The President’s Radical 529 Plan: Eliminating Tax Benefits

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Update: January 28, 2015

In response to widespread criticism, President Obama has dropped his proposal to effectively eliminate the tax benefits of 529 savings plans.

While the White House initially framed the proposal as a way to benefit middle-class families, leaders on both ends of the political spectrum said the move would wind up hurting middle-income investors. The administration has said it will continue to support lower- and middle-income households by advocating expanded tax credits for higher-education costs.

President Obama’s got a new plan to make college more affordable for middle-class Americans—but will it backfire?

As part of the President’s recently released tax plan, a key tax benefit from 529 college savings plans would be eliminated: Families would no longer be able to withdraw savings from these accounts tax-free.

To be sure, earnings would still be allowed to grow tax-deferred, but any withdrawals would be treated as student income—and taxed accordingly. (Withdrawals from existing 529 plans would likely remain tax-free.)

According to the White House, the money saved from curbing this tax break would help support other programs that could benefit more families, especially those in the middle class.

That includes an expanded American Opportunity Tax Credit, which provides families making less than $180,000 a year with a credit of up to $2,500 in college expenses per student. Obama’s proposal would make the AOTC, which is set to expire in 2017, permanent.

But some college-savings experts warn that, should the 529 proposal become law, interest in those plans would decrease considerably—and families might opt to take out heavy loans instead. “This would have a chilling effect on contributions by middle-income Americans,” Mary Morris, Chair of the College Savings Foundation, said in a press release. “529 college savings plans are now helping millions to attend college, and reducing the amount of student loan debt students must incur.”

Yet the Obama administration contends that as they are now, tax breaks on 529 accounts disproportionately benefit high-income investors. In fact, one 2010 report from the Government Accountability Office found that less than 3% of families take advantage of 529 plans—and those who do tend to be wealthier, with almost half of those families earning more than $150,000 a year.

Still trying to get caught up on the basics of 529 plans? Check out our comprehensive guide to college savings here.