Little incentive to use 529 plans under Obama proposal

College planning would change under president's reforms to education tax code

Jan 21, 2015 @ 1:57 pm

By Liz Skinner

The way Americans save money to send their children to college would likely change under proposals President Barack Obama alluded to in his State of the Union address Tuesday.

The tax benefits of the nation's 529 college savings plans and Coverdell education are among several education tax incentives that would be eliminated going forward, according to details the White House released on Jan. 17.

Mr. Obama's goal is to consolidate these and other tax incentives for education savings to fund expansion of a single tax credit aimed at making it easier for middle-class Americans to pay for college. He also would adjust how the government helps students repay their loans.

Today's complex education tax system is preventing Americans from realizing their full benefits, the administration said. It cited a Government Accountability Office report that found 27% of families who claimed one tax benefit would have been better off under another one, and 14% of those who were eligible failed to seek any assistance.

The changes, while unlikely to make it through a Republican-controlled Congress, would dissuade wealthy Americans from using 529 plans to save for college, financial planning professionals said.

“You would see contributions substantially decline without that benefit of being able to withdraw the amounts tax free,” said Nicole Hart, director of trusts and estates for New York-based Sontag Advisory, which manages about $4 billion in client assets.

Investors had about $217 billion in 529 savings plans as of Sept. 30, 2014, according to Strategic Insight.

(More: Morningstar releases new college savings plan ratings)

Those who continued to put money in 529 plans would see those funds taxed as ordinary income when they were used, though it would be at the child's tax rate, which likely would be lower than the parent's rate, Ms. Hart said.

Tax benefits that some states offer their residents who fund that state's 529 plan likely would not change,she said.

The White House proposal would:

- Expand the American Opportunity Tax Credit to provide up to $2,500 for each of five years for students working on a college degree. Applies to couples with modified adjusted gross income of $180,000 or less and singles with $90,000 or less.

- Roll back tax cuts that allow new money invested in 529 education savings plans to be used for college tuition and other costs tax free and repeal tax incentives going forward for Coverdell education savings accounts.

- Repeal the student loan interest deduction for new borrowers and eliminate a tax on student loan debt forgiveness that the government now collects from taxpayers who use income-based repayment plans for student loans.

(More: Should your clients use prepaid college tuition plans?)

Those who support the use of 529 plans for college savings say the middle-class benefits from these programs and tax incentive to save should not be removed.

They point out that 70% of the plans open today are owned by households with income below $150,000, according to research from Strategic Insight from March 2014. About 10% are owned by households with income below $50,000 and 95% of accounts are held by families with income below $250,000, the research found.

“529 college savings plans are now helping millions to attend college, and reducing the amount of student loan debt students must incur,” said Mary Morris, chairman of the College Savings Foundation.

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