The SECURE backdoor into 529 assets

Become a Patron!I've written extensively in the past about 529 College Savings Plans, an extremely tax-advantaged method of saving for higher education expenses. Contributions are made after federal and state taxes (although many states offer in-state tax deductions for contributions), compound internally tax-free, and are withdrawn tax-free for "qualified higher education expenses."In the Smash-and-Grab Tax Act of 2017, Republicans expanded those eligible tax-free withdrawals to $10,000 per year in elementary and secondary education expenses as well. Increasing the expenses that are eligible for tax-and-penalty-free withdrawals mechanically increases the value of the 529 tax shelter since it decreases the risk of saving "too much" in an account and being forced to pay taxes and penalties on any withdrawals.A bill is being rushed through Congress that will create a new, even more cavernous loophole to avoid taxes and penalties on 529 plan assets.

The SECURE Act Double Dip

H.R. 1994, hilariously titled the "Setting Every Community Up For Retirement Enhancement Act of 2019" (SECURE, get it?), passed the House Ways & Means Committee early last month with bipartisan support, and is being fast-tracked through the House alongside a companion measure in the Senate.The House bill makes an unprecedented change to what expenses are eligible for tax-and-penalty-free withdrawals of 529 assets.As a refresher, there are three kinds of withdrawals from 529 College Savings Plans:

• withdrawals for qualified higher education expenses paid out of pocket or with student loans are completely tax-free;
• withdrawals for qualified higher education expenses covered by grants and scholarships are penalty-free, but subject to income tax on the earnings portion of the withdrawal;
• and withdrawals for non-qualified higher education expenses are subject to income tax on the earnings portion of the withdrawal and a 10% penalty on the earnings portion of the withdrawal.

All withdrawals are made proportionately from contributions and earnings, so it's not possible to designate withdrawals as coming first from contributions or first from earnings.Section 302(c)(1) of the SECURE Act is simple: "Any reference in this subsection to the term ‘qualified higher education expense’ shall include a reference to amounts paid as principal or interest on any qualified education loan...of the designated beneficiary or a sibling of the designated beneficiary."The tax-and-penalty-free student loan withdrawals are capped at $10,000 per individual.Attentive readers have no doubt already noticed the problem: the SECURE act would allow tax-free withdrawals for higher education expenses financed with student loans and for the repayment of those student loans!

The double dip, illustrated

To see how this would work in practice, take the example of someone who contributes $10,500 to a 529 plan the day their child is born, which compounds at 6% annually for 18 years, reaching a final value of $30,000 on the child's 18th birthday, when the 529 plan account is reallocated to an FDIC-insured money market fund. On that date, the child also enrolls in a higher education institution with a total annual cost of attendance of $5,000, and receives a $2,500 annual scholarship. The student takes out $2,500 in federal Stafford loans to cover the remaining balance.Under current law, the 529 plan owner can make a $2,500 tax-free withdrawal (the amount of qualified higher education expenses paid for with student loans) and a $2,500 penalty-free withdrawal (the amount of qualified higher education expenses paid for with grants and scholarships). They would owe ordinary income taxes on the earnings portion of the second $2,500 (roughly 65% of it, or $1,625).After four years, the account owner would have withdrawn $20,000 of the $30,000 balance, with $10,000 in completely tax-free withdrawals and $6,500 taxed as ordinary income. The remaining balance in the account would be $10,000. To withdraw that balance, the account owner would have to pay ordinary income taxes plus a 10% penalty on the earnings portion, which comes to roughly $1,788. A high-income account owner in a high-income state might pay as much as 50% of that in income taxes, or $894.Under the SECURE Act, if that withdrawal is used to repay the student's $10,000 student loan balance, it is also completely tax-free.

Conclusion: the system is breaking down

There are a few foundational principles of American tax law. You can't deduct an expense incurred by someone else. You can't claim a deduction and a credit for the same expense. What we are seeing right now is that system breaking down in real time.When the second Bush administration eliminated the estate tax, they also eliminated the stepped-up basis rule, so that appreciated assets would be taxed as capital gains when sold instead. When the Trump administration all-but-eliminated the estate tax, they left the stepped-up basis rule intact, so that appreciated assets would never be taxed.Today, so many assets have been sheltered from taxation for so long, and appreciated by so much, that their value looms over the entire system, with the tiniest changes to tax law having enormous downstream effects on those sheltered assets.Pre-tax contributions to accounts like IRA's and 401(k)'s were justified with the promise that they would eventually be taxed when withdrawn in retirement. Now that the wealthiest generation in human history is in retirement and being forced to make those withdrawals and tax payments, it seems they've found that they would prefer not to. And unlike poor Bartleby, the Boomers vote.Become a Patron!

Three bad and one good way to think about public higher education and tuition

Become a Patron!Elizabeth Warren made a splash this week with her plan to both ensure public higher education is tuition-free and forgive up to $50,000 per student of the existing stock of federal student debt.I already offered my hottest takes on Twitter, but I think a lot of the disagreements surrounding public tuition and student debt revolve around fundamentally different conceptions of the nature and purpose of higher education. As often happens in politics, that means people who think they are disagreeing about one thing (the appropriate level of tuition at public universities), are actually disagreeing about something else (what is education, who owns it, and who benefits from it?).I think there are basically four ways to look at the issue, and it's these competing perspectives that lie at the heart of the disagreement.

Education as a Private Capital Good

In this view, education is literally treated as an investment, made by the student, in a combination of individual "capital" (knowledge, experience, and credentials) and social "capital" (meeting friends, spouses, and business partners). Like many investments, the upfront cost is large, but since it yields an even higher time-weighted and risk-weighted return, it's still an investment worth making.Since education is a purely private capital good, purely private commercial loans are an obvious way of financing that investment. In a rationalized educational system, students would simply be charged for the appropriate fraction of their instructors' time, controlled for salary, enrollment, and overhead, and then borrow the necessary amount semester-by-semester at a market rate of interest.While this perspective has been beaten into Americans by the Reagan-Clinton neoliberal revolution, it's important to understand how completely novel it is, and what its real-world implications would be.First, what is the cost of overhead? If we are to completely rationalize the charge on the student's side of the equation, it seems necessary to likewise rationalize the expenses on the university's side of the equation. If they are to charge the entire cost of providing education, then the federal government should also capitalize the cost incurred through the Morrill Land-Grant Acts. Profitable universities, of course, would be able to take out long-term loans to finance the one-time cost of reimbursing the federal government for their land, but some institutions would no doubt fall into default and the federal government would have to seize and auction them off.Second, what is the market rate for an unsecured debt by a 17-or-18-year-old borrower? If the payoff to higher education has a barbell distribution, with a high percentage of low-income dropouts and an above-average income to graduates, the market interest rate would have to be astronomical: low-income dropouts and graduates will declare bankruptcy, while high-income graduates will repay their loans early.If higher education is a purely private capital good, obviously there's no reason for the federal government to get involved with loan guarantees or financing, and without them, it's unfathomable that private sector financing will be available at all.

Education as Intergenerational Wealth Transfer

Until 2015, this was the unspoken premise of a lot of opposition to universal tuition-free public higher education. And then in 2015, the unspoken became spoken, when Hillary Clinton insisted that "I am not in favor of making college free for Donald Trump's kids" (Interestingly, she did not insist on means-tested co-payments at public libraries, swimming pools, parks, museums, or elementary and secondary schools, so I gather the Trump clan is free to visit them at will without furnishing their tax returns).The logic here is simple: since we refuse to appropriately tax high incomes, and we refuse to tax estate transfers, and we refuse to treat capital income the same as earned income, the only mechanism we have left to tax the wealthy is through our system of public higher education, where we charge them full tuition. If tuition were low or non-existent at our public universities, we would lose our last remaining option to share any part of the largest private fortunes in the world.Hillary Clinton is a savvy politician, and she made this argument for a reason: it has immediate, emotional appeal. The trouble is, it begs the question. If we taxed high incomes properly, why would we need to single out high-income parents for additional tuition charges? If we taxed estate transfers properly, why would we need to finance universities with levies on high-net-worth parents? If we taxed capital income properly, why would we need to single out high-capital-income parents for special tuition fees?

Education as Class War

If "stick it to the rich" is one version of the argument for public higher education tuition, "stick it to the poor" is its mirror image, helpfully illustrated on Twitter. In this version of the story, public higher education is not a public or private investment, it's an ordinary consumption good. The poor buy cheap public higher education for less money, and the rich buy expensive public higher education for more money; the poor go to technical colleges, the rich go to flagship universities.I appreciate the fact that this view has resurfaced precisely because it disputes the entire premise of American meritocracy. College graduates do not become more qualified because of anything that takes place during the course of their education; rather, they're more qualified because of their starting wealth.However, if anyone really believed this was true (and I think almost no one does), the consequences would be radical. Graduates of elite universities would not receive more consideration during job applications, they would receive less, since such a large percentage of their education is attributable to their starting wealth, rather than any accrued qualifications.Needless to say, almost no one explicitly professes this belief. Rather, you end up with just-so stories wherein the well-genetically-endowed accumulate their wealth through hard work and intelligence, their children inherit their hard work and intelligence genes, and so the people who "deserve" to attend elite universities (thanks to the genes) also happen to be able to afford it (thanks to the wealth). There's even a term for it in the eugenics literature: "mismatch theory," whereby it's downright dangerous to admit the poor to elite universities where they are destined to underperform.

Conclusion: Student Debt as Aggregate Demand Management

It would be unfair to conclude without sharing my own view of the student debt crisis, which is simple: the experiment has failed.Federal student loans (and other federal programs like Pell and FSEOG grants) were intended to address a particular problem: if Baumol's cost disease causes the cost of public education provision to accelerate faster than the increase in productivity in the higher education sector, then the states (which are constrained by balanced budget rules) will be forced to radically reduce the quality of education they offer or radically increase their taxes to finance it, and over time gradually but permanently reduce the education level of the American people.Instead, the federal government decided to print money in order to finance those public education services. But this decision created a different problem: if the federal government had simply assumed the cost of operating the nation's public universities, the entire cost of that operation would be brought "on-budget," creating an expense that would have to be matched with increased taxes or debt.Instead, we went a different route. Rather than simply operating, and paying for, a system of nationwide free public universities, we created a system of federally-backed student loans. This has the great technical advantage of creating an entry on the asset side of the federal ledger. Indeed, the federal student loan program is "profitable," in the specific, bizarre sense that the money it earns in principle and interest payments exceeds the amount it loses in loans discharged due to death, disability, or other reasons.President Obama made important changes to the system again with the introduction of Income-Based Repayment, which allows the remaining balance of federal student loans to be discharged after 20 years of payments.The question remains, however: why assign the cost of a publicly-financed system of colleges and universities to the people who happen to attend them? If graduates earn higher incomes, then we can easily impose a progressive income tax that captures a share of their increased income over that of non-graduates. If graduates accumulate more lifetime wealth, then we can easily impose an estate tax that reclaims far more than the cost of their attendance at a public university. If graduates earn an unusually high share of income from capital, we can easily equalize the tax treatment of income and capital gains (as we did it as recently as the 1980's).The experiment was simple: if college attendees really exerted a unique upward pressure on wages and prices by earning and spending much more money than non-attendees, then isolating them for specific surcharges might have made sense, in order to prevent overall price inflation. But the experiment failed. In the very worst cases, it turned into just another bullshit means-tested program that no one qualifies for.The fact is, we already operate a system of publicly-financed colleges and universities, because we know as a country we rely on the graduates of that system. All that's left is to admit it.Become a Patron!

One weird old trick to save money on student loan interest

Back in September I wrote about how structuring your borrowing and investing decisions properly in the first place is superior to continually trying to optimize and re-optimize them. However, there's an important corner case where you're able to optimize your post-borrowing behavior, and that's the case of student loans.Depending on a number of factors including the prevailing student loan interest rates when you were enrolled, the number of years you took to graduate (or drop out — we don't judge around here), and the student loan repayment regime when you were enrolled, you might have a number of federal and private student loans with different interest rates and different repayment options.For loans which are eligible, I'm the world's biggest proponent of "income-based repayment," or IBR. Your payments are capped at a percentage of your income, and any remaining balances are forgiven at the end of the IBR repayment period.However, folks who know they won't be eligible for IBR loan forgiveness (or the public service loan forgiveness program) may understandably want to accelerate the repayment of their student loans. That impulse may become even more tempting if the Republican Party succeeds in their effort to repeal the federal income tax deduction for student loan interest, which would almost double the after-tax cost of student loan interest for high-income borrowers.

Send your student loan processor written instructions on how to process payments in excess of the minimum

Thanks to the consolidation of the federal student loan program under President Obama, there are relatively few student loan servicers today, but each has somewhat different methods of processing payments in excess of your monthly minimum owed.If you don't know how your student loan servicer processes excess payments, you may be shocked (or disgusted) to learn that they are not required to apply payments in excess of your monthly minimum to your highest-interest balances. They are, legally, free to apply excess payments to your loan balances in any manner they choose — unless you instruct them otherwise.So, instruct them otherwise! The Consumer Financial Protection Bureau has produced a draft letter you can use to specify exactly how excess payments should be applied to your student loans. Read it carefully, fill it out with your own personal information and preferences, and send it by certified mail to your loan servicer. Then check with them in 10-14 days to make sure they've received and applied your instructions to your account.