Changes to 529 plans as proposed by the Obama administration

I was asked by a friend to objectively explain the changes to 529 plans proposed by the Obama administration. If you’re interested, here’s what I told him.

There is no removal of the 529 plan being proposed by the administration. But the administration changes would affect both types of plans.

Today, 529 accounts, many of which are run by the states, allow people to make contributions that grow tax-free. The money can be withdrawn without the paying of capital gains taxes as long as the proceeds are used for education expenses. Many states provide state income tax deductions for contributions as well.

The administration is proposing to go back to the previous tax rules, revised by the Bush tax cuts of 2001. The administration wants to defer taxes until you start drawing from the account, counting as ordinary income on the student’s taxes. This functions essentially as a type of traditional IRA. The consequence of this change may cause the student to disqualify for certain student aid as they will have income to report on their taxes.

The reason the administration is proposing the change is that 529 plans and Coverdell ESAs (another saving option) disproportionately help families earning over $150,000 a year and had median assets of $413,000, according to the GAO. The College Savings Foundation said the 2012 GAO study is outdated and does not reflect the reality of who invests in the plan these days.

Some states provide 529 benefits which would not be affected by the administration’s plan. These are typically the pre-purchase tuition programs for qualified state schools.

There is little chance this will pass in a Republican-controlled Congress, however.