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Expanding Section 529 Might Be Its Undoing

Posted on May 29, 2019

May 29 was “529 day,” according to some section 529 plans and investment firms. Last week a major piece of retirement legislation hit a roadblock in Congress because of the elimination of proposed statutory text that would have broadened the types of expenses that are allowable under 529 plans. The legislative goals of section 529 have always been a little unclear, and pushes to increase participation in those savings vehicles and expand them could lead to their eventual unraveling.

Section 529 was introduced in 1996. At that point it was a tax-deferred savings vehicle, but in 2001 it became an exemption from tax on the earnings accumulated in a 529 account when the funds are used for qualified expenses. In the Tax Cuts and Jobs Act, Congress expanded the definition of qualified higher education expense to include expenses for tuition at elementary or secondary schools.

In conjunction with those incremental expansions of the tax incentive, the amount of money invested in 529 plans has grown substantially, from almost $13.6 billion in 2.4 million accounts in 2001 to almost $329 billion in 13.6 million accounts in 2018. The Joint Committee on Taxation estimates that between 2018 and 2022, the exclusion of tax on earnings of qualified tuition programs under section 529 will come at a cost of $7.5 billion in forgone tax revenue to the federal government. The increased use of 529 plans also has implications for some states’ tax revenues.

The proposal that caused the recent legislative holdup would have allowed distributions to apply to fees, books, and supplies required for participation in an apprenticeship program; some home-schooling expenses such as curriculum, books, tutoring or outside class expenses, dual enrollment expenses, and educational therapies; some payments on principal or interest of a qualified education loan; and other expenses related to elementary or secondary school. According to the Ways and Means Committee report, the point of the expansion was to allow families to "customize the use of education savings to make education more affordable.”

Expanding the purposes for which families can use their savings probably does increase the desirability of saving in a section 529 plan from the perspective of the individual taxpayer. But it also puts pressure on the background question in any discussion of section 529 — whether encouraging savings through a tax incentive that is mostly used by higher-income taxpayers and more advantageous to taxpayers with higher incomes and tax liabilities is an ideal approach. The problem with attempts to restructure section 529 plans to better promote equity in educational options is that they aren’t especially equitable instruments in the first place. To reap tax benefits, taxpayers must have savings to invest.

In a 2012 report, the Government Accountability Office noted that less than 3 percent of U.S. families saved in section 529 plans or Coverdell accounts in 2010, and it listed important questions for Congress to consider regarding section 529 plans: “What is the purpose of the federal tax benefits provided through 529 plans? Are the goals and objectives clearly defined and measurable? Who is the target population for 529 plans and does the current structure provide appropriate incentives for that population?” These questions are increasingly important as the amount taxpayers invest in 529 plans grows and the list of items on which they can spend their savings expands.

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