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01-6: Call it the Twilight Zone
Thursday, July 12th 2001
For most people the word "sunset" evokes a beautiful image, a vision of the sky exploding into color, turning deeper shades of red, and ultimately fading to black. A few hours later and the sun shines brightly again.
Leave it to the government to turn a sunset into something ugly.
The new tax law that provides additional incentives for college savings, along with other tax cuts, will "sunset" after December 31, 2010. In the language of Washington this means that, unless a future Congress decides to do something about it, we lose the tax benefits that begin in 2002, chief among them your ability to take tax-free withdrawals from a 529 plan.
How should we react to this situation? Are 529 plans useful for our 12-year old but not for our 2-year old? Is there any way we can plan for the loss of tax exemption nine years down the road when we are making our investment decisions today?
Plan for the worst, and hope for the best.
The worst is that the federal government does nothing, and 529 exemption drops over the horizon at the end of 2010, never to return. Your accumulated and future 529 earnings are taxed to your account beneficiary when withdrawn. Unfortunate? Yes. Catastrophic? Not really. Remember, under the "old" rules, with earnings taxed to the beneficiary and full availability of the Hope and Lifetime Learning credits, you still can save a lot of taxes.
You'll also look for ways to achieve the least amount of tax as the sunset draws near. Inspiration comes from a recent case in which the family of a woman on her deathbed saw a way to save a chunk of estate taxes by having her pay for her grandchildren's school tuition several years in advance. The IRS said this was okay. Prepayment of college tuition in 2010, when withdrawals are still exempt from income tax, might make sense for some 529 account owners.
Now let's be more realistic. What are the odds that our elected representatives will just stand around doing nothing and allow the tax code to revert to pre-2002 rules? Very slim, I think. The resulting mess would be too unpalatable for even the most partisan member of Congress. And imagine the reaction of millions of parents depending on their college savings accounts and prepaid tuition contracts.
The best result is that the 529 tax break is made permanent. House Republicans have already submitted several bills that would extend some or all of the provisions of the Tax Relief Act. A blanket removal would add a few hundred billion dollars to the $1.35 trillion cost of the recent tax cut. The 529 piece is just a small piece of that additional cost, according to Treasury.
Of course, Congress could come up with something short of making the exclusion permanent. I would not be surprised to see any of the following:
- Permit the exclusion to expire, but "grandfather" the earnings built up in a 529 account before 2011. Only earnings generated after 2010 would be subject to federal income tax.
- Make the exclusion permanent but take the opportunity to impose additional requirements, such as an income threshold on taxpayers.
- Approve a limited exemption, perhaps excluding all of the distributions from a prepaid tuition plan (after all, you are really not "earning" anything above tuition inflation), but excluding only the portion of distributions from a college savings plan that represents inflation. Excess earnings would be subject to tax.
- Approve "rollovers" from 529 plans to tax-free Education IRAs. Currently, rollovers only go one way, from EIRAs to 529 plans. Since EIRAs were tax-exempt prior to the 2001 Tax Relief Act, permitting rollovers in the other direction would serve to lock in the tax-free earnings. Of course, the states would not be too happy to see their 529 assets flow out to Education IRAs.
The longer we go without a final answer, the more likely it is that one of these watered-down alternatives will take hold. Whatever is the right answer, our government should put an end to the guesswork and take care of it now.
» 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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