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Taxing 529 College Savings Plans: A Plan That Went Awry

Credit...Robert Neubecker

Earlier this week, we were treated to a truly odd Washington spectacle. Just over a week after making a set of pointed policy proposals that had little chance of getting to Congress and surviving intact, President Obama made front-page news by changing his mind about one of the smaller ones.

Just to be perfectly clear, what he announced was this: A small thing that probably wasn’t going to happen, which had been part of a big thing that probably wasn’t going to happen, definitely wasn’t going to happen now because he didn’t really want it to happen anymore.

How could a plan to remove a tax break for saving money for college in 529 plans — one that has been in formal existence for only 19 years — go so awry? The answer lies with feelings, not just money.

But the discussion does start with a growing mountain of dollars that families have squirreled away, so let’s begin our story there. As of Sept. 30 last year, $240.7 billion was on deposit with 529 college savings plans, according to Strategic Insight, most of it in plans that are run by states. While some plans let you buy discounted tuition credits for future use, most people today shovel the money into mutual funds, cross their fingers and hope that it grows. In the last several years, it mostly has.

Anyone, of any income, can contribute money. Many states give a tax credit or deduction when you make a deposit. But the big win for families, especially affluent ones who can afford to put a lot away each year, is the fact that the earnings grow free of taxes over time. Then, you can take all the money out without paying capital gains taxes as long as you use the money for approved education expenses.

This is what the president hoped to change. He didn’t just want to hit families with capital gains taxes; he wanted to charge the ordinary income tax rates that are much higher for affluent families, though he planned to grandfather existing 529 balances.

What kind of tax hit might that have added up to for families who are just about to start 529 accounts themselves? I asked Vanguard to run some numbers. Parents who deposited $5,000 a year over 18 years and got a 6 percent return each year on their money would eventually end up with $179,140.48 that they could draw on during college.

That’s a lot of tax-free growth, so it’s only natural that it might have become a target. A family in the 25 percent tax bracket would have paid $22,285.12 in income taxes on that growth under the president’s plan if they withdrew it over four years, according to Vanguard. A household earning enough to be in the 35 percent tax bracket would have paid $31,199.17.

That’s a lot of money, but the president and his advisers knew that it takes a lot of money to grow a pile of money in the first place. His team clearly figured that people who can set aside that much could surely part with some of it to pay for different tax breaks that are solely for families who have a lot more trouble affording college.

It is true that they could. It’s also true that the piles of money from affluent families have helped lower administrative costs in the 529 plans, which used to be much too high. Everyone benefits from that, including people with lower balances. Moreover, if the wealthier families abandoned the plans because of tax law changes, many states would close down their plans. That would discourage people with less from saving what they can.

But the conversations that went on among families between the time the president announced his plan, which took most people by surprise, and when he abandoned it were much more about feelings than they were about the dollars. The dialogue fell along two lines.

First, people have a visceral, resentful, anxiety-ridden reaction to the sticker price of college these days. Relatively quickly in this country, we’ve gone from college being something that students work their way through and pay for with part-time jobs to something that parents save a bit for and then pay for out of current income to something that will cost $275,000 for a freshman at New York University today who pays full freight for four years.

Most people will end up paying nothing of the sort. Their children will go to community college first or spend four or five years at a state university. They will qualify for need-based aid at the college of their choice. Or they’ll get merit aid or other discounts off the rack rate, even if their family doesn’t need the money.

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Credit...Carl Richards

But parents don’t know any of that for sure when their children are younger and they are frantically trying to put away something for their college educations. The future is uncertain, and the past, where undergraduates could wait tables and pay their entire tuition bill, seems like a golden age that they were born too late to live in. As Nancy Farmer, who runs a 529 plan that helps people nationwide save for private colleges and universities, put it, college has all of a sudden become something that we have to pay for over decades, with regular savings or debt, like retirement and buying a home. That is an enormous change, and it stings.

What also stings is that even at $200,000 in annual income, it’s not easy to save enough to put two children through college while also covering daily expenses, the children’s enrichment and ample retirement savings, let alone write a $65,000 or even a $25,000 annual college check out of current income. There is no reason at all to shed one, single tear for people who are so fortunate, but it is also not a bit surprising that they would find the president’s five-figure tax grab upsetting. Especially if they earn just enough so that they do not qualify for any need-based financial aid.

Which brings us to the second part of the dialogue, which has more to do with animal behavior than the economics of higher education. Tax proposals come and go, but when a parent senses that somebody is trying to pick the pocket of their toddler’s onesie, it feels downright dirty when you want nothing more than to protect and provide for your offspring.

“I think what they failed to recognize is how proud parents are of their decision to set aside money for college,” said Joe Hurley, the founder of Savingforcollege.com, which helps parents sort out the absurdly confusing array of 529 plan offerings. “It isn’t money for a fishing boat. It’s money that they are sacrificing. Anything that threatens that is essentially telling them that they did the wrong thing when they felt like they did the right thing.”

It will most likely be a long time before somebody tries to mess with 529 plans again. That may not be the right policy result, but that is no matter for a personal finance column. The tax breaks live on, and most people should try to take advantage of them.

Tempting as it is to rubberneck at the president’s miscalculation, it’s really beside the point. Politicians misjudge their constituents all the time. Whatever.

The real problem lies with something else the president was hoping to effect in the education arena, which bedevils the world of personal finance generally: complexity. Because when everyone has forgotten all about this strange little 529 episode, we will still be left with our grab bag of 401(k)’s, 403(b)’s, 457s, I.R.A.s, Roth I.R.A.s, S.E.P. I.R.A.s, 529s, health savings accounts, health care flexible spending accounts, dependent care accounts, pretax transit accounts and the like.

Managing your money should not be a full-time job. But with each passing year, it feels more like that, and that’s if you’re lucky enough to have money left over to funnel into all of these places in the first place. So if you’re looking for something to get upset about, be angry about that.

Twitter: @ronlieber

A version of this article appears in print on  , Section B, Page 1 of the New York edition with the headline: Taxing 529 Accounts: A Plan That Went Awry. Order Reprints | Today’s Paper | Subscribe

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