Pushing parents to start a college fund
Dismal college savings statistics among middle-income families have the Obama administration pushing for a series of changes to so-called 529 plans, the cornerstone of tax-favored higher education savings accounts.
But industry experts gave the proposed changes mixed reviews, saying they were more positive about the potential than the particulars. Some said the proposals from a vice presidential task force went too far; others said they didn’t go far enough.
“The real goal of the task force is to increase awareness of 529s,” said Peter Mazareas, vice chairman of the College Savings Foundation. “Despite being a tremendous savings vehicle, participation rates tend to be much lower than they should be, given the benefits.
“We are supportive of increasing awareness and participation. But we can’t take any position on the specific recommendations.”
College savings plans, called 529s for the federal code section that gives them their tax-favored status, work a bit like Roth IRAs. You contribute after-tax dollars, but if the money is used for qualified purposes, neither contributions nor investment income will be taxed by the federal government when withdrawn.
However, these plans are offered and governed by individual states. And almost every state has at least one -- and sometimes several -- options. Individual states also determine what state income tax breaks are available to contributors, and those benefits vary widely too.
The combination of differing rules and a cacophony of confusing investment options have made the plans tough to navigate and can discourage their use by less sophisticated savers, said Joseph Hurley, founder of SavingforCollege.com and author of “The Best Way to Save for College: A Complete Guide to 529 Plans.”
“The plans are confusing by nature,” he said. “And there are so many of them out there, it’s hard to get a handle on it all and effectively compare plans.”
Only about 5% of middle-income filers use the accounts, according to Treasury Secretary Timothy F. Geithner, even though the tax breaks can make saving through these plans vastly more lucrative.
They are a hit among high-income filers, Geithner added. Roughly one-third of top earners have a 529 account. Roughly 11 million accounts have been opened since the federal government gave them tax exemptions in 2002, and they now account for about $100 billion in savings, according to the College Savings Plan Network in Lexington, Ky.
The Obama administration, through a vice presidential task force focused on the middle class, has suggested five changes that would make the plans more uniform and potentially more attractive to everyone. But not all of the proposals have been well received.
Two of the five proposed rules are procedural changes aimed at stamping out potential abuses by making contribution limits uniform in all states and by requiring that information be shared with the IRS to ensure that rich tax cheats don’t use the accounts to hide money. Another proposal would simply create uniform standards for reporting returns to make it easier for investors to compare the performance of one 529 plan to another. Experts are largely supportive of all three of those changes.
The remaining two proposals are more controversial. These suggest that all states offer at least one cheap and easy investment choice that would be stocked with index funds and would mix assets based on the beneficiary’s age, allowing parents a hands-off, low-cost and low-maintenance approach.
The task force also asked that states eliminate “home state bias,” which can make it more costly to invest in a 529 sponsored by another state.
What is home state bias? Some 34 states provide credits or deductions on state income taxes to residents who contribute to their home state 529 plan. Only five states provide similar tax benefits to residents who contribute to another state’s 529. (California does not offer any state tax incentives to buyers of 529 plans, except to mirror the federal rules that exclude investment gains from tax if the money is used for qualified education expenses.)
That tax disparity causes experts, such as Hurley, to urge parents to consider their own state’s 529 plans first and turn to another state plan only if their own state’s offerings prove inadequate.
The conundrum for parents is to weigh the potential loss of tax breaks against the potentially better investment returns from out-of-state 529s. The task force believed that was a deterrent to opening accounts. However, the College Savings Plan Network, which represents state treasurers’ offices that offer the plans, said that a wide array of investment choices are one of the key draws to 529s. They maintain that states should be able to give their own residents special tax breaks if they want to make their home state plan more competitive.
The New America Foundation, a public policy institute, said the task force should have gone further, recommending matching grants for families below certain income levels, enrolling infants in 529 savings plans at birth or kindergarten and exempting 529 assets from being considered in financial aid calculations.
What will happen with the proposals remains to be seen. For these recommendations to become law, legislation would have to be introduced and passed, and there’s certain to be heated arguments about states’ rights if the administration pushes to create standard tax treatment and investment choices.
“It’s impossible to say what is going to stick,” Hurley said. “The one thing we know is that Congress keeps making these plans more attractive. This is really to guide Congress to keep that up.”