President Barack Obama’s about-face this week on his proposal to end college savings accounts called 529s, just days after proposing it in his State of the Union speech, left many Americans wondering just what they are and how they work.
Here are some answers to questions about the college-savings tool.
Q: What are 529s?
A: They take their name from a section in the federal tax code that helps taxpayers set aside money for college tuition or other qualified expenses. Most states now offer 529s, and they work like a 401(k) or an individual retirement account, where contributions usually are invested in a mutual fund or other financial instrument that grows in value over time.
Q: What are the tax advantages of 529s?
A: As the investment grows, the profits are not taxed. If, at the point of withdrawal, they’re used for college tuition or qualifying college expenses, they’re never taxed. However, if the money is withdrawn for non-education purposes, the earnings will be taxed and subjected to a 10 percent penalty.
Q: Are there any restrictions on participating?
A: Few. There are no income limitations. They can be opened for yourself, a spouse, a child, a grandkid and even a friend. But the same rules governing the plan apply: The profits must be used for college and related qualified expenses or be subject to taxes and the additional penalty.
Q: How about restrictions on contributions?
A: Annual contributions above $13,000 are generally subject to gift taxes, but a contributor can give anywhere from $13,000 to $65,000 and treat it as having been given over five calendar years without being hit with federal gift taxes.
Q: Is there a limit on how much can remain in a 529 account?
A: There’s no monetary limit per se. But since earnings are tax free only if they’re used for college and qualified expenses, there’d be no real value in having large sums in the account after families are finished with college expenses, since earnings not only would be taxed but also hit with a 10 percent penalty. The center-left Center for American Progress proposes capping tax-free account balances at $200,000.
Q: Are these plans a tax shelter for great wealth?
A: No, given that their earnings are taxed with a penalty if they’re used for anything but college education.
Q: Are they for the rich?
A: It depends on how you define rich, and where you live. The midpoint annual income for families with college students but not 529 accounts was $45,100. The midpoint income for those with 529s was $142,400. It suggests that they’re used more by those with higher incomes. But two-income families earning $142,000 in many parts of the Northeast, San Francisco Bay Area, Seattle and even Washington, D.C., might argue they aren’t rich given the cost of living and high state taxes.
Q: What does the income distribution look like within 529 contributors?
A: The Government Accountability Office found that about 30 percent of the families that had 529 accounts had incomes of $100,000 or less, and another 24 percent or so had incomes of $101,000 to $150,000. The remaining approximately 47 percent had incomes above $150,000. Supporters of 529s argue that the nearly 50-50 split reflects contributors’ ability to set money aside for college, not a shelter that attracts wealthy investors.
Q: Are contributions made pretax or after taxes?
A: There’s no federal tax break when you contribute money to the account. But some states allow contributions to the accounts to be deducted from taxable income on state income-tax returns.
Q: How popular are these 529s?
A: There were about 11 million of them in late 2012, according to the GAO. It found that fewer than 3 percent of American families had 529 accounts.
Q: Since Obama has flipped on his 529 proposal, is the debate over the savings plan dead?
A: Hardly. Republicans are getting behind a proposal from Rep. Lynn Jenkins, R-Kan., that would expand 529 rules to allow employers to match some contributions. She has another bill that would broaden the list of qualified expenses to computers and computer technology.