529 Plans

A couple of clients called me recently about comments made by Rush Limbaugh regarding the proposal put forth by President Obama to eliminate the tax break for 529 plans to help pay for his plan to provide free community college to some people. Since many people are not familiar with 529 plans, I thought I would explain something about how they work.

529 plans got their origin from states that set up prepaid tuition programs to help people pay for the cost of college.  They were first recognized by Federal law in 1996.  Over the years there have been some expansions in the types of plans offered and who can offer them.  Currently there are two types of 529 plans available, prepaid plans and savings plans.  Prepaid plans allow the purchase of tuition credits at todays rates to be used in the future. By buying tuition credits with todays dollars, you protect against future tuition increases.  Prepaid plans can now be offered by states or by higher education institutions.  Savings plans are different in that they rely on the performance of the underlying assets in the plan to determine the growth.  Savings plans can only be offered by states.

Currently up to 14,000 per year can be contributed to a 529 plan by an individual taxpayer.  There is no federal tax deduction for contributing to a 529 plan, but some states offer deductions for contributing to their state sponsored plans.  The federal tax benefit is that the earnings on the plan are not taxed as long as the money is eventually withdrawn to pay qualified education  expenses.  President Obama is proposing to eliminate this tax deduction and make the earnings taxable upon withdrawal.  Of course, his rationale is that this is a tax break for the wealthy and they don’t need it

From my perspective, my tax practice deals with mostly middle class or wealthy individuals and I have found that 529 plans are far more attractive for the middle class than for the wealthy.  Paying for college is a much bigger issue for middle class taxpayers than for the wealthy.  Middle class taxpayers frequently need to set aside money for many years to accumulate sufficient money to pay for college but most wealthy individuals can simply write a check and don’t have that same concern.  Also, there are a limited number of 529 plans and a wealthy investor looking to invest for the long term has numerous other options available with potentially higher rates of return and more attractive investment options.

Another factor to consider is that usually when Uncle Sam offers a carrot there is also a stick attached.  In this case, the carrot is tax free growth as long as the money is eventually spent on qualifying educational costs.  The stick is that if you withdraw money for any other purpose, the earnings are taxable plus you get to pay a 10% penalty.  Each year Uncle Sam takes in revenue from this penalty.  For the 2012 tax year, the Statistics of Income information posted on the IRS website shows that over 109 million dollars were received in penalties relating to 529 plans and Coverdell ESA’s.  If people stop funding 529 plans, this revenue goes away.

So, what do I think of “free community college”?  Well, just remember that free actually means taxpayer funded.  Should taxpayers fund free community college?  That’s a discussion for another day and one I don’t plan to have on this blog anytime soon.  After all, tax season is here and I have to fill out all of those new Obamacare tax forms for all my clients to see if they get to pay a penalty for not having health insurance.  For more information on 529 plans, a good resource can be found here.