Some states are unfairly discriminating against investors choosing to invest in 529 college savings plans outside of the state in which they reside, creating mounting problems for the industry, according to a recent white paper by the College Savings Foundation (CSF).

The Washington-based lobby group is calling for all states to come into compliance with federal laws as inequitable income tax policies by some have impeded the growth of 529 college savings plans and created an uneven playing field.

The industry has run into problems because some states essentially require, through their tax laws, that investors wishing to enjoy some of the main benefits of the plan invest in their home state's 529 offering.

Federal law does not require investors to enroll in their local plan in order to enjoy the tax-savings benefit. Under federal law, individuals can make after-tax contributions to a plan and then have the earnings grow tax-free. They can withdraw funds from the account for qualified secondary education purposes and not have to pay taxes on the income generated from their investments.

However, states are the entities entrusted with creating their own 529 plans, and some are drawing a distinction between in-state plans and out-of-state plans. States with no income tax were already in compliance with federal law and all states with income tax have fixed their rules to mirror federal regulations in regard to withdrawals from their own state's 529 plan. However, Alabama, Illinois, Mississippi and Pennsylvania have failed to do the same for withdrawals by state residents invested in out-of-state plans, leaving those investors to face income taxes on their withdrawals.

Aside from unfairly penalizing those not investing in home-state plans, two other forms of tax inequity exist in the treatment of contributions and in the treatment of rollovers. Some states have provided a tax incentive in the form of a deduction or credit from state income tax for contributions into in-state plans. However, this perk is not afforded to those investing with plans based in other states. Furthermore, some states have hit investors with a tax on their earnings when they rollover their funds to a plan from another state. Still others have been subject to a recapture tax during a rollover if they were earlier able to take advantage of state income tax deductions on contributions into in-state plans.

"When state sponsorship is combined with preferential state tax treatment for the in-state plan, an inflexible and noncompetitive environment is created that adversely impacts the state's resident," the College Savings Foundation white paper states. The fallout from this behavior by some rogue states is that competition and innovation is hampered, while investment choices for families are limited and investment portability, or the ability to move between plans, is hindered. Families located in different geographic regions are penalized and these actions further complicate the industry, which already faces a fair amount of complexity due to the state-level regulation of the plans.

One-Team Town

One of the biggest drawbacks from this type of inequitable tax treatment is that competition and innovation are deterred. As it now stands, many 529 plans face almost no competition from out-of-state plans, offering plan providers little, if any, incentive to improve quality or to provide maximum value to plan participants. Of particular concern to CSF is the impact this could have on investment performance and customer service.

In addition to a potential dropoff in service, this environment has created a situation where investors have little choice as to the financial institution they choose to invest with and the strategy they employ when saving for college. Those that have been dissatisfied with the performance of the investments in their plan have very limited options and may be in the undesirable position of having to choose between staying in an unwanted plan or experiencing a penalty for ditching the investment for a better 529 plan elsewhere.

Families, both immediate and extended, that are geographically separated may incur penalties when trying to contribute to a plan as well. Federal law factors in the reality that many families are often spread out over several states, but many on the state level have yet to adjust their regulations to account for such circumstances. "Clearly, this is not a saver-friendly or family-friendly state of affairs," according to CSF.


The way several states are enacting their tax policies for college savings plans is complicating the investment process for many savers. CSF said many families simply choose an in-state plan because they fail to look beyond the significant tax incentives of an in-state plan. However, this can often lead to investors failing to adequately examine many of the underlying investment strategies.

For others, comprehension of all the differing tax benefits and fallouts may simply be too much information and intimidate some potential investors into sitting on their hands and put off saving. Families considering relocation may also abstain from opening an account due to penalties they may be hit with upon moving. "The inequitable and differing state income tax regimes inject so much complexity into the system that simple comparison of state plans and investment options becomes almost impossible."

The solution to all these problems, CSF says, is to have states bring their laws into conformity with federal regulations, just as was done for Roth IRAs. The group calls for equal treatment of all withdrawals from 529 plans as well as consistent treatment for contributions from rollovers. States should also extend the benefits they currently provide to in-state plan investors to all investors, including those in out-of-state plans. Lastly, CSF urges states to repeal all barriers to moving from one plan to another.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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