To tax or not to tax 529 plans

In his State of the Union address, President Obama outlined a number of ways to make education more affordable. I’m sure that most of you realize that the cost of going to college has been going up for decades at a rate that far outstrips the growth of wages. College is getting less and less affordable.

His speech outlined a number of proposals to help middle-class and lower-income families afford to send their children to college. It also included ways the government could get the money in order to help them do that (in other words, taxes). What is interesting is that one of his proposals was to start taxing the growth in 529 College Savings Plans.

The President has backed away from this idea. But why did he think to tax college savings if the goal is to make college more affordable in the first place? And why the reversal? The answer to these questions is what I want to talk about today.

529 College Savings Plans allow you to put money into an account, and the earnings grow tax deferred. Then, if used to pay for qualified college expenses, the earnings end up being tax-free. The problem, as the administration saw it, is that this disproportionally helps those rich folks in the higher tax brackets. They are right. Around 80% of the tax benefits go to households earning over $150,000 a year. (Thus, if your family earns that amount, you’re considered one of the rich folks.) And it is assumed that those sorts of people don’t need any help with college savings.

Politically, the plan to tax college savings was opposed by pretty much the entire Republican Party. That’s not surprising since it is a tax and Republicans posture as anti-tax. Yet in addition to Republicans, quite a few influential Democrats were resistant to this plan.

Why were the Democrats not on board with this proposal? Aren’t they for the wealth redistribution of “paying your fair share”? The issue is that while 80% of the tax benefits go to better off families, 70% of 529 Plan accounts are owned by those making less than $150,000 a year. That’s where the core of Democratic support is and their leaders certainly didn’t want to offend their constituents. For while the wealthy can afford to put more into their savings accounts, the less affluent like to save taxes too.

I expect we’ll see this topic come up again. After all, there’s an easy way to solve this problem for the Democrats: means test it. Means testing would likely make the ability to use the plan, or the tax-free nature of it, only available for those of more modest incomes. In that way, maybe you let the middle-class tax-payers keep their tax-free withdrawals from their college savings account while at the same time taxing withdrawals by higher-income families.

Only time will tell.

This article was published under the title "College fund tax didn't go over well" in the Wichita Falls Times Record News March 15, 2015.