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529 E-ditorials

00-20: The Number One Target
Joe Hurley
Wednesday, October 25th 2000

After discussing Stupid Rules 2 and 3 in the last 529 E-ditorial (00-19 The 3 Stupid Rules of 529) I heard back from quite a few of you. Some were guessing (for the most part correctly) Stupid Rule Number One. Others were reminding me of some rules that are in fact quite stupid but did not make it onto my list (e.g. the room and board dollar limitation for off-campus housing).

Well here goes.

The Number One Target (we won't call this ""stupid""): Earnings withdrawn from a 529 plan account to pay for college are subject to income tax.

Section 529 says that the earnings portion of any distribution from a 529 plan account will be taxed as ordinary income to the distributee. If the distribution is to pay for the beneficiary's qualified higher education expenses, then the distributee is automatically the student/beneficiary. Since most students are in a very low tax bracket (zero or 15 percent), this can be quite beneficial, compared to investments owned directly by the parents. Further, the Hope and Lifetime Learning credits can very effectively offset the taxed generated by 529 plan distributions for many families.

So why should this rule be changed?

Well, to begin with, the money in a 529 account is being spent on higher education, and higher education is clearly viewed as a priority in this country. The earnings are not being spent on vacations or consumer goods, but rather in helping to create educated citizens who can be more productive and successful. A recent report from the government shows that an investment in higher education provides a 12% annual return to society in general. Public policy considerations support tax exemption for the earnings.

It's interesting to note that the federal government's own tuition savings program, the education IRA, provides tax exemption of distributed earnings used for college. If this is good policy for the federal program, why shouldn't it be equally good policy for the state-sponsored plans? Perhaps this is just an indication of Big Brother's desire to upstage the states.

Many states, by the way, have gone even further in providing tax incentives to families who save, either by exempting the earnings, or by allowing a deduction against state income for your contributions. Some states do both. As far as I know, no state has decided to tax the earnings coming from an education IRA.

Second, the primary purpose of a 529 plan is to provide families with protection from the increasing cost of a college education. This is particularly true for the prepaid tuition plans that have no real upside investment potential beyond the tuition hedge. The current laws impose tax on participants even when they have no real economic gain. Even worse, Section 529 requires that they pay a PENALTY on any withdrawals from the plan that are used to pay the tax on the inflation gain.

For years, the tax law has provided breaks for homeowners who sell their residence at a gain in recognition of the fact that much of the gain merely represents inflation. Shouldn't a college education be viewed in a similar manner?

Finally, and most importantly, tax exemption of earnings in a 529 plan will be a spur to many families to begin saving in earnest for their children's college education. Too many families procrastinate and ""before they know it"" Junior is in ninth grade without a college savings fund. Anxiety takes over, and the family usually ends up taking on a small mountain of debt. The mere promise of tax exemption on 529 earnings will create a tremendous incentive to start saving now.

Granting tax exemption probably won't kill the federal budget surplus (although I admit I haven't looked too closely at this aspect). We already have the Hope and Lifetime Learning credits to help with cost of paying for college, and there is little doubt that an exemption for 529 earnings will be coordinated with these credits to prevent ""double-dipping"". A greater level of savings may also lead to less dependence on federal student aid programs, so that the aid can be better directed to families that truly cannot afford to send their kids to college.

Will the tax exemption for earnings give rise to a new ""tax shelter"" as wealthier families pour many thousands of dollars into 529 plans? Not likely. In fact, the 10% penalty on non-qualified distributions coming from an over-funded 529 account will have more ""teeth"" when combined with the loss of tax exemption on the earnings. There will be an even stronger incentive to use the account for qualified college costs.

Congress passed legislation providing for tax exemption of 529 plan earnings in both 1998 and 1999, but each time the legislation was vetoed by the President due to other objectionable provisions in those bills. There seems to be a good chance that the exemption will be enacted in the future, no matter how the November elections turn out.

Is the 529 plan a poor investment option without tax exemption? Not at all. It remains a terrific savings tool for many families and, as pointed out earlier, the tax results can be managed very effectively. We list taxation as The Number One Target simply because a change to this rule will have a very significant impact on the amount of money that many families save for college. And that has to benefit just about everyone.

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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