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Let’s Discuss Obama’s 529 Taxation Plan

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I've been reading a number of articles on President Barack Obama's proposal for 529 plans. Some of the articles I've read include: The Slate, Vox, and Market Watch.

I watched the State of Union in part to hear from the horse's mouth what this was all about. Unfortunately, the address was so general covering so many topics that it wasn't specifically addressed.

The proposal, as best I can tell, is the following:

Currently, savings for college in 529 plans are not taxed when they are withdrawn. The proposal is to tax 529 plan withdrawals as income as using that money to provide free community college. I understand that this taxation was the way it used to be in the past. In that respect, I can't say it is a new tax. However, it feels new to me, because I was too young to know or care about it the first time around.

The Slate article thinks this is a great idea. The reasoning was that the "47 percent of families that had [these college savings plans] earned more than $150,000 per year." The author concludes, "I generally don't think that our higher education policy should be geared toward helping families that earned $150,000 or more send their kid to the most expensive possible school."

I thought that was an interesting way to spin it. There's nothing anywhere in 529 Plans that discuss the most expensive possible school. I'm not sure that anyone would use that logic in choosing a school. I would imagine that people who make $150,000 or more are fairly intelligent and would put more thought into college education than just, "What is the most expensive possible school? That's where junior is going!"

So let's look at this logically for a minute.

Studies show that 36% of Americans have less than $1000 in savings. Let's presume that they aren't socking money away for college. These people for whatever reason (either hardship or just their own spending habits) don't appear to be savers.

Next up you have the people maxing out their retirement accounts. Personal finance experts correctly point out that you can't get a loan for retirement, so it wisest to always save money there first. Student loans will be an option for children. Presumably a large number of people make the smart choice here and funnel money towards retirement.

So who are the 529 Plan savers going to be? They are most likely to be the educated people who have already maxed out their retirement tax benefits. That's likely to people who have higher incomes. I point this out, because it shouldn't be a surprise that many of the people saving in these plans have more income. It's the nature of the beast when it comes to saving for college.

Here's the thing that really irks me though... the change to tax withdrawals at ordinary income sends the message to people, "Don't save money for college." It would kill 529 Plans. Why would anyone put after tax money into an account that is subject to withdrawal penalties and taxation at ordinary income in withdrawal? I could open an account with any brokerage and put after tax money into a balanced fund and withdraw it at a (very likely) cheaper long-term capital gains rate.

A 529 Plan would offer worse taxation and the potential of penalties. Some states have tax incentives, but most of them are very minor and certainly wouldn't match with the negatives.

The other thing that irks me is that it feels like a penalty to those who do right thing and live within their means, plan ahead, and utilize a tax-benefit that can help them give their children something they didn't have. It might take away the chance for those blue collar workers to send their kid to Princeton. Meanwhile, the high income people are going to have no problem affording it. Thus the rich get richer by being able to send them to the best schools and the lower class loses an avenue to rise up.

I don't think the 529 Plan is the biggest tax break in the world. It essentially puts saving for college on same footing as the Roth IRA when it comes to saving retirement. Changing the 529 Plan taxation to fund community college for all feels like changing the Roth IRA taxation to fund Social Security. I'm not against community college for all or Social Security. I'm for incentivizing people to save money for college and retirement.

I'm not one to just complain, so I'll take a crack at a solution. How about a Free Federal Accredited Online College (FFAOC)? Why can't the government make a University of Phoenix Online and offer classes and curriculum to everyone free of charge? Instead of trying to come up with the money to physically send tens of millions of kids to thousands and thousands of different college for two years, do what scales. Build and maintain one system that can support tens of millions students.

Please don't give any Obamacare technology jokes, hundreds, maybe thousands of companies in Silicon Valley scale at this level. The most question I can think of is whether companies would take the FFAOC degree. That can easily be answered by having a grading system to go with the degree, just like we have now with graduating Harvard Cum Laude. The classes could be as easy as any community college or as difficult as Stanford depending on how the government designs the curriculum. Personally, I'd like to see people have all options.

Is this a perfect solution? Of course not. People shouldn't spend all time learning in front of a computer. It clearly wouldn't duplicate the experience of an on-campus university. However, let's remember that this is a free option. It's a way for anyone with a computer and an internet connection to get a college-level degree in their spare time. If you want to go to community college, you can still pay for it. If you want to go public or private 4-year schools you can pay for that too.

If the government did create a FFAOC, I think many might prefer that over traditional colleges. When I was in high school, I was given the opportunity to take a class for real credit at a local university. I jumped on the opportunity. I would hope that if my sons have the same option to take some free college classes online and get credit they jump all over it as well. It would be a really interesting way to solve the student debt problem in the country. A majority of students might find that the FFAOC fulfills all their needs. Others might find that the FFAOC can give them some credits so that they can get a degree from MIT in 2 or 3 years.

So let's create a system that scales and boosts the education for every American who wants to do the work... and let's keep incentives in place for those who want to save money to pay for premium education.

Posted on January 21, 2015.

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9 Responses to “Let’s Discuss Obama’s 529 Taxation Plan”

  1. Captain Betty says:

    I’ll make it real simple for you all… just get gov’t out of education all together. Fixed.

  2. Steve says:

    I doubt the plan will be enacted exactly as proposed. If it were, they might as well go ahead and just stop all new contributions to 529 plans. Taxing the gains at ordinary income would make a 529 account generally worse than just investing in a regular taxable account. It would be like a non-deductible traditional IRA, suitable basically only for temporarily hold money until you convert/roll over into other accounts, or (according to the Bogleheads’ wiki) to hold tax-inefficient investments that distribute dividends that would be taxed at your marginal rate every year. Neither of those uses would apply to an account designated for education.

  3. Ray says:

    Online education should be the avenues all of our parents, legislators, and educators should be looking at to reduce the overwhelming costs we incurr each and every day of the calendar year.

    I recently completed a 2 year degree at our local community college and i think that in more than a few classes, I learned more from “YouTube” than from the instructor.

    Yes, i wholeheartedly agree with your suggested premise and the tax money spent for all these brick and mortar schools could help students succeed in better ways.

  4. Kathy says:

    Without getting political, the Slate is a very leftwing organization that will support higher taxes and penalizing the wealthy every time.

    One thing so awful about this plan is that once again the rules are being changed after people have invested into this plan under another set of rules. It is like a football player running toward the goal and the NFL tells him now he must score in another city. This country needs consistent and un-changing rules that we can count on to be the same when we make a withdrawal as they were when we made the investment. The outcome is that fewer people will now invest in those plans, more students will end up needing loans and once again the government has created more people dependent upon it for their “income equality”.

    • Lazy Man says:

      I don’t read the Slate on a regular basis, it came up in my Google News search. In the past when I’ve read it about supplements (such as this article), it has made complete sense. It’s why I had to specifically call out the article here, for being so far off that it should be corrected in my opinion.

      I didn’t read the proposal in detail (couldn’t find it from the horse’s mouth), but I read some people on Twitter saying that it would be effective with new contributions. If true, they aren’t changing the rules mid-game or mid-run, but putting in a fix next season (year). I’d imagine that’s how it would have to work.

  5. Heather M says:

    While it doesn’t come with course credit so it is not quite the FFAOC you dream of, have you heard of MOOCs? Cousera is one of the big ones. You can take college level classes for free. Some universities such as Stanford and MIT have there own versions as well. A great way for your son to have the college course experience. I love the classes for learning about new topics as an adult.

    • Lazy Man says:

      Yep, I’ve heard of them. I hope that we can do something to create a curriculum that is accredited. I feel like there’s knowledge itself, which is all over the internet, and there’s the proof of achievement. I want to make that proof of achievement available to everyone for free.

  6. D. M. Treon says:

    I like the idea of online courses. However, do not allow testing to be done online. I am an educator, and I believe that testing needs to be done at a location where the test takers can be supervised. They should also be required to present a picture I.D. before being allowed to take any assessment, otherwise people will just pay someone else to take the test for them and their degree will not be something that a prospective employer could trust.

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