Obama was smart to keep tax breaks for 529 plans

The plan was to take away a very generous tax break for college savings. It was, I believed, as did so many other college savings advocates, ill-conceived.

President Barack Obama had proposed taxing the earnings in 529 plans; avoiding these taxes is an advantage that is a huge selling point for the accounts. To defend the move, the administration pointed out that the plans benefit a lot of high-income families who don’t need the tax break.

But the furor was so swift, the administration is backing off the proposal.

“The 529 provision is a very small component of the president’s overall plan to deliver $50 billion in education tax cuts for middle class families,” a White House official said in an email. “We proposed it because we thought it was a sensible approach, part of consolidating six programs to two and expanding and better targeting education tax relief for the middle class. Given it has become such a distraction, we’re not going to ask Congress to pass the 529 provision so that they can instead focus on delivering a larger package of education tax relief that has bipartisan support.”

That was the right thing to do. And now perhaps the story about 529 plans can go back to discussing what they can do for all families.

“There are families who save $5 a month in our plans,” said Mary Morris, chief executive officer of the Virginia529 College Savings Plan and chair of the College Savings Foundation, which opposed Obama’s proposal. “Are there high-net-worth families who have 529 plans? Sure there are, but that’s not a bad thing. But we also know we have many families with lower dollar amount accounts. I reject the premise that was used to put out this proposal.”

Painting 529 plans as a rich man’s tax haven sent the wrong message about a great way for all families to save for college. In addition to the tax advantage, 529 plans offer families an opportunity to start investing with small amounts. Most state plans allow people to open an account with as little as $25.

My hope has always been that 529 plans do for college savings what 401(k)s and similar plans have done for retirement savings. In the first six months of 2014, total investments in 529 plans reached a record $244.5 billion, according to the College Savings Plans Network

“Having a 529 incentivizes the right behavior to plan and save more,” Morris said.

There are two types of 529 plans — prepaid tuition plans and college savings plans. A prepaid tuition plan allows you to pay a child’s tuition and fees in advance with the intent of locking in today’s prices. In the 529 savings plan, which is more popular, you invest much as you would in a workplace 401(k). This means your returns are based on how your portfolio performs throughout the years.

Earnings in such plans grow tax-deferred and are exempt from federal income tax if the funds are used to pay for qualified higher education expenses. In most cases, earnings are also free from state and local taxes. There are no income limitations on who can contribute to an account.

A report by the Government Accountability Office found that in 2010 less than 3 percent of families saved in a 529 plan or Coverdell Education Savings Account, which is another tax-advantaged way to save. The report estimates that of those families with 529 plans or Coverdells, 47 percent had incomes of more than $150,000.

That leaves a lot of other families not in that high-income bracket, Morris points out.

The College Savings Foundation, a nonprofit trying to help and encourage families to save for college, found in a more recent survey that nearly 10 percent of 529 accounts are owned by households with income below $50,000, with more than 70 percent of accounts owned by households with income lower than $150,000.

The foundation’s survey also found the average 529 account’s value was about $20,000. The average monthly contribution was about $175.

And there is this, says Mark Kantrowitz, senior vice president and publisher of Edvisors.com: If 529 plans terms had changed, it could have impacted the eligibility for need-based aid for students in lower-income households. The taxability of distributions would cause the money to be counted as income on the Free Application for Federal Student Aid or FAFSA.

With the rising cost of college and more than $1 trillion in student loan debt, having a dedicated vehicle that discourages spending the money on anything else makes 529 plans valuable for more than just the tax advantage.