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529 E-ditorials

03-3: Think again, 529 naysayer
Joe Hurley
Tuesday, June 24th 2003

You may have read that 529 plans are less attractive in the wake of recent tax cuts that reduce the tax rates on certain stocks and mutual funds. "Why even bother with 529s," suggest some, "when the tax on dividends and capital gains is now only 5% or 15%?"

The reality is that no tax is still better than some tax, and 529 plans remain the most powerful and flexible vehicle available for no-tax college savings. Believe it or not, the 2003 tax cuts on dividends and capital gains actually provide a boost for 529 plans. Here's why:


The dreaded sunset

The 529 tax exclusion is scheduled to expire at the end of 2010. If that happens, distributed earnings become taxable to the beneficiary in 2011 under the same rules that existed before 2002.

In my opinion, that won't happen. The new lower tax rates on dividends and capital gains practically guarantee that Congress will extend the 529 tax exclusion beyond the year 2010 (or, better yet, make it permanent). Since 1996, Congress has remained steadfast in supporting favorable tax treatment for college-bound families utilizing 529 plans and Coverdell education savings accounts. The continuing tax exclusion makes more economic and political sense now than ever before.

Interestingly, the new tax rates on dividends and capital gains are scheduled to expire at the end of 2008, two years prior to the 529 sunset. Who knows what the federal budget will look like over the next five years, or what the appetite of Congress will be to extend those breaks? If you decide to take advantage of the low capital gains rates by selling your appreciated investments before 2009, what will you do with the proceeds? If you have college expenses ahead of you, a 529 plan will still be looking mighty attractive.


The state advantage

The federal tax cuts don't help when it comes to state income taxes. States generally provide no preference for dividends and capital gains, and, in fact, many are now increasing their income-tax rates. But with very few exceptions, states exempt qualified withdrawals from 529 plans. Furthermore, twenty-five states and the District of Columbia now give their residents a tax deduction or credit for 529 contributions, and several more states provide low- and moderate-income families with matching contributions or scholarships through their 529 plans.

States appear intent on maintaining, and in some cases, increasing the incentive to invest in their 529 plans. The federal tax cuts will provide added impetus. Sure, a few have recently attempted to punish their residents using 529 plans from other states, but that particular trend seems to be reversing as state legislatures revisit the issue.


Stock market strength

If lower tax rates on dividends and capital gains succeed in stimulating the economy, boosting investor confidence, and raising stock prices, just about everyone wins. The market seems to have responded rather well so far. If money starts coming out of the mattress, emboldened investors will be looking for investments providing the best returns within defined risk parameters. Income taxes will remain the biggest expense for many investors putting their money into stocks, bonds, and mutual funds. As investors begin to see gains, not losses, the tax advantage of 529 plans will become even more compelling.

Even the prepaid tuition plans have much to gain. High tuition and a lagging market have placed a severe financial strain on many of these programs. A recovering economy and advancing market should serve to moderate tuition increases and boost program reserves.


Conservative investments

The new tax cuts do little to help risk-averse college savers who prefer safe, interest-paying investments. Tax rates are still high for ordinary income. But you can now find very attractive conservative investments in many 529 plans. Guaranteed options, stable value investments, CollegeSure® CDs, and inflation-protected treasury securities are all available. Many options will adjust if interest rates go up but won't drop below a floor of two or three percent. In many cases, there is no minimum investment period. These attributes are clearly superior to taxable money market accounts or certificates of deposit.


Financial aid

Under the federal financial aid formula, parent-owned accounts in a 529 savings program have very little impact on student eligibility for need-based aid. Is any other college-specific investment treated more favorably? I don't think so. There is reason to believe that Congress will soon grant similar treatment to 529 prepaid programs (they suffer under the current rules).

If you shift taxable investments to your child to capture income-tax savings, you may discover too late that you have severely compromised his or her need-based aid eligibility. Student-owned assets (including Coverdell education savings accounts) are assessed at a much higher rate.

Taxable investments in your own name can hurt as well. The "simplified EFC" allows many low- and moderate-income families to exclude all assets from the aid formula. How many parents realize that just one measly dollar of capital gains can disqualify them from using the simplified EFC? Section 529 plans do not produce capital gains.

Sure, private colleges have their own ways of looking at 529 plans when doling out their own funds. The best advice is to ask the colleges about their policies when your son or daughter is filling out applications. Think about changing your 529 account beneficiary to another family member, if it helps your case.

Bottom line

The tax cuts will help all families saving for college. But 529 plans will still be tough to beat.

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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