For parents sending high-school seniors to college in the fall, here’s a surprising financial tip: Contributing to a 529 plan even just months before the first tuition payment is due will qualify the account owner for a tax benefit in many states.
Ms. Rosenthal on the benefits of contributing to a 529 college savings plan even if your child is heading to school this fall with Mathew Passy.
Adding to a 529 can lower the state taxes you oweâunder certain conditionsâin 34 states and the District of Columbia, according to a tally by college-planning website FinAid.org.
Make sure your plan doesn’t require a minimum holding period before withdrawals to get the tax break. While most states don’t require such a holding period, a handful doâlike Michigan. There, the deduction of up to $5,000 per year for individuals (and $10,000 for a married couple filing jointly) is determined by subtracting distributions from the total contributions to the plan within the same calendar year. This implies you need to take the distribution in a subsequent tax year to get the deduction.
Joe Hurley, founder of the website savingforcollege.com, says he wouldn’t be surprised if more states add holding-period requirements because of the revenue losses states have suffered in recent years. It’s possible, he says, that most states either haven’t seen this as a big issue or that they remain unaware of it.
Investors can open any state-sponsored 529, though most states offer tax incentives only for residents who enroll in a plan in their home state. “Always start with your own state plan” when shopping for 529s, says Stuart Ritter, a vice president and certified financial planner at T. Rowe Price Group.
“But don’t stop there,” particularly if you are investing for the long term, he says. Some state plans have high fees, limited investment options or poor records that should be weighed against tax benefits, Mr. Ritter says. Morningstar.com and savingforcollege.com offer ratings for 529s based on such criteria.
Note that some statesâincluding Pennsylvania, Arizona, Maine, Missouri and Kansasâoffer a tax benefit for contributions to out-of-state plans. No break is available in states without income tax.
If a student will apply for need-based aid, consider federal aid rules before setting up a 529 as well. The rules determine what each student can afford to pay based on his or her income and assets and on the income and assets of the parents if the student is a dependent.
When a 529 is owned by a grandparent, the assets aren’t counted, but payments from the account on behalf of the student count as income for the student. In light of this, Keith Bernhardt, vice president of Fidelity Investments’ college-planning group, says it may be better for grandparents to contribute to a 529 owned by the parents. In most states, grandparents residing in the state where the plan is sponsored will get the deduction, no matter who owns the account or where he lives, says Mr. Hurley.
Another tip: If the 529 contribution will be spent in a few months, the investment option should be conservative. College-savings professionals recommend money-market and short-term-bond funds.
Ms. Rosenthal is an editor for WSJ.com. Email her at email@example.com.
A version of this article appeared April 7, 2013, on page R1 in the U.S. edition of The Wall Street Journal, with the headline: Student Starting College This Year? A 529 Savings Plan Might Still Help..