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taxes (although many states offer in-state tax deductions for contributions), compound internally tax-free, and are withdrawn tax-free for "qualified higher education expenses."In the Smash-and-Grab Tax Act of 2017, Republicans expanded those eligible tax-free withdrawals to $10,000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!
