This week President Obama decided to drop his State of the Union proposal to tax earnings from 529 plans. These plans are a tax advantaged way to save for college — distributions from the accounts are not taxed when used for educational purposes. (Washington’s GET program is one of them; we wrote about the program as part of our policy brief on the higher education system earlier this week.) The administration had proposed the tax change in order to help pay for its “free” community college proposal.
According to Forbes,
When 529 plans were created in 1996, earnings were tax deferred–taxed to the beneficiary at their tax rate at the time of distribution. In 2001, Congress instituted the current tax advantages and made them “permanent” in the Pension Protection Act of 2006. Savings in 529 plans spiked after those two tax events, says [Betty] Lochner.
529 expert Joseph Hurley says the proposed tax would cause 529 contributions to “dry up.” Yet he notes that in the meantime the proposal could cause another spike in contributions, as parents and grandparent rush to increase their 529 college savings and receive grandfathered tax-free status.
The Seattle Times reported on the potential impact to the GET program:
A proposal by the Obama administration to eliminate the tax benefits of college savings accounts would be “devastating” for Washington’s program, called Guaranteed Education Tuition (GET) as well as those run by other states, the GET program’s director said.
“We want to encourage families to save more for college, not less,” said Betty Lochner. Along with running GET, Lochner is also chair of a national College Savings Plans Network, an industry group. . . .
It’s unclear how a change in the tax law might affect GET’s financial solvency. At one point in 2012, GET’s unfunded liability — the gap between the value of all units sold and the market value of all its assets — was $631 million. GET was underfunded in large part because the state raised state tuition much faster than the fund’s managers had predicted, even as the stock market plunged during the recession. It has since recovered and is now fully funded, with its assets valued at about $2.93 billion.
GET’s solvency depends on three factors, Lochner said: a predictable increase in tuition, solid investment returns and ongoing purchases by investors. Lochner said she didn’t know how the loss of tax-exempt status might affect the fund, “but I do think it messes with that third assumption” — purchaser behavior.
The GET program began in fiscal year 1998. As shown in the charts below, new enrollments and total contributions increased dramatically in FY 2001 (July 1, 2000 to June 30, 2001). The 529 plan tax changes were first enacted in June 2001 and became effective in January 2002, so they don’t account for what’s going on here — except that they probably increased people’s interest in and knowledge of the program and could conceivably have led to some new activity before the end of that June. A 2002 Seattle Times article noted that enrollments had increased due to “a sour stock market combined with the tax-law changes and increased exposure through television ads.”
GET’s enrollments and contributions have been declining; it’s easy to imagine that trend continuing in spades if changes to the tax status of 529 plans were changed.