Obama's Blues for the Middle Class: Let's Tax Withdrawals From 529 College Savings Accounts

NEW YORK (MainStreet) - The Obama administration's fight for the middle class, trumpeted in last week's State of the Union address also includes an all-out war on 529 College Saving plans and people who are saving for their kids' education.

Savers currently put after-tax dollars into a 529 account which are run mainly by states. It grows tax free and money is withdrawn tax free when its time for school. Obama wants to end tax-free withdrawals from these accounts, beginning with new contributions, supposedly to eliminate a tax break for the wealth. His intentions were announced in the State of the Union Fact Sheet, a little-known document released on January 17, three days before his speech to Congress.

Observers from the Left and Right immediately cried foul-charging that Obama's plan would penalize those that should be helped-and were already trying to help themselves.

According to the Washington, D.C.-based College Savings Foundation, almost 10% of accounts are held by families with an income below $50,000 per year. Over 70% are owned by families with incomes below $150,000.

A survey produced by SavingForCollege.com finds that 59% of those who open a 529 account did it mainly to get federal tax benefits.

"The President claims that 529 savings plans only help the wealthy, but we couldn't disagree more," said Kathryn Flynn, content director at SavingForCollege.com. "Many hard working families are currently taking advantage of these benefits to help ensure a solid future for their children. In fact, we found that 73% of SavingforCollege.com visitors that were planning to open a 529 account in the next 12 months had household incomes of less than $150,000."

Those who support Obama's plan say it targets the wealthy.

"The intent of the tax incentives for education is to encourage college-going via increased saving," said University of Michigan economics professor Susan Dyanrski, who has provided Senate testimony on education and tax incentives. "Just about everyone with an income over $200,000 goes to college anyway. The breaks could be limited to those for whom they are an incentive, rather than a windfall."

Is this an attempt to implement tax policy on the backs of college students? 

Obama is looking to use the estimated $2 billion in revenue from taxing the 529s to raise the American Opportunity Tax Credit, a $2,500 write-off for low- and middle-income families paying college tuition. No one has yet accused the administration of trying to rob Peter to pay Paul.

Before the Bush 2001 tax cuts, money withdrawn from a 529 plan was taxed as ordinary income. After 2005, legislative changes have gradually driven up the age threshold at which a borrower could be taxed on these benefits. The Tax Increase Prevention and Reconciliation Act of 2005 raised the age from 14 to 18 and the U.S. Troop Readiness, Veterans' Care, Katrina Recovery and Iraq Accountability Appropriations Act of 2007 raised the age threshold from 18 to 19-24 for full-time students. Now Obama apparently wants to turn back the clock and tax 529s at pre-2001 levels.

"The proposed changes would have a chilling effect on contributions to these college savings plans," said Mark Kantrowtiz, senior vice president and publisher of Edvisors.com, a provider of intelligence on college financing. "The President's proposal would not really be reverting the tax treatment back to the way things were in 2001; it would be much worse. Most of the earnings would be taxed at the parent's rate, not the student's rate."

"Because the earnings portion of distributions from college savings plans would be reported as taxable income on the beneficiary's federal income tax return, the increase in income would affect eligibility for need-based financial aid on the subsequent year's Free Application for Federal Student Aid (FAFSA)," Kantrowitz said. He added that eligibility for needs-based financial aid will decrease by as much as $4 billion per year.

Some observers believe that the worst thing about Obama's plan is that by scraping the tax break, it eliminated the defining feature of these accounts by fiat. Since taxation of the 529s can't be implemented without an act of Congress-one that would never pass the House of Representatives-what was the White House thinking?

"Supporting a proposal to tax college savings plans is political suicide for Democrats and Republicans alike," said Kantrowitz. "It would be like a proposal to tax Roth IRAs."

--Written by John Sandman for MainStreet

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