina	Full amount of contribution, above the line exclusion from income
South Dakota	No state income tax
Tennessee	--
Texas	No state income tax
Utah	5% tax credit on contributions of up to $1,740 single/$3,480 joint per beneficiary (credit of $87 single/$174 joint)
Vermont	10% tax credit on up to $2,500 in contributions per beneficiary (up to $250 tax credit per taxpayer per beneficiary)
Virginia	$4,000 per account per year (no limit age 70 and older), above the line exclusion from income, unlimited carryforward of excess contributions
Washington, DC	$4,000 single/$8,000 joint, above the line exclusion from income
Washington	No state income tax
West Virginia	Full amount of contribution up to extent of income, above the line exclusion from income, five-year carryforward of excess contributions
Wisconsin	$3,000 per dependent beneficiary, self or grandchild, above the line exclusion from income
Wyoming	No state income tax

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Tax Parity

Only Pennsylvania, Arizona, Maine, Missouri and Kansas provide for state tax parity, where contributions to any state plan are eligible for the state's income tax deduction. An Illinois class action lawsuit, Maryam Ahmad v. Illinois Department of Revenue (filed May 15, 2007), challenges the constitutionality of the Illinois tax break which does not provide for tax parity. A related case concerning municipal bonds, Davis v. Department of Revenue of Kentucky, ruled that state statutes that do not provide for tax parity (i.e., that limit state income tax deductions to in-state bonds) are unconstitutional in 2006 by the Kentucky appellate court (and was let stand by the Kentucky Supreme Court). At issue was the commerce clause of the US Constitution, which reserves to Congress the right to regulate interstate commerce. However, the US Supreme Court reversed the decision and remanded the case to the lower court on May 19, 2008, finding that "Kentucky's differential tax scheme does not offend the Commerce Clause" (No. 06-666, argued November 5, 2007). The ruling is not surprising because the US Supreme Court previously declined to hear an appeal of an Ohio case, Shaper v. Tracy, which affirmed the state's right to discriminate against other states' municipal bonds. The US Supreme Court ruling might or might not affect the Illinois lawsuit, in part because there are four states that are providing for tax parity, in part because the single-state plan vs national plan argument is weaker with regard to 529 plans, and in part because 529 college savings plans are established to encourage families to save for college and not as a way of funding public projects.

State Income Tax Loophole

While 529 college savings plans are intended to encourage long-term savings, the ability to deduct current contributions creates a loophole that encourages short-term savings. In some states a parent could contribute the current year's college costs to the state's 529 college savings plan in order to qualify for the income tax deduction, and then withdraw the funds a day later to pay the bursar's bill. So long as the distribution is taken to pay for qualified higher education expenses, the parent qualifies for the state income tax deduction. Most states do not have a waiting period on withdrawals. Some states have a one-year waiting period on withdrawals.

The one-year waiting period is usually implemented by basing the tax deduction on the net contributions within a tax year, after subtracting any distributions. For example, Michigan allows a net contribution deduction based on the total contributions to a 529 plan account less any distributions from that account within the same tax year. Rollovers from another state plan do not qualify for the state income tax deduction. (Other states, like Oklahoma and Vermont, do allow transfers from another 529 college savings plan to qualify for the deduction or credit.) So you will need to take the distribution in a subsequent tax year in order to benefit from the state income tax deduction. (You can, however, make a contribution to the 529 plan account of a younger sibling in the same tax year you take a distribution from the 529 plan account of an older child. It is only when the contribution and distribution are from and to the same 529 plan account that the deduction is based on the difference.) The tax deduction will also be recaptured if the taxpayer takes a nonqualified distribution from the state 529 college savings plan. In some states the tax deduction will also be recaptured if the taxpayer rolls over the funds into a different state's college savings plan.

The financial benefit of the state income tax deduction (or credit) depends on your marginal tax rate and the contribution limits. The maximum financial benefit from a state income tax deduction is the same as the top income tax bracket in the state. This varies from 3.0% to 9.9%, depending on the state. (States with higher tax rates tend to have lower limits on the total amount of the deduction.) However, Vermont has a 10% tax credit and Indiana a 20% tax credit. The Indiana tax credit is far more valuable than the state income tax deductions.

Several states, including Arkansas, Colorado and Michigan, also offer matching grant programs to encourage low income families to save for college. For example, the Arkansas Aspring Scholars Program matches 200% of contributions for family incomes less than or equal to $30,000 and 100% of contributions for family incomes of $30,000 to $60,000 with a five year limit.

Strategies for Using State Income Tax Deductions

If all else is equal, it is better to focus on your state's 529 college savings plan if it offers a full or partial deduction for contributions on your state income tax return. However, if another state's plan has lower fees, it may be better to focus on the lowest fee plan in certain circumstances. (Plans run by Vanguard, TIAA-CREF and Fidelity tend to have the lowest fees.)

• Focus on Fees for Long-Term Investments. If you have a longer-term investing horizon, the plan with the lower fees is usually better despite not having a state income tax deduction. The value of the state income tax deduction is effectively amortized over the term of the investment, yielding a very small financial benefit per year.

  For example, consider a lump sum investment of $10,000 in two plans with a 5% annual return on investment, one with annual fees of 1.1% and a state income tax deduction that is the equivalent of a 4% discount and one with annual fees of 0.8% and no state income tax deduction. In the state plan with a state income tax deduction you invest $10,416.67 so that your net cash outlay is $10,000 after the state income tax deduction. After 17 years your investment will be worth $19,961.50. But your investment in the 529 plan with the lower fees would be $20,125.71.

  If T is the marginal tax rate, Y the investment term in years, D the difference in fees, R the investment return and F the higher fee, a lump sum investment in the state plan with the lower fees will yield a greater return on investment when D > (Power(1/(1-T), 1/Y) - 1) * (1 + R - F). Since R - F > 0, the simpler heuristic D > [Power(1/(1-T), 1/Y) - 1] is true. Although this heuristic isn't as tight, it still works well in practice. In this particular example a difference in fees of at least 0.25% is superior to the state income tax deduction worth 4%.

• Focus on the State Income Tax Deduction When College Is Only A Few Years Away. If you have a shorter investment horizon, the state income tax deduction might be worth more than the lower fees since the amortization is over a shorter time period. For example, if college is a year away a 4% one-time discount on the contributions will clearly outweigh a single year's fees that are 0.30% higher.

• Optimize with a Hybrid Approach. The impact of a state income tax deduction the year the child is born is amortized over 17 years and so has a minimal impact compared with the fees. This leads to a preference for 529 plans with the lowest fees. On the other hand, the impact of a state income tax deduction is amortized over a shorter period of time when college is just a few years away. This leads to a preference for your state's 529 plan if they offer a good state income tax deduction even if the fees are somewhat higher. Since you can open 529 plans in multiple states, an optimal strategy might involve starting off with all contributions in a 529 plan with the lowest fees when the child is young, and switching all new contributions to your own state's 529 plan (if they offer a state income tax deduction) when the child enters high school.