In his State of the Union speech last Tuesday, President Obama proposed eliminating tax breaks for college saving accounts known as 529 plans. A week later, that major policy proposal is dead, dropped by the administration in the face of vehement opposition from Republicans and Democrats alike, as well as state treasurers, financial firms, educational institutions and families.
If you have children under 18, this moment in the sun for 529 savings plans should make you sit up and take notice. There are potentially significant tax benefits to reap, especially if your income puts you in the sweet spot for these plans.
Sponsored by states and administered by financial firms, 529 plans allow families to sock away large sums of after-tax money for college costs. The money is typically invested and as long as the proceeds go for education costs, withdrawals are tax free at the federal level. Many states offer tax breaks as well.
Obama proposed taxing 529 withdrawals as part of a plan to consolidate a handful of separate tuition tax breaks and fund a $2,500 a year tax credit. The administration argued the existing tax benefits accrued mainly to the wealthy. The White House will now look to push ahead with the rest of its college access plan, including an expanded tuition tax credit, but it won’t seek changes to 529 accounts.
“Your voices were heard and we can all continue, without uncertainty, to rely on 529 plans which help families plan and save for their future higher education goals – and reduce their reliance on student loan debt,” the College Savings Foundation, a non-profit which supports 529 plans, said in a statement.
One reason for the opposition to the president’s proposal is that, while it’s certainly true that the bulk of the tax savings accrue to wealthier people, most of the accounts are held by middle income folks.
The wealthy are the ones who have the disposable income to sock away, the high tax brackets to reap the most benefits and the financial advisors to push them to enroll. The Obamas themselves put away $240,000 in 2008 — $120,000 for each daughter. Tax law allows for large up-front deposits that, for gift tax purposes, are treated as if made over five years. Who else but the well-to-do get to take advantage of that provision?
Yet most accounts are opened by middle income families. Strategic Insight, a mutual fund research firm, found in a 2014 survey that 70 percent of 529 account holders have incomes under $150,000. The number of accounts has grown to 12 million, up from 1 million in 2001.
But 529 plans aren’t necessarily for everyone. They make the most sense for families whose kids are not likely to qualify for a lot of direct aid and grants for college. Savings in a 529 plan owned by a parent is reported as a parental asset on the federal financial aid application (FAFSA). Those assets will be assessed at a 5.64 percent rate in determining the expected family contribution to a child’s college costs. Distributions from the plan do not count as income that could reduce financial aid eligibility, however. Note: For grandparents, it’s the reverse. The 529 plan doesn’t count toward the family contribution, but it is “added back” when reporting income on the FAFSA.
Many families with extra cash to save for the future would be better off contributing more to their retirement plans (assuming they aren’t already submitting the maximum amount allowed). Retirement accounts aren’t counted as parental assets for financial aid purposes and have many of the same tax advantages as 529 plans.
The truth is, states, universities, financial firms and the federal treasury all benefit from families doing more to save and invest for their children’s college. It means those students should need fewer loans and graduate with less debt. But keep in mind, it may mean they qualify for less financial aid as well.
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