7 Reasons You Might Not Want To Contribute To Your State’s 529 Plan

In case you didn’t notice, today, 5/29, is 529 Day. Many states are offering contests and other incentives for their 529 plans. If your state doesn’t have a promotion or if you miss it, your state may still provide a state tax break for contributing to their plan anytime. Should you? Let’s take a look at some reasons why you might not:

1) You don’t have enough emergency savings.

Having some cash set aside for emergencies should be your first priority. Otherwise, you may end up taking money out of your 529 plan and paying a 10% penalty on the earnings the next time Murphy’s Law kicks in. If the investments in the 529 plan are down when you need them, you may end up taking a loss or not have enough money to cover the emergency.. Make sure you have enough savings to cover at least 3-6 months of necessary expenses before locking money up in a long-term vehicle like a 529 plan.

2) You haven’t maxed the match in your employer’s retirement account.

You want to contribute at least enough to your employer’s retirement plan to qualify for any matching funds you can receive. If not, you’re leaving free money on the table. No 529 plan can compete with that.

3) You have high-interest debt.

If you have credit card or other debt with an interest rate of more than 4-6%, you’ll probably be better off paying it down before you start investing. Even with the 529 growing tax-free for education expenses, your 529 investments would have to earn as much as the interest on your debt just to break even and there’s no guarantee that will happen.

4) You’re saving for a home purchase.

You’ll have to pay a penalty on earnings if you want to withdraw the money from your 529 for a home purchase. If you focus instead on saving for a 20% down payment, you can take the money you would have spent on mortgage insurance (PMI) and contribute that to a 529 plan. In the meantime, you’ll be building equity instead of paying increasing rents.

5) You’re not saving enough for retirement.

Aside from maxing the match in your employer’s retirement plan, run a retirement calculator like this and make sure you’re on track before saving for college. After all, there’s no financial aid for retirement. Keep in mind that if your retirement plan ends up ahead of schedule, you can always dip into retirement funds to help pay for education expenses.

6) You won’t get any special benefits from your state’s plan.

All 529 plans are equally federal tax-free for qualified education expenses, but not all state plans are equal when it comes to benefits for residents. Some states, like my home state of New York, offer special tax breaks or even matching funds for contributing to your state’s plan but many do not. After all, there are states like Texas that don’t even have a state income tax. Others, like my former home state of California, have a state income tax but offer no tax breaks for 529 contributions.

On the opposite end are states like Pennsylvania that give you a state income tax break no matter which state’s 529 plan you contribute to. Even if your state offers a benefit, make sure that you qualify for it since there might be income restrictions. You can also contribute just enough to maximize the benefit in your state’s plan and contribute the rest to another state’s plan.

7) Your state plan doesn’t have good investment options.

Don’t let the tax tail wag the dog. Just because your state offers a special tax benefit for contributing to their plan, doesn’t mean you should invest in it if the plan’s investment options aren’t very good. That’s because the benefit of a small tax deduction can be easily outweighed by poor investment performance. (When you do the math, most of these tax breaks are pretty small, especially when you factor in the loss of the state tax deduction from your federal income taxes.)

For example, a New York couple earning $150k contributing $10k to the New York state 529 plan would save about $585 in state income taxes. But if that $10k earned 7% rather than 6% over 18 years, they would end up with over $5k more. That $585 doesn’t look so great now, does it?

So how do you know if your state plan is worth the tax break? Financial expert Clark Howard has put together a nifty 529 guide that includes an honor roll of plans that are worth investing in if you live in that state. If you don’t see your state’s plan there or don’t get any special state tax benefits, check out the plans in his “Dean’s List with High Honors” for the very best plans in the country.

While your state’s 529 Day promotion may be tempting, there could be better options for you and your family. As always, it’s best to understand the pros and cons of each. But if your state does offer you the best option, today might be the best day to go for it.