Proposed Changes to 529 Plans Would Dampen Their Appeal

In his State of the Union address Tuesday, President Obama proposed changes to 529 college plans that may force the 7 million families using them to rethink their college financial game plan.

Currently, you can make contributions to a 529 plan, invest those funds, and eventually withdraw the earnings tax-free as long as the money is used for education expenses such as tuition, room and board, or books. That makes it one of the more appealing ways to save for your child’s education. Plus, some states offer income-tax deductions on contributions.

But under the new proposal, investment gains in a 529 college savings plan would be considered ordinary income and subject to capital-gains taxes.

This would eliminate perhaps the most attractive feature of the mostly state-run plans. And as The New York Times points out, it would also impact how much federal financial aid a family would qualify for, because their income would be greater in a year when they withdraw funds from their 529 plan.

Why Eliminate a Popular Tax Break?

The White House says its goal is to simplify the tax code and consolidate education-related tax breaks to help the middle class pay for college. The president estimates that ending the 529 tax break would generate about $2 billion in revenue, and he wants to use that money to expand and make permanent the American Opportunity Tax Credit, according to the Times.

That refundable credit, as discussed in our Tax Guide for College Students, is available to undergraduates during their first four years of college. The maximum annual credit is currently $2,500 toward the cost of tuition, fees, and course materials, and $1,000 of the credit is refundable — meaning even if you have no tax obligation (for example, you only earned a few hundred dollars working part time freshman year), you can receive a $1,000 refund toward education expenses.

Obama’s plan would make the credit available for five years, open it up to part-time students, and increase the refundable portion to $1,500.

Why get rid of one educational tax break to expand another? Some critics argue that 529 plans disproportionately benefit wealthy families.

A reported 70% of 529 accounts are held by families with incomes greater than $200,000. And according to a report by Sallie Mae, 49% of families who plan to send a child to college aren’t even sure what a 529 savings plan is.

However, as Time points out, anyone is able to open a 529 account. In fact, 14 states are offering matching grants for contributions,  aimed at encouraging low-income families to save.

And there are other ways to beef up that 529 account regardless of your income. We’ve covered other programs to help fund your child’s education, such as the Gift of College or LEAF, which allows family members and friends to give a gift directly to your child’s 529 plan. There are also credit cards that pay rewards directly into your college savings account.

What Does This Mean for You?

Good question. First of all, according to the Times, none of this is likely to pass with a Republican-controlled Congress. A spokesman for Rep. Paul Ryan, R-Wis., told The Wall Street Journal, “You don’t produce a healthy economy and an educated workforce by raising taxes on college savings.”

However, even if the plan somehow were to pass, it would not affect any prior contributions or investment gains you have already accumulated in a 529 plan. It would only affect new contributions.

An alternative way to achieve similar results is to save for college using a Roth IRA, which allows you to withdraw investment gains penalty- and tax-free for qualified education costs. The catch is that annual contributions to a Roth IRA are capped, currently at $5,500 per year, and subject to maximum income limits.

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