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529 E-ditorials

02-5: Wanted: One Beautiful Mind
Joe Hurley
Thursday, June 6th 2002

Perhaps John Nash can explain better than I can what is going on these days with the states and their 529 college savings programs. As you may recall from the movie "A Beautiful Mind" (and the outstanding book of the same name written by Sylvia Nasar), mathematician Nash won the Nobel Prize for his study of "game theory", or the investigation of how rational decision makers act when competing for similar interests.

Game theory might help us understand the movement in some states to revisit their tax rules in an effort to close the barn door on residents who want state tax benefits for their 529 plan investments but don't particularly desire using the state's own 529 plan.

Here is the way the game works. First, the state decides to offer an upfront tax deduction to residents making contributions into the state's 529 plan (23 states now offer this). That can be a wonderful benefit and a powerful inducement for a family to begin using the 529 plan. But then, the state discovers that some of its residents are planning to take advantage of the deduction even when their money ends up in another state's 529 plan. "Rollovers" can make this strategy possible. Finally, the state imposes new rules that require prior tax deductions to be "recaptured" anytime that the contributions are moved out of state.

Consider, for example, recent developments in New York. The NYS Department of Taxation and Finance ("DTF") now takes the position that deductions are subject to recapture upon rollover, despite issuing a formal notice three years ago that interpreted New York law to require recapture only on non-qualified distributions, and not on rollovers. Nothing in the law itself has changed. It is simply the DTF doing a 180-degree turn.

It is not only the front-end deductions coming under fire. Another version of the game involves the back-end exclusion of qualified earnings in states that may not like the idea of residents placing their college savings dollars with out-of-state 529 plans. You may recall that many states adopted exclusion of qualified withdrawals from state income tax when developing their 529 plans. In the vast majority of these states (with notable exceptions in Arizona, Colorado, and New Jersey) the exclusion was limited to withdrawals from the in-state 529 plan.

Then along came the 2001 federal tax law changes offering federal tax exclusion for qualified withdrawals, and all of a sudden the rules of the game changed for the states that piggyback on the federal tax code. Residents of these states can now exclude withdrawals from state tax no matter which 529 plan the withdrawals come from.

The Illinois General Assembly doesn't like that. It has passed "Oh No You Don't" legislation that would specifically require an add-back on an Illinois personal income tax return for earnings withdrawn from out-of-state 529 plans. Only the qualified withdrawals from Illinois' own 529 plans would remain fully excluded. The measure appears to have a good chance of being signed into law.

(A few other states-e.g. Pennsylvania-do the same thing being proposed in Illinois, but in those other states it happens because their tax laws do not conform to the federal definition of income which now excludes qualified 529 withdrawals. Illinois would be the first state to specifically override its general conformity in an effort to zap residents who place their college savings outside the state.)

It could get even worse for the 529 gamer living in Illinois. The proposed changes would also remove Illinois' upfront state income deduction for any contributions to its Bright Start 529 program that represent rollovers from other 529 plans. This so-called "virgin contribution" rule is reportedly being considered in some other states as well.

Finally, there is the Maryland saga. In a stunningly pro-investor move, the Maryland state legislature passed a measure earlier this year by an overwhelming margin that would permit Marylanders to claim a state income tax deduction even for contributions to out-of-state 529 plans. This would have made Maryland the first to remove its border restriction on deductions. Alas, the Governor of Maryland, realizing that any rational game player would not be so foolish as to offer a benefit that so obviously detracts from the state's own 529 plan, vetoed the bill before becoming law.

Now I have always been of the opinion that it's not my business to tell the states what they should and should not be doing with their income taxes. The state taxpayers, not I, are the ones footing the bill for generous incentives being offered to college savers, and they should be the ones to judge.

And I can't really blame the states for coming up with rules designed to favor their own 529 plans. Whether for budgetary purposes, personal pride, political gain, or contractual relationships with their outside program managers, maintaining the strength of a 529 plan can be an important and valid objective. And we all know it's getting more competitive out there among the states as out-of-state 529 plans increasingly vie for everyone's college savings.

But from the consumer perspective, the overall goal of helping families save for college in the most effective way possible is diminished by the protectionism being built into so many of the 529 plans these days. It seems to me that everyone would benefit if the states cooperated with their incentives, rather than use them as competitive weapons.

Please, Mr. Nash, let us know if there is any hope of that happening.

» 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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