So it actually happened.
Just last month, it was not certain that the Senate would go along with the House of Representatives’ proposal to let families use 529 college savings plans to pay for private school from elementary school onward. In a bill that offered many perks for the wealthy, the 529 provision was a particularly brazen giveaway.
After all, it’s mostly wealthier people who can save enough to reap large benefits from the provision, which allows $10,000 in annual tax-free 529 account withdrawals for pre-college students starting in 2018.
But it really did happen, and President Trump will soon sign the bill that makes it the law of the land.
The short-term opportunities for affluent families are potentially worth five figures. The schools, however, will now confront a major financial aid question that the new bill forces on them. And states could make offsetting tax changes that cost 529 savers money. Any eventual populist blowback could threaten the plans, too.
But let’s start with the good news, for those who have the money and the inclination. With 529 plans, you put money in, let it grow for years in mutual funds and then pull it out to use for higher education expenses. When you do, you don’t pay capital gains taxes on what you’ve earned over time.
Other 529 tax breaks exist, too. It is states, not the federal government, that actually administer the plans, and 35 of them offer some sort of tax deduction or credit when you deposit money. If you want to know how things work in your state, Savingforcollege.com is an excellent resource.
In what we should now refer to as the old days, you might save money for 18 years and then pull the money out over four years while a child completes college. But now, wealthy families can do what’s known as “superfunding” 529 accounts with a pile of money upfront. Then, they can pull out the $10,000 maximum each year to use for elementary and secondary school, until a child starts college. (The money will not be available for home schooling expenses, however, as that fell out of the final bill this week for technical reasons.)
Last month, Vanguard ran a scenario for me that is worth examining again to see the possibilities. At this point, it would be financial malpractice for accountants and financial advisers not to be recommending to clients that they consider this kind of upfront investment.
Imagine a wealthy family in the highest tax bracket that opens a 529 plan with $200,000 and doesn’t add another cent. The money grows at 6 percent annually, and the family takes out the maximum $10,000 each year, avoiding $2,380 in taxes annually. During the elementary and secondary school years, it saves $30,940 in taxes.
At that point, the account would still have money left over. A lot of money: $370,717. And once the beneficiary of the 529 account enters college, the family can withdraw as much as the entire annual cost of college and related expenses (not just $10,000) each year, avoiding even more capital gains taxes over that period.
If you have anything to do with running a private school, you’re probably licking your chops at this point. Heck, why not raise tuition by $2,380 right away! But consider your less-affluent families for a moment: Integrating a family’s 529 accounts into your financial aid formula was a whole lot easier in the old days, when families did not use them to pay tuition before college.
In the future, however, those 529 deposits will be fair game. Board members and administrators at private elementary and secondary schools are going to have to take a hard look at making a direct ask for some of that 529 money from families that are applying for tuition discounts.
But now imagine being that family and having assumed all along that the money in the 529 account was for college. Then, suddenly, your current school wants to take it? Would it truly have the nerve to ask?
Yes, said Andrea Feirstein, a consultant to 529 plans. “Of course, they are going to want to go after that money,” she said of the private schools. “I don’t know why you wouldn’t. That is what you are supposed to do.” Indeed, people with available assets are supposed to use them so that others with fewer or no assets can get more help. And now that 529 money is available.
Now, imagine that you’re a legislator in a state with its own income tax. The new tax bill puts a strict $10,000 annual limit on the deductibility of those taxes. That will make residents feel like their taxes have gone up, which will make it harder for states to raise taxes in the future. They might even come under pressure to cut taxes.
Except the tax bill also makes 529 accounts that much more attractive, which means more people in those 35 states with tax breaks will use the accounts more often. And because those states offer tax incentives to people saving money in the 529 plans, they’ll be coming under even more fiscal pressure by forgoing tax revenue.
Or will they? Given the benefits wealthy families will now receive on the federal level with 529 plans, it will be tempting for states to put income caps in place on the tax breaks they offer. Those states might follow the lead of officials in Minnesota, who introduced tax breaks for 529 contributions this year but placed income restrictions on one of them.
Even if you’re not wealthy enough to save piles of money in 529 plans and wait out the tax-free capital gains, little is stopping you from parking your annual private school tuition in an account for a few weeks just to pick up that year’s tax break. At the moment, just Montana and Wisconsin penalize people for that quick toe-touch, according to Kathryn Flynn, content director at Savingforcollege.com.
Might more states do that once the word spreads about said fancy footwork? “It’s definitely reasonable to think that,” Ms. Flynn said. “It’s their benefit, so they can change it however they want.”
As for the longer term, one has to wonder how long a big tax break for private school tuition can persist. On one hand, President Obama failed in his 2015 attempt to cut back federal tax breaks in 529 plans, when they merely covered higher education.
On the other, we’ll almost certainly see data within a few years that proves that affluent families control a large majority of the 529 money that people are using for private school, just as they do now for college money under the former rules, according to one Federal Reserve study.
To people like Richard V. Reeves, the author of “Dream Hoarders,” a book about how the upper middle class get an outsize share of goodies in American life, that inevitability feels insulting. “If you did reverse means testing on a tax deduction, it would be hard to find a better one than this,” he said.
Ms. Feirstein, who does not buy the thesis that 529s were already a plaything solely for the upper classes, agrees with Mr. Reeves on how squarely the plans will be in the sites of many Democratic lawmakers now.
“I’m horrified that it happened,” she said of the expansion of the plans, even if the 529 plans she works with will gather more assets in the short run. “It’s going to mean more money, but it’s more money from wealthy people. We are just a sitting duck now as a target.”