Presently, those monies are withdrawn tax free, but a proposed rule change by the Obama administration may introduce a tax component.
Obama’s plan is part of a far-reaching initiative to overhaul the current tax code. That code is complicated, confusing and costly to the government. Under the guise of helping the middle class, new contributions in the future would be taxable. Monies already contributed would elude taxation.
About 529 Plans
Most 529 plans are managed at the state level and give Americans a host of ways to invest their money. Those monies are always withdrawn free of taxes, provided that they’re used for educational purposes. Such funds are used by more than seven million American families with contributions now topping $200 billion.
The concern for the Obama administration is that the benefits derived from affluential families, who enjoy a disproportionate share of the advantages that these plans provide. For example, those families that begin to save toward college early on can accumulate large sums of monies for education, repositories that remain shielded from taxation.
If taxed, the Obama administration would have withdrawals treated as ordinary income. In effect, such withdrawals would raise income levels in those years that they are withdrawn, pushing people into a higher tax bracket. However, gaining approval from the now Republican-controlled Congress to introduce legislation acceding to the president’s demands may not be feasible.
High-Wealth Individuals
The worry voiced by some in the higher education community is that taxation would lead to two problems:
1), contributions to 529 plans would drop substantially, and
2), the reduced participation rate would make it difficult for states to keep these plans open.
Just how vested are people of higher means in 529 plans? Reports have it that at least 70 percent of such account balances are owned by people with incomes of at least $200,000. These individuals and families may still be “middle class” by most definitions, but they are on the higher end of the class segment and are often lumped in with “the rich” for political purposes.
The average account balance for 529 plans is about $20,000, what closely parallels the tuition and board that parents might pay for one year of in-state education at a public university. Therefore, that still leaves people supplying personal funds or borrowing money for the other three years. And at that salary level, financial aid is typically not forthcoming.
American Opportunity Tax Credit
Where 529 plans would essentially be gutted, the Obama administration proposes expanding the American Opportunity Tax Credit, used to manage select education expenses across the first four years of higher education. For instance, s it currently stands, the maximum credit is $2,500 per year, but phases out and then eventually disappears for high net worth individuals. The Obama agendum would boost that benefit to five years and enlarge it to a level $1,500.
Other changes proposed include: eliminating the lifetime learning credit, terminating the tuition and fees tax deduction, and disposing of the student loan interest deduction on new loans.
The likelihood that the Obama administration will see legislation introduced to gut what many consider a sacred promise seems small. What it does do is maintain two narratives:
1), college is too expensive and,
2), the government is looking to close additional tax loopholes and credits.
Both narratives coalesce to provide political fodder for Obama in the face of stiff opposition.
See Also — How to Open a College Savings Account for Your Child
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