529 plans are special accounts authorized by their eponymous section of the Internal Revenue Code, “sponsored” by the states and administered, with some exceptions, by Upromise Investments.
I am going to tell you five facts about 529 plans:
- Depending on the plan, you can contribute up to $511,758 in after-tax income per designated beneficiary (some states have much lower caps);
- Contributions are excluded from your taxable estate;
- You can designate yourself as a beneficiary;
- You can open plans in multiple states;
- Plans are inherited tax-free.
Knowing all that information, the only possible conclusion you could reach was that this is a scam to transfer wealth between generations tax-free.
Now, it happens to also be true that this scam was foisted on the American people with “college affordability” branding. Taking money literally means looking through that branding and seeing how these plans work mechanically.
Contributions are made after tax and appreciate tax-free
In this way, 529 plans are similar to Roth IRA’s. However, Roth IRA’s have strict limits, including an annual cap on contributions. It’s possible to game those limits by “contributing” improperly-valued or hard-to-value assets (Mitt Romney’s IRA had a value over $20 million when he ran for President, leading some to speculate he had done this), but they are at least a gesture at limiting the cost to taxpayers of shielding the assets of the wealthy from capital gains taxes.
529 plans have contribution limits set by the plan administrators to approximate the “maximum cost” of attending college in the sponsor state. That amount can be contributed to the account all at once, and in fact if the investments in the account go down in value, even more money can be added.
Contributions are treated as federal gifts to the beneficiary
Most articles about 529 plans go to great pains to explain the annual tax-free gift limits ($14,000) and the lifetime gift tax exclusion ($5,450,000).
This is nonsense. You can designate yourself as the beneficiary of your own 529 plan, and “There are no tax consequences if you change the designated beneficiary to another member of the family.“
529 plans are inherited tax-free
When a 529 plan owner dies, the account gets a new owner but since the value of the plan is treated as part of the beneficiary’s estate, it’s not taxed. At all.
You might ask, “Ah hah, Indy, now I’ve got you! That means that if the beneficiary dies unexpectedly the 529 plan will be taxable as part of their estate!”
Nope. The owner just gets to designate a new beneficiary.
I’m sure the IRS doesn’t love it when people do this
That’s what lawyers are for.
If you think “maybe the IRS will frown on this scam” stops wealthy people from leveraging the language of the tax code to the maximum extent possible, I’ve got a $916 million deduction to sell you.
It would be trivially easy to identify and penalize the people taking advantage of this scam. The IRS budget has been cut 17% since 2010. Maybe estate tax avoidance is an enforcement priority for the IRS. Maybe they sometimes catch people doing this. Maybe the wealthy know that shielding $2 million is “safe” and shielding $10 million is “risky.” The federal estate tax rate is 40%, making that a “mere” $800,000 in taxes avoided.
What about restrictions on withdrawals?
Are you talking about “qualified education expenses?” Forget about it.
First of all, contributions are always free to withdraw. There’s no tax or penalty if the value of the account is the same as the value contributed or below. Since the wealthy are using these plans as tax shelters, not investment vehicles, contributions could just be left in cash for simplicity’s sake.
Second of all, paying for education expenses for future generations is largely the point of intergenerational wealth transfers; I gather it’s the central conceit of “Gilmore Girls.”
529 plans were a bad idea, are a bad idea, and will always be a bad idea
“The problem” is not high contribution limits, it’s not being able to designate yourself as a beneficiary, it’s not tax-free inheritance, it’s not being able to change beneficiaries, it’s not being able to make penalty-free withdrawals of contributions, it’s not limited IRS resources.
“The problem” is that it’s a bad idea to allow people to shield their assets from taxation when sold or transferred.
This has nothing to do with college affordability because 529 plans have nothing to do with college affordability, just like HSA accounts have nothing to do with health care affordability and the mortgage interest tax deduction has nothing to do with housing affordability.
They are all just branding used by the wealthy to shield their income and assets from taxation.
The only question is, how long are we going to put up with it?