The presidential primary season may have been sidelined due the ongoing Coronavirus crisis, but one idea generated on the Democratic side of the aisle – a tax on financial transactions – will have an impact on college savings plans.
A financial transaction tax charges a percentage of all securities transactions, such as stock and bond trades, including those that occur within mutual funds and exchange-traded funds. The financial transaction tax applies when you buy and when you sell the securities.
While the transaction tax plans from the major Democratic party presidential contenders differ, there is some commonality on the major financial transaction tax proposals.
For example, the typical tax rate linked to the proposal clocks in at 0.1% of the transaction costs. That means if you buy or sell 100 shares of ABC Company stock at $10 per share, the transaction tax would amount to $1.
Some plan proposals go higher. For example. Sen. Bernie Sanders (D-Vt.) calls for a financial transaction tax of 0.5% on stocks and 0.1% on bonds.
Impact on College 529 Plans
Given that college 529 plans invest heavily in the financial markets, a financial transaction tax, if enacted) could pop a dent into American’s college savings plans.
Consider a family who saves in a 529 college savings plan (or in taxable accounts). Just by investing the money in either type of account, the family would pay the tax at least twice – once when they invest and once when they sell the investments.
As with any government tax on transactions, the more of those transactions you make, the more taxes you pay.
Case in point. Let’s say you invest $250 per month for 17 years at an annual 6% return on your investment. Tack on the 0.1% financial transaction tax, and you’ve earned $88,749 in total savings, but you’ll owe $51 from the financial transaction tax on your initial investments, along with another $89 when you sell your investments.
That’s not all. When you engage in asset allocation with your college 529 savings plan (i.e., shift portfolio assets around to maximize your investment returns), you’re conducting more trades and accumulating higher taxes on those transactions.
That impacts your total taxes owed due a financial transaction tax in two ways:
Via asset allocation strategies. Using the example cited above, an asset allocation strategy in your college 529 portfolio impacts about 25% of your entire plan balance when you’re done.
You sell your riskier stocks as you grow closer to your child attending college and you buy conservative bonds and/or bond funds to protect the money you’ve already accumulated in your 529 portfolio.
Ultimately, the financial transaction tax will be applied to approximately 50% of the final balance of the 529 plan, spread out over the 17 year life of your 529 college savings plan. In this instance, you’re adding another $44 in financial transaction taxes from the additional 529 plan trading you’ve done to properly allocate your plan assets as you go along.
Via the buying and selling of stocks and bonds within each of the 529 plan's portfolios. The way the financial transaction tax is modeled, the more you trade stocks, bonds and funds within your college 529 plan, the more you’re reducing your own plan’s return on investment.
That amount will depend on whether the portfolio is managed in a tax efficient manner, with less frequent trades or with more frequent trades. It will also depend on whether the low-risk portion of your portfolio is invested in bonds or cash.
For example, actively managed portfolios are likely to incur a greater financial transaction tax than passively managed portfolios, since there’s more trading involved in managing that portfolio.
Either way, there’s enough trading “churn” within investment portfolios like college 529 plans to turn over the entire investment at least once a year. Assuming a middling amount of trade churn, this would yield financial transaction taxes of about 0.7% of your final college 529 plan balance, or about $620 when your child is ready for college and you start withdrawing cash from your 529 plan.
All told, and using the examples listed above, the 529 plan holder will pay an additional $804 after the implementation of a financial transaction tax. That’s equivalent to 0.9% of your overall plan balance over the course of the 17-years you’ve saved with a college 529 plan.
The Takeaway on a Financial Transaction Tax and College Savings
Collectively, a financial transaction tax on 529 plans would cost U.S. college savers
$19 million, or the equivalent of a year of full in-state tuition for 1,900 students at a public university, according to a recent Modern Markets Initiative study entitled A Study on the Effects of a Retirement Tax/Financial Transaction Tax on Retirement Security, College Savings and University Investments.
“Our analysis shows that a financial transaction tax that has been presented by some politicians in Washington as a ‘pound of flesh from Wall Street’ is in reality, a severe retirement tax on American savers from all income levels,” said MMI CEO Kirsten Wegner.
“It is truly ironic that the tax would actually hurt the very same people that the proponents of the tax aim to help,” Wegner said.
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