President Barack Obama’s budget proposal—which he will outline during his State of the Union address Tuesday night—would tax college savings plans that benefit middle-class families, raising concerns among some policy experts.
Obama’s budget includes $320 billion in tax hikes over the next decade to pay for larger child-care and education tax credits and free tuition for community college students. One of those tax increases involves eliminating some of the tax-free benefits of 529 college savings plans, which the president would replace by broadening eligibility for the American Opportunity Tax Credit (AOTC).
The 529 plans, named after that section of the Internal Revenue Code, allow families to participate in pre-paid tuition plans at some colleges and universities or invest in a savings program managed by a state’s plan or a broker. Earnings from the plans have been tax-exempt since 2001 as long as they are spent on higher education costs, but Obama’s budget would reduce that benefit.
Taxing earnings from the 529 plans could further depress the savings rate among Americans, which is already at historic lows.
Ryan Ellis with Americans for Tax Reform (ATR) said in an email that repealing tax benefits on the plans would primarily hurt middle-class families.
"529 plans are what middle class families use to save money for college for their kids," he said in an email. "Rich people don't bother with them, as they have access to much more exotic trust vehicles. By definition, this is a tax hike on middle class families struggling to save for college."
The White House did not respond to a request for comment.
Obama’s budget also calls for enlarging the benefits of the AOTC for lower and middle class families and making it a permanent feature of the tax code. A Congressional Research Service report from July 2014 said that enabling more taxpayers to accept the credit could induce schools to "raise tuition levels, reducing the effective value of the AOTC and potentially increasing the after-tax cost of college for students ineligible for the AOTC."
Tuition costs have surged by 1,225 percent since 1978, according to the Bureau of Labor Statistics, much higher than medical expenses and inflation.
Critics of the 529 plans say they disproportionately benefit a small number of wealthy families and include high fees. A Government Accountability Office (GAO) report from 2012 found that participants had about three times the median income of those without plans. About 5.5 million households held plans that year.
However, the GAO report noted that states have implemented several measures to attract low-income families to the 529 plans, including matching contributions, minimal initial commitments, and investment options that are less risky. Families might also be unaware that the plans actually exist, and that they have the option of investing in plans from other states and using the savings at any college or university. One study found that nearly half of parents saving for college were unfamiliar with the program.
While Americans in the highest income tax brackets can save as much as 39 percent on taxes using the 529 plans, low-income families can also save 22 percent with a state deduction, according to a 2009 Treasury Department report.
ATR noted that Obama’s budget would raise the capital gains and dividends tax rate from 23.8 percent to 28 percent and the estate tax from 40 percent to almost 60 percent. The liabilities of U.S. firms with assets of more than $50 billion would also be taxed, potentially leading to higher costs for customers and employees.
"When it comes to tax hikes Democrats are like a teenage boy on a prom date: They keep asking the same question different ways but always to the same point," said Grover Norquist, president of ATR, in a statement.
It is unclear whether Obama will mention the loss of tax savings on 529 plans during his State of the Union speech on Tuesday. The House of Representatives will also propose its own appropriations bills.