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03-2: April Fool’s 529
Joe Hurley
Monday, March 31st 2003
“We didn’t write the law; we only interpret it.”
That excuse won’t placate many parents, grandparents, professional advisers, and tax preparers in Tennessee who are being smacked across the forehead by a new pronouncement, issued by the Tennessee Department of Revenue, concerning tax treatment of state residents investing in out-of-state 529 savings programs. The notice may be dated April 1, but believe me, it’s no joke.
Because Tennessee income, gift, and inheritance taxes don’t follow federal treatment as described in Section 529 of the Internal Revenue Code, residents of that state have been asking tough tax questions. Now the agency in charge of collecting taxes has supplied the following answers:
- Interest and dividends received by the non-Tennessee 529 plan on its investments are taxable to the Tennessee investor. It’s not clear from the notice whether the income is to be reported each year as it is received by the program fund or deferred to the year of distribution. It doesn’t matter whether or not the money is used for college.
- Contributions to non-Tennessee 529s are not gifts under Tennessee’s gift-tax laws. And distributions on behalf of the beneficiary are gifts, unless they are for the payment of tuition. For federal gift tax, the reverse treatment applies.
- A non-Tennessee 529 account is included in the deceased account owner’s estate for purposes of the state inheritance tax. Under federal rules, a 529 account is excluded from the account owner’s taxable estate.
But the Tennessee plans may not be the best choice for every Tennessee investor. Non-Tennessee 529 plans offer different investments and features that may be more appropriate for some. And investors relying on the advice of financial advisers face a predicament because Tennessee 529 plans are not available through commission-based brokers. Since three-quarters of all 529 contributions are initiated by brokers, it’s fair to say that a number of Tennessee residents (along with their advisers) will feel unfairly discriminated against.
Ironically, the April Fool’s Day joke may be on the Tennessee Department of Revenue. The tax treatment as outlined is essentially unenforceable; the income they intend to tax requires information that’s impossible to gather. Most 529 plans do not maintain records identifying the source of account earnings as interest, dividends, capital gains, or anything else. Even if they did, none of the 529 plans issue statements reporting these details on an annual basis. So what is an honest taxpayer, or his or her professional tax preparer, to do?
Even those of us who don’t live in Tennessee should care about this development because our states might eventually do something similar. Some already have. New York’s tax agency recently re-interpreted its 529 law to the detriment of investors in its own 529 plan. Illinois passed protectionist legislation last year that intentionally discriminates against out-of-state 529 plans. I would even be a little nervous if I were a 529 investor in the beautiful state of New Hampshire; it has an interest-and-dividends tax much like Tennessee and appears to have adopted a similar position with respect to “non-NH education plans.”
States that offer 529 tax incentives should be commended for encouraging families to save, even when the incentives are restricted to the in-state program. But they should also be questioned on what public purpose or good they are serving by penalizing well-intentioned parents and grandparents seeking to exercise some discretion and save in a program other than their own state’s. Without some valid response alleging public good, those states and the responsible officials should be prepared for criticism.
» 05-4: The 529 marshals have arrived - 08/30/05
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» 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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