PRESIDENT OBAMA has caused a furor with his plan to tax withdrawals from so-called 529 plans, a tax-advantaged savings account through which families save for children’s college tuition. Annual contributions to 529s, often deductible from state income taxes, accumulate earnings tax-free and then — under current law — can be withdrawn tax-free to pay for tuition and other college expenses. Mr. Obama proposes to tax these withdrawals from new — not existing — accounts as ordinary income. He would then use the proceeds, about $1 billion in the first decade, to help lower- and middle-income students pay for college through other programs.
Republicans are attacking the proposal as a tax increase on the middle class that would hit 12 million individual accounts, administered by state governments, with an estimated $244 billion in assets. On top of that, critics say, taxing 529s would encourage people to pay for college by borrowing, adding to the nation’s already mountainous student debt burden.
The real story here is the difficulty of trying to achieve socially desirable goals piecemeal, through this or that tax carve-out. This is doubly difficult when those very same tax breaks and other government subsidies get captured by higher ed institutions, driving up the cost of tuition. Putting those issues aside, however, the administration’s claim that 529s are less than optimal as a means of fostering college access is a truism. Yes, 529s enhance the value of college savings, and yes, it’s often better, other things being equal, to finance college from savings rather than borrowing. But given the income tax’s progressivity, the value of any tax deduction — for mortgage interest, state and local income taxes or tuition — increases as you ascend the income scale.
There’s no upper-income limit on eligibility for 529s, so the White House is undoubtedly right that the biggest benefits are being reaped by families that probably could save for college without a 529. In fact, if we taxed 529s out of existence, high-income families could, and probably would, simply shift their college funds to tax-efficient investment accounts. They would then pay the capital gains tax rate, which is still much lower than the ordinary income rate, on withdrawals, as Mark Kantrowitz of Edvisors.com noted.
If politicians insist on subsidizing college savings through tax-free accounts, they should impose a means test. A model could be tax-free Roth IRAs, a popular retirement savings vehicle to which couples making no more than $181,000 per year may contribute as much as $13,000 per year (depending on age and other factors). It so happens that $181,000 is near the $180,000 cutoff below which Harvard charges students no more than 10 percent of family income. Yes, $180,000 is three and a half times the median family income, but in the realm of sky-high college costs, it’s an all-too-plausible definition of middle class.
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