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529 E-ditorials

04-1: No good deed goes unpunished
Joe Hurley
Tuesday, February 24th 2004

Call me paranoid, but I get the feeling the federal government doesn't particularly care for Section 529 savings plans.

President Bush's fiscal 2005 budget proposal contains a slew of provisions that would significantly diminish a 529 plan's advantages. Chief among them is a change in the account owner/beneficiary relationship. Instead of truly owning the account, you would become a mere custodian, with a duty to act on behalf of the account beneficiary. Other proposed changes include mandatory distribution upon the beneficiary's 35th birthday, and a new higher penalty on certain nonqualified withdrawals. For example, a child with $200,000 in her 529 account who uses the money to start a software company, instead of going to college and graduate school, would owe a penalty of at least $60,000. (More details can be found HERE.) The Treasury Department claims these reforms are needed to prevent individuals from abusing 529 plans for purposes other than college.

As if all that isn't enough to quell enthusiasm for 529 plans, the Bush budget for the second year in a row is calling for a new Lifetime Savings Account (LSA) that would offer greater investment flexibility than 529 plans, and would permit tax-free withdrawals at any time for any purpose. Annual contributions would be capped at $5,000 per individual account holder ($20,000 total for a family of four).

States are justifiably proud of their 529 plans. They've helped millions of families start saving for college expenses. But let's face it - the supremely attractive LSA will make it difficult for some 529 plans to continue to operate. The Treasury Department is attempting to mollify the states by suggesting they offer LSAs alongside their 529s. Assistant Treasury Secretary Pamela Olson, with true Hamiltonian fervor, was even quoted in one newspaper as predicting that states will eventually substitute LSAs for their 529s.

The anti-529 backlash in Washington doesn’t come as a complete surprise. The IRS has struggled for years to develop loophole-tightening rules and regulations. Furthermore, some feel the states have gone too far too fast in turning their tuition programs into conventional investment products. I recall a member of the Senate Finance Committee staff speaking before an audience of state officials and program managers in 2001 and hinting at the challenge these programs might someday face from the feds. “When we passed Section 529 in 1996,” he said, “no one anticipated that 529 plans would become a bunch of mutual funds in a tax-free wrapper.”

But let's not schedule the 529 funeral yet. The federal budget deficit and public policy concerns make the odds of LSA passage uncertain at best. And there will be increasing recognition that Treasury's proposed solution to 529 "abuse" is worse than the problem. Meantime, it's more important than ever to either continue with your current college savings strategy or kick one into high gear. In fact, if you've been delaying your decision to get into a 529 plan, it may make sense to get in now, since the Bush proposal would exempt "old" 529 accounts (those started before the new law is signed) from the new rules under a "grandfathering" clause.

Of course, the best part of the budget proposal for 529 plans is the elimination of the 2010 sunset, thus making permanent the tax exclusion on withdrawals used for college. Now that's what I call a good idea.

» 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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