529 Plan Tax Benefits Are Subject To Future Change

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529During the most recent State of the Union address, the President’s proposal includes removing one of the current key tax advantages for 529 college savings plans. It is important to remember that this is only a proposal and is unlikely to pass a Congress with a Republican-majority. But it does serve as a reminder that the features of all tax-advantaged accounts are subject to future change.

Section 529 plans currently offer excellent tax advantages for college savings. You put in after-tax money, and that money is allows to grow on a tax-deferred basis, and as long as future withdrawals are used for qualified education expenses, there are no taxes on the back-end either.

The proposed changes are to now tax withdrawals (capital gains only) as ordinary income, leaving only the ongoing tax-deferral aspect. In exchange, the annual limits of educational tax credits would be increased along with other changes.

A quick history lesson on 529 plans. Per Wikipedia, Section 529 plans have only been around since 1996, and started out with withdrawals taxed as ordinary income. Tax-free withdrawals for qualified educational expenses were only added in 2001 on a temporary basis (scheduled to expire in 2010) but then in 2006 they were made “permanent” (not scheduled to expire). That is why this is referred to as a “roll back”.

The concern now is that the tax advantages only benefit a small group of people (read: rich folks). From CNN Money:

An analysis by the Government Accountability Office found that in 2010 less than 3% of families saved in a 529 plan. The GAO estimated that families who saved in 529s had a “median financial asset value” that was 25 times that of families without a 529.

But the College Savings Foundation, citing an investment industry analysis, noted that in 2014, over 70% of 529 plans were owned by households with income below $150,000.

The lesson here is that not all tax benefits are considered “sacred”, especially if they can be spun as rich vs. poor. For example, in my opinion the ability to inherit IRAs (“Stretch IRAs”) in order to give your children decades more of tax-free growth probably won’t last forever. But the idea of taxing Roth IRA withdrawals would be very hard sell as it would broadly affect people across various income levels.

I don’t think I would have minded if this was for a newly-designed plan, but I dislike the idea of penalizing the many families (like myself) who have placed their money in a 529 due primarily to the promised tax benefit (which can’t be withdrawn early without penalties). (Edit: The proposal language actually only refers to “new” contributions, so existing contributions should be grandfathered. Might make for some confusing accounting.) Still, as the parent of two kids under 3, I have to decide whether to keep putting money into these things without knowing what the rules will be in the future.

More: WhiteHouse.gov, WSJ

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  1. The whitehouse.gov site says: “The President’s plan will roll back expanded tax cuts for 529 education savings plans that were enacted in 2001 for new contributions.” To me that means the changes would only apply to new contributions.

    • Thanks for pointing that out.

      Now, I wonder how they would track that though. Hypothetically, I put in $5k before the tax change (no tax on cap gains) and $5k after the change (tax on cap gains). How do they track what money was invested in what? They would effectively have to keep two separate accounts for everyone who had a 529, like a Roth and Traditional 401k. More paperwork, more tax headaches, more bureaucracy.

  2. I think a change in 529 benefits would be sorely disappointing to me personally (since I plan to use that as a major vehicle to fund my kids’ college) but I can see making what is ultimately a small concession, and one with a greater benefit to high income earners, in order to put forth the rest of the president’s higher education agenda. Like you said, though, this is unlikely to get any traction in Congress.

  3. Sucks when government reneges. Makes it hard to plan for the future.

    I guess tax diversification through Roth + Trad IRA is a good strategy.

    I think the best policy going forward it to keep expenses low so that you only have to realize $20k income/year. But this strategy can only survive if there isn’t a wealth tax, which I feel is coming down the road…

  4. My hope is if anything as awful as this were to ever pass that they would grandfather those who starting contributing before a bill of this nature was passed. Maybe that’s wishful thinking.

  5. This kind of thing is why I’ve always been reluctant to do much with a Roth. I’d rather just focus on the traditional 401k and get my tax break now while it’s certain. Sure, the Roth may be the best deal in the long run, but why run the risk of finding out if the rules will still be the same in 30+ years?

    • This is a thought I have had as well regarding conversion of a traditional IRA to a Roth as a “backdoor” Roth contribution (I’m not eligible for a regular Roth IRA). My fear is that I’ll pay the tax now on the conversion and then the government will change the rules on Roth IRAs and I’ll pay again.

    • I think this proposed change, and a possible change to Roth handling, is a risk worth considering. That being said, I think this risk is mitigated by the fact that those that make the laws, as well as those that pay to get them elected, are the primary beneficiaries of these tax policies. If they move their money, I’ll move mine.

  6. Another option is to put the money into a Roth IRA (assuming you’re not already maxing out your IRA contributions). You can pull the principal out to help for school and leave the investment gains in for your retirement.

  7. Also disappointed in the change, but it should be noted that the proposal notes that only the investment gains will be taxed at the back end. You’ve already paid tax on the contribution and it will not be taxed again upon withdrawal.
    And yes, @kevin, the WSJ article says that current 529 plans would be grandfathered in with the current terms, so withdrawal of current funds would still be tax free.

    • That’s correct. The CNN story isn’t well written but the WSJ story makes it clear that this would be for new contributions and would the taxation would only apply to the gains. Further, the gains would be taxed as ordinary income to the beneficiary, not the account owner. So the gains would be taxed at the student’s tax rate, and they may be in a lower tax bracket than the parent who established the account.

      Nevertheless, this proposal is totally unacceptable to me as a big 529-saver!

      • two comments:
        1. It’s a proposal by the Obama admin and this will never see the light of day by the current Congress (thank god).
        2. A proposal and what is a law can be completely two different things.

        Though as I have suggested in the past, don’t expect the tax deferred/exempt item to exist in the same form 10,20, or 30 years from now.

    • Thanks for the correction on the gains and the grandfathering on current contributions as part of the proposed change. Maybe I need to make more contributions now!

      • Remember there is a $14k per year contribution limit for each beneficiary! Above that you will face gift taxes.

        • That number doubles to $28k per year from a married couple. And no gift taxes are owed until the lifetime gift/estate tax exemption is reached, which is currently over $5 million.

  8. Keep in mind that this is just a proposal by the President and has virtually no chance at all of passing Republican controlled House and Senate.

    • Isn’t that my 2nd sentence? 😉

      • Yes I just wanted to remind people since the commentary seemed to react otherwise. NO sense in getting upset about something that really won’t happen…

        • Very true, it is highly unlikely to happen in the next few years and the media always needs something to talk about. But I think this is a good example that taxes can and do change quite regularly and will no doubt change in the future.

          • Also, please remember, the president’s proposal, or anyone’s tax reform proposal for that matter, is a basket of measures that meant to result in redistribute/balance the tax burden while ensure the US government will continue have a strong tax revenue source for its needs. Thus, 529 plan’s change will likely coincide with a bunch of other things. In the end, you may or may not have a net benefit or net loss due to the change. Overall, however, I think the lack of interest (hence support) in 529 plan among majority of the population will likely cause it to change.

            Last Christmas, I pitched at two of my coworkers who recently had babies that instead of giving them a gift, I would like to make a cash donation for their 529 plans. But they need to first sign one up and send me the link. To this day, neither has done so.

  9. No idea what President Obama is trying to accomplish with this proposal. If only 3% opt for a 529 plan, the amount can’t be big enough to get a lot of $$$ for government.. Such a disappointment – penalize folks who plan well to save, and give money to folks who did not do so 🙁

  10. Worst idea ever!

    Why not set it up to only tax the 529 account where the account owner makes over x per year.

    • because then only people why made below that threshold would contribute, and no money would be collected. I’m thinking a lot of grandparents who no longer had income would suddenly be setting up the 529 instead of the parents.

  11. Son’s five twenty nine is making nice dough.regardless of what happens we feel like a 529 is a scam. Like our 401ks we see that these exist to line pockets of the wealthy.

    • How exactly is a retirement plan that can’t be spent until you are 59.5 years old and limited to $18k of employee contributions per year going to “line the pockets of the wealthy?”

      • because employers don’t care about the end returns and generally select available funds to invest in with high management fees that line the financial industries pockets with the returns that could have went to the individual if he had been allowed to invest in a general etf.

        • As an employer, I can assure you that employers do care about end returns considering the fact that we put our own money into these plans. Speak about what you know and don’t just toss around reckless statements about things you know nothing of. Maybe YOUR employer doesn’t care. If that’s the case, then be more specific.

  12. Perhaps the Republican controlled Congress will bundle some of the President’s proposals with others laws that are not as popular with him. This might be a strategy for Congress to get past the veto pen. You never really know. Something like this might actually get signed into law in the very near future.

  13. Typical government sticking their hands where they don’t belong. This gravy train will not last forever. 18+ trillion in debt and they want to tax 529 accounts. How sickening.

  14. I’m surprised at all the anger over the idea of changing tax breaks that drastically favor the rich going forward. (I understand the frustration of retroactively messing with 529s, but not with changing the rules going forward.)

    The tax code should not be used to subsidize the rich, it ideally (in my opinion) should have targeted and proven tax incentives that help achieve certain societal goals (lifting people out of poverty, curbing climate change, etc.)

    Allowing the rich to keep even more of their money through 529s, the home mortgage interest deduction, college deductions, etc. is not worth our country going into greater debt for. That’s my opinion, but I’d hope it’s not wildly controversial.

    • “Allowing the rich to keep even more of their money”. Wow, you said that, huh? How dare we allow those rich people to keep their money. We should take it and spend it for them.

      You should realize that our nations debt problem is not a revenue problem, it’s a spending problem. What I mean by that is, tax revenues (money taken from people by the government) has been consistently high and recently increasing. The “greater debt” you speak of is from increased spending above and beyond revenue. If you really care about how much debt we’re in, start voting for politicians that want to actually tackle the spending problems and quit voting for those that try to convince you that taking more from rich people will solve our problems. The math isn’t even close to being there to make that argument, but most people don’t care to look at the numbers…and by your comment, you’re included in that group.

      • Right on the $ Robert. And guess who pays most of the taxes in this country.

      • Agree. By that logic the biggest subsidy to the “rich” is the 39.6% tax bracket. Think of how much they more they could be paying with a 100% marginal tax rate!

      • @Robert You are free to make straw man arguments and knock them down, but of course I was not suggesting a 100% income or wealth tax. I was arguing against specific tax deductions that disproportionately benefit the rich instead of the lower and middle class families that politicians originally said these provisions were created for. Your reply didn’t seem to touch that topic directly.

        I disagree with you that revenue is not part of the problem. In 1998, we had our first budget surplus in decades in part due to tax increases (that brought in more revenue) from a few years earlier. Tax cuts passed in 2001 and 2003 played a role in decreasing America’s revenue, and also increasing our deficits. http://www.washingtonpost.com/blogs/wonkblog/wp/2012/09/05/the-three-best-charts-on-how-clintons-surpluses-became-bush-and-obamas-deficits/

        Of course, spending played a big role in both. Defense spending was cut at the same time taxes were increased in the 1990s – leading to the surplus, while in the early 2000s we saw a general spending bonanza and two expensive wars launched. So I don’t disagree spending is part of the equation, but how you could say that slashing our revenue is not part of the deficit equation is incomprehensible.

        (Notice I didn’t say “Clinton’s surplus” or “Bush’s tax cuts.” Too often people project everything onto the President, when Congress has much more power, which is how the government was designed. Some GOP members worked with Clinton to cut spending, and some Democrats voted for Bush’s tax cuts and Iraq war resolution. To pretend that legislation passed was 100% the President’s achievement/fault is just wrong.)

        But my point was about tax deductions. They are supposed to be helping Americans in certain ways. Reagan and Congress protected and expanded the home mortgage interest deduction because it supposedly helps people afford to own a home. Yet the deduction isn’t helping people who have a tough time affording a home, it’s overwhelmingly going to people who earn over $100,000/year, who get around $70 billion in deductions annually from it. What sense does it make giving a tax deduction to billionaire Michael Bloomberg for interest on his mansion, with the purported goal of home ownership? Do you think that a sound public policy to have?

  15. I did the Coverdale thing. It was more trouble than it was worth.

    I saved $2k-$4k per year, for about 12 years. These were after tax dollars invested in a mixture of low cost index funds and a target date fund. The small savings of not being taxed on the earnings of these investments wasn’t worth the hassle of dealing with making sure the tax forms came out right with the withdrawals.

    I guess if you’r saving $100K + maybe the tax benefits may make this worthwhile.

  16. i don’t see the point then, why not just put after tax $ into a regular account and buy & hold. At least then you only pay the capital gains tax, whereas in what’s being described here you pay income tax… sure, maybe you pay some income tax in the dividends or small gains that are thrown off, but the major gains over the long haul will be pure cap gains.
    i don’t get it then why anyone would want a 529 if this were true. Am i missing something?

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