Despite uncertainties, stick with 529 plan

Question

Dear Joe, Is it true that in 2010 the tax benefit will have expired on 529 college accounts? -- Mona

Answer

Dear Mona,
As the law stands, the federal tax exclusion for qualified withdrawals from a 529 plan will expire at the end of 2010. Beginning in 2011 -- if nothing changes between now and then -- the earnings portion of the withdrawal will be reported as taxable income to the student-beneficiary. This treatment will apply regardless of whether the earnings accrue before or after the expiration date.

Naturally, this situation might cause some parents to think twice before deciding to make a 529 plan the primary college savings vehicle for a child who will not have graduated from college by 2010. But I don't think it should dissuade you, and I'll give you two reasons why I feel this way:

The first is that I fully expect Congress to do the right thing by passing a bill to make the tax exclusion permanent. Families deserve this protection from ever-increasing college costs. Why should Uncle Sam get a slice of the earnings when those earnings are needed just to keep up with tuition inflation? I should note that the federal budget impact of making the 529 exclusion permanent is minimal, according to government projections.

Even if the argument for the 529 tax exclusion is not sufficiently persuasive to get Congress to move, consider that legislative action will be necessary to retain several other important "fixes" made to 529 plans back in 2001. For example, the private-college prepaid tuition plan, named Independent 529 Plan, will no longer be a 529 plan after 2010, unless Congress passes a bill to preserve its status. I can't imagine the private-college lobby allowing that to happen. Any bill touching on 529 plans that moves through Congress is almost certain to contain the tax-exclusion provision.

In fact, bills have already been introduced in both the Senate and the House of Representatives that would accomplish these goals. The Senate bill (S. 1112) has more than 60 sponsors and co-sponsors, and the House bill (HR 2386) also has wide bipartisan support. There is every indication that the president would sign such a bill if it lands on his desk. You can help this effort by contacting your elected representatives in Washington.

Now for my second reason not to back away from 529 plans: Even the worst-case scenario provides a favorable result for most families. If withdrawals lose their tax-free status in 2011, the earnings become reportable to the student. This means the income is shifted off your return and onto theirs. Most full-time students will pay little, if any, taxes on the 529 withdrawals. They tend to fall into low-income tax brackets. And many will be able to offset the taxes generated by 529 withdrawals with a Hope Scholarship credit or a Lifetime Learning credit that would otherwise go unused. (Parents above a certain income level are not able to claim the credits on their own returns.)

The math gets a little tricky in proving my second reason to stay with 529 plans in the face of the 2010 "sunset." I suggest you run it by your own tax professional. Better yet, Congress might save us the trouble by simply passing 529 tax permanency.