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Critics decry administration proposal to end tax breaks on 529 plans

WASHINGTON – President Obama this week touted new ways to help students pay for college, but he also proposed stripping away a popular benefit: a significant tax advantage of college savings plans used by millions of American families.

The benefit allows families to withdraw money tax-free from savings plans that have become a primary way for parents to save to send their children to college. The plans, known as 529 plans, are considered a critical tool for Americans as the cost of tuition continues to rise and outstanding student debt stands at more than $1 trillion.

The administration has tried to frame the elimination of the tax break as a way to redirect more money to middle class families, saying that 70 percent of account balances are held by households making more than $200,000 a year.

But conservative critics quickly pounced on Obama’s plan, saying that it is deaf to the needs of ordinary Americans who are looking for any help they can get saving money for college.

“People don’t care that a wealthy person might also own a 529 plan. People care that they own a 529 plan, and that Obama is seeking to tax it out of practical existence,” Ryan Ellis, tax policy director for the conservative think tank Americans for Tax Reform, wrote in Forbes this week.

Conservatives warn that ending a key benefit of 529 plans would discourage families from saving and drive them to take on more debt to pay for college. They say the administration distorts the fact that a growing number of Americans earning less than six figures are investing in 529 plans.

“Why won’t Pres. Obama just admit his tax hike on college savings will hit the middle class?” tweeted House Speaker John A. Boehner, R-Ohio.

Even if the proposal goes nowhere, which is likely in a Republican-controlled Congress, it could shape future higher education policy. And that’s alarming to people outside the Beltway.

“This would eliminate all new investment in 529 plans,” said Mark Kantrowitz, publisher of Edvisors.com, a financial aid website. He noted that Obama’s proposal would treat the earnings on 529 plans as student income, which would hurt a child’s chances of receiving financial aid.

“When you take into account not just the impact on taxes, but also the impact on financial aid, it wipes out all of the earnings,” Kantrowitz said. “You’d be better off in a way just putting the money in a mattress, than using one of these plans.”

The advantage to 529 plans, named for a section of the tax code, is that families can invest through these accounts without the earnings and withdrawals being taxed as long as the funds are used to pay for college expenses. But it wasn’t always this way.

Before the Bush tax cuts of 2001, any money withdrawn from a 529 plan was treated as ordinary income subject to taxes – a rule that Obama would like to revisit. Very few people used the plans in those days, but that started to change once the tax cuts took effect. Assets in 529 plans have risen from $19.4 billion at the end of 2001 to $245 billion in 2014, according to the Investment Company Institute.

Affluent families have disproportionately benefited from the changes in the law. A report from the Government Accountability Office found that nearly half of families with 529 plans made more than $150,000 a year and had median assets of $413,000 – 25 times higher than the assets for families without the plans.

“It’s kind of just a cash giveaway to upper-income folks,” said Mark Huelsman, a senior policy analyst at liberal think tank Demos. “The president, both from a policy and a political perspective, sees something like that and says why don’t we use some of that to pay for the cost of college up front.”

Supporters of 529 plans argue that there is no need to tamper with such an important vehicle for savings, especially at a time when more middle class families are opening accounts.

The College Savings Foundation, a nonprofit that advocates for 529s, said the 2012 GAO study is outdated and does not reflect the reality of who invests in the plan these days. The organization estimates that 70 percent of account holders earn less than $150,000 based on a 2014 survey conducted by Strategic Insight, a mutual fund research firm. Another 10 percent of account owners have income below $50,000. Families on average contribute $175 a month and amass about $19,774 in their accounts.

States, which run most 529 plans, have been offering more income tax breaks to encourage families to invest. There are even 15 states, including Colorado, Nevada and Maine, that will match college savings up to a certain dollar amount or provide income tax credits to get low- to moderate-income residents to participate in their 529 plans.

To be clear, Obama is not calling for the abolishment of 529 plans. Families could still defer paying taxes on the plans as the earnings grow, but that ends once they start drawing down the account, according to the White House.

The administration argues that the larger goal is to simplify the jumble of education tax credits to make college affordable for more Americans, and the tax cut for middle class families would be $50 billion. The president wants to expand and make permanent the American Opportunity Tax Credit, which provides families up to $2,500 a year for the tuition, books and supplies.

“Overwhelmingly, this plan provides much more of a tax incentive, much more assistance through the tax code to go to college than anything that we have in our system now,” said Jason Furman, chairman of the White House Council of Economic Advisers, at a meeting on Friday with Bloomberg reporters and editors in Washington. “The current 529 is very tilted towards the upper end, and a variety of research has shown it’s ineffective in serving its goals of getting people to go to college who wouldn’t otherwise have gone.”

But Kantrowitz went so far as to say the proposal could be characterized as a broken promise. “People saved money in 529 plans because of the expectation that the favorable tax treatment would continue,” he said. “Imagine the uproar if the federal government were to begin taxing Roth IRAs.”

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