“And let’s close the loopholes that lead to inequality by allowing the top one percent to avoid paying taxes on their accumulated wealth. We can use that money to help more families pay for childcare and send their kids to college.”
When the President said that in Tuesday night’s State of the Union Address, he was talking about dramatically scaling back the rules regarding a stepped-up basis on inherited assets allowing you to pass things like stocks and real estate to your heirs tax-free. But he was also alluding to his proposal to start taxing money coming out of the 529 college savings plans.
This is not new, exactly. Prior to the Bush tax cuts of 2001, contributions to 529s were made with after-tax dollars. The money then grew tax-deferred, but when it was withdrawn to pay for education expenses it was taxed as ordinary income. Since then, withdrawals used for education (including not just tuition, but also room and board for students enrolled at least half time) have been tax-free – and assets in the plans have jumped from 19.4 billion at the end of 2001 to 245 billion in 2014, according to the Investment Company Institute. The President wants to roll those breaks back.
With his pitch to make the first two years of community college free for every student who can keep his or her grades up, it’s clear education is a priority for the President. So why would he want to do this?
Middle-class economics – a phrase that came out of his mouth five times last night. Fewer than 3% of families have 529s or Coverdell Education Savings Accounts (a smaller program on which the President also wants to do away with tax breaks), according to a 2012 report from the General Accounting Office. Of those that do, about half earn more than $150,000 a year. More than that, the tax break those families earn annually, the report said, amounts to more than $3,000 – which is six times the break received by families earning less than $100,000 a year.
So, if you have a 529 – or a baby/child/grandchild and are thinking about opening one – what does this mean for you? Perhaps nothing. With a Republican-controlled Congress, it’s going to be tough for the President to pass any, if not all, of the items he proposed last night. But what if he does?
Money already in the plan is safe. The White House’s Fact Sheet on what it’s calling a “simpler, fairer tax code” specifically says it will roll the break backs on “new contributions.”
It’s helpful to keep in mind how much taxable income you’re actually talking about. For the typical family saving from birth, when the child is ready to go to college, one-third of the balance generally comes from earnings, according to financial aid expert Mark Kantrowitz, senior vp and publisher of edvisors.com. That’s the amount that would be taxed. At that point, he says, the picture gets foggy. Among the questions that need answers:
*Will withdrawals be taxed at the rate of the beneficiary (i.e. your child) or the owner of the account? If it’s the former, current kiddie tax rules dictate that the first $1,000 in investment income is tax-free, the second $1,000 is taxed at the child’s (presumably lower) rate, and the rest taxed at the rate of the parent.
* What happens to state-tax breaks? Currently, Kantrowitz says, 34 states plus the District of Columbia provide some sort of break on state income tax for contributing to 529s. Will the states follow suit and start eliminating them as well?
* How about the five-year contribution loophole? Today, some grandparents take advantage of the ability to front-load five years worth of annual gifts ($70,000 per grandparent, $140,000 if grandma and grandpa do it together) into a 529 at one time. It’s a nifty way to move assets out of the elder’s estate and into that of a grandchild, but clearly it doesn’t fall into the middle-class bucket. Again, we’ll have to wait and see.
All in all, Kantrowitz notes, this is yet another reason to have a look at a Roth IRA. This year, couples filing jointly with a modified adjusted gross income of less than $181,000 and singles earning less than $114,000 can fully fund a Roth. You can do this even if you’re making a contribution to a 401(k) or similar plan. Roth contributions can be used – without penalty or taxation – to pay for the same educational expenses that 529s can. And this year at least, they are not on the chopping block.
Arielle O’Shea contributed to this report.
Watch more of Obama’s State of the Union from Fortune’s video team: