A WTF Proposal on Reducing 529 Tax Benefits

It was an audible what the f*#% that escaped my lips as I read a NY Times article that explained how President Obama was now proposing to eliminate tax-free withdrawals from 529 college savings plans.  Under the proposed changes, the money earned from any new contributions to 529 accounts would lose the capital gains tax protections that have made 529 plans a decent tool in the belt for paying for higher education.  In addition to the loss of the capital gains tax forgiveness – if the money is used for qualified educational expenses – the money earned via the accounts investments would actually be taxed at the much higher ordinary income rate.  Incredibly enough, the proposal is part of a much broader package that a White House official described as designed to consolidate a variety of educational tax breaks and also funnel more money to middle-class families.

Let’s take a few minutes to actually parse through the proposed changes since this strikes me as a measure with multiple intents.  First, I have no doubt that this is tied to the floated proposal to fund free community college for eligible students..  While the tuition proposal is the carrot however, this measure would be the stick to help herd even more young people into the community college track.  We already know that the disparity between the stagnant income and the wildly inflative tuition rates has led to a shifting of family income levels downwards through the college system.  What I mean by this is that as tuition rates have risen far faster than family incomes, what a family could afford for their children has shifted downwards from private non-profit institutions (Yale or Pacific Lutheran for example) to state supported institutions (any of the SUNY institutions or your local state college).  So while a solidly middle class family could get the kids through a Pacific Lutheran in 1980, the same family would be hard-pressed to do so in 2015 and would be more likely to have the kid attending the local state college or university instead.  Even if the states are, as a group, funding less on a per student basis than in the past decades, state schools are still more affordable and the 529 plans are a legitimate tool in saving for that alternative.  Remove the 529 plans as an effective savings instrument and even the public institutions become more unaffordable; the result is that if the youngsters are going to be educated, then one of the few alternatives is to utilize the community college for an associate degree or if a bachelor’s degree is sought, the first two years of general education requirements.

Second, make no mistake that there’s an almost punitive intent in this proposal.  It would be one thing to make the 529 less attractive by simply removing the preferred tax status of capital gains forgiveness and there are more than a few people who would probably look at the 529 and say meh, moving on to other alternatives.  But this proposal moves far beyond that: this actually turns standard taxation and accounting measures on their heads by taking what monies have been made from a capital gain status – which is precisely what they are – and wholesale shifting them to an income status with a concomitant increase in taxes.  The authors of this proposal are doing the old west equivalent of dumping dead animals in the water hole to poison it for anyone else.

Third, there is signifcant debate over what income level is, in the eyes of the authors, the middle class.  The class card is played by the notion that the 529 plans “primarily provide a subsidy to people who would save in other forms anyway”, according to Sandy Baum of the Urban Institute.  Yes, it does provide extra bang for the proverbial buck over other investment vehicles.  But that tax provision was an intentional public policy message that higher education did matter and this program was an effort to help offset what even then was recognized as an oncoming problem.  The notion that the 529 is simply another investment vehicle, akin to the standard mutual fund or whatever, is also not true since anybody who’s investing in the 529 plan understands that use of the funds for any other purposes means that there’s going to be a tax penalty for withdrawal.  If this is just another savings vehicle, then just take the money and dump into a consistent money-losing fund that costs you 10% annually.  The class argument is also offset by the fact that the average 529 account only has about $19770 and the average regular monthly contribution is $175.  This isn’t the kind of investor that’s looking to get subsidized; this is the kind of investor that’s hoping to squirrel away enough money to get the kids through a state institution.  The GAO notes that while only a small percentage of families utilize 529 accounts, the median income of those families with 529 accounts is three times that of those without 529 accounts.  I believe that would actually be true, apart from the fact that it’s coming from the GAO.  The simple fact however, is that it’s common knowledge that higher incomes simply remove the possibility of any grant or need-based scholarship for the student, leaving the costs to be either borne by the family and/or student with savings and debt.

The Obama Administration notes that it has other incentives to more than adequately offset the 529 change.  These include making the American Opportunity Tax Credit permanent, with a maximum credit of $2500 annually, subject to income requirements.  The other notable action put forward by the administration is that the tax bill on any student forgiven (yes, they’ll forgive the debt but you have to pay taxes as though it was an income) would be eliminated.  The reality there is that unless you are engaged in a program that eliminates student debt in return for service of some kind, it’s damned hard to get the student debt forgiven.  The onus is upon the borrower and the person has to demonstrably show that it is indeed a hardship for self and family; that is a steep hill to climb and few are able to do so.

The families utilizing the 529 plans are the ones who are looking ahead to the future and making an effort to save for it.  Eliminating the benefits of the 529 is as much a penalty for savers as are the other policies of the government, most especially the ridiculous rates on various savings accounts.  The message from the power structure is that we aren’t to worry, that there will be other options and if nothing else, we can always just borrow more when the time comes…precisely the last thing that savers and responsible parents want to hear.

There is also another aspect to this entire matter that bothers me, but it’s something that I frankly have to work through before I put it out there.  Suffice it to say, there will something more on this when I’m comfortable that I’ve thought it through.

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