Obama Shelves Plan to End Tax Breaks on 529 College Savings Plans
January 29, 2015

President Obama has abandoned plans to roll back the tax breaks for 529 college-savings plans in the face of mounting political pressure. The proposal, made public by President Obama during his State of the Union address recently, aimed at making Americans pay tax on the earnings in the account at the time of withdrawal.

President Announces Proposal to Tax College Savings Plans

Recently, President Obama proposed to eliminate the tax breaks on 529 college savings plans, prepaid tuition plans and Coverdell education savings accounts. The objective behind this proposal was to obtain funds to pay for other student aid initiatives.

At present, each of these college savings plans accumulate earnings on a tax-deferred basis. Typically, the qualified distributions are tax-free, while non-qualified distributions require the beneficiary to pay the appropriate tax rate in addition to a 10 percent penalty.

The implementation of President Obama’s proposal would have had no effect on the non-qualified distributions. However, it would have treated qualified distributions as a beneficiary’s ordinary income, thereby bringing it under the tax dragnet. This step would have effectively rolled back the changes enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).

The changes in the EGTRRA are primarily responsible for the increase in college savings. Kantrowitz mentions that the total assets in 529 college savings plans and prepaid tuition plans rose from $14 billion in 2001 to approximately $265 billion in 2014. Since the changes to the EGTRRA in 2001, 529 college savings plans and prepaid tuition plans accumulated no less than 95 percent of their current volume of assets.

The Potential Impact of President Obama’s Proposal

In recent times, federal aid for post-secondary education has decreased. It has also moved from a system of providing grants to offering guaranteed student loans. Given the rising cost of tuition and college expenses, people began investing heavily in 529 college savings plans and prepaid tuition plans. The tax-free distributions gave them a strong incentive for doing so. Data suggests that there are over 12 million 529 college savings plans and prepaid tuition plans today.

Kantrowitz mentions that President Obama’s proposal would not revert the tax treatment of these 529 college savings plans to the way things were in 2001. The proposal would not tax the earnings at the student’s rate. Instead, it would apply tax rates on the earnings at the parent’s rates, thereby making things worse.

Moreover, treating the earnings on these plans as part of the beneficiary’s ordinary income would have other repercussions as well. For example, beneficiaries will need to report the earnings on these accounts in their federal income tax returns. The earnings would register as increase in incomes, thereby affecting the beneficiary’s eligibility for federal college aid on the subsequent year’s Free Application for Federal Student Aid (FAFSA).

When evaluating the eligibility of a student for federal college aid, the evaluators reduce the volume of need-based financial aid that a student can get by half of the student’s total income. In addition, the FAFSA reports college savings plans as parent assets, thereby reducing aid eligibility by about 5.64 percent of the net worth of the assets. This is applicable regardless of whether the parent or the dependent student owns the college savings plan.

Illustrating the Effect of Implementing President Obama’s Proposal

To highlight the consequences of the implementation of this proposal, Kantrowitz uses the following table. The table considers the following assumptions:

  • There are four equal annual qualified distributions
  • The parent’s tax bracket is 25 percent, while the child’s tax bracket is 10 percent
  • The student qualifies for need-based aid and,
  • The parents save for the child’s college education from the birth of the child
Scenario A Scenario B Scenario C Scenario D Scenario E
Monthly Contribution $250 $250 $250 $250 $250
Interest Rate 4% 6% 8% 6% 6%
Number of Years 17 17 17 12 4
Total Contributions $51,000 $51,000 $51,000 $36,000 $12,000
Total Earnings $22,116 $37,749 $57,669 $16,800 $1,592
Total Savings $73,116 $88,749 $108,669 $52,800 $13,592
Earnings/Savings Ratio 30.3% 42.5% 53.1% 31.8% 11.7%
Tax Liability $3,929 $7,837 $12,817 $2,600 $0
Financial Aid Impact (Income) $9,058 $16,875 $26,835 $6,400 $0
Financial Aid Impact (Assets) $10,309 $12,514 $15,322 $7,445 $1,916
Total Financial Impact $23,296 $37,226 $54,974 $16,445 $1,916
Impact as Percentage of Savings 31.9% 41.9% 50.6% 31.1% 14.1%

Based on the illustration above, the tax payable on the earnings will be steep. However, the financial impact that parents and children will face will be even costlier. Implementing President Obama’s proposal would end up costing the family over a third of the qualified distributions, after combining the effect of federal income taxes along with the loss of eligibility for need-based financial aid. Even worse, it would consume a lion’s share of the earnings, except for those students who do not qualify for need-based financial aid.

A Sweeping Impact Across Families at All Income Levels

However, administrators claim that only the upper-middle and middle-class families use the 529 college savings accounts. This claim stems from a 2010 US Government Accountability Office report that only three percent of families invest in 529 plans. The report also states that the median income of these families ($142,400) is thrice the median income of families that do not invest in these 529 plans ($45,100).

Therefore, administrators state that low-income families will not have much by way of savings for college, while the wealthy will probably have trust funds in place for paying for their children’s college. Therefore, officials claimed that ending the tax breaks on these college-savings plans would end the benefits that high-income families typically enjoy.

However, a 2014 report refutes this claim. Compiled by the College Savings Foundation, this report reveals that families having incomes below $150,000 own over 70 percent of 529 college savings plans. In addition, families having income levels under $50,000 own about 10 percent of these plans.

Therefore, Kantrowitz concludes that the implementation of this proposal would impact families at all income levels. At the same time, the proposal would also offer no incentives to people for saving for college. Given that about 40 million Americans have at least one outstanding student loan and that many of them have an average debt of $29,000, this strategy does not seem appropriate.

Backing Off in the Face of an Uproar from Parents and Political Opponents

On Jan. 17, President Obama will be sharing his budget plan for the 2016 fiscal year. The proposal to tax the earnings from college savings plans formed a part of this budget plan. However, mounting political pressure has resulted in making President Obama back away from implementing this proposal. The decision came just hours after Speaker John A Boehner of Ohio demanded the withdrawal of the proposal, with the support of other top Democrats.

White House economists felt that by ending the tax breaks on the 529 college savings plans, they would be bringing about greater levels of tax fairness. The objective had been to utilize the savings that accrue from terminating these tax breaks into providing the middle class with a larger expansion of another tuition tax credit. However, the proposal angered people because it would simply have made 529 accounts redundant. Therefore, Jonathan Weisman writes that while the wealthy might be benefiting from the tax breaks provided on 529 college savings plans, they are not the sole beneficiaries.

Weisman also mentions that a family having an income of $100,000 or less could expect approximately $561 in benefits from investment gains when withdrawing earnings from a 529 account. Families that had income levels of over $150,000 could expect benefits amounting to $3,132. In comparison, implementation of President Obama’s proposal would give people $2,500 more for college, according to White House officials.

Therefore, officials felt that the vast majority of middle-income families who lost the tax break for earnings on 529 college savings plans would stand to benefit from the expansion of the American Opportunity Tax Credit, if President Obama’s proposal became a law. However, many Americans will remember the proposal as a plan that could have spelled the end of college savings plans, whilst driving them further into debt as they attempt to pay for college.

With the future of the country intimately related to the future of higher education in the country, exploring avenues for extending the opportunities for education to more people will remain one of the biggest priorities for the administrators of the nation.