The effect of estate tax repeal on the 529 scam

One of the first posts I wrote here was about the 529 scam. I explained that 529 plans are a way for wealthy individuals to permanently shield an almost unlimited amount of assets from taxation, and that the scam was made sustainable by the very large number of middle class people saving a very small amount of money who are absolutely convinced that 529 plans are a way to save money for college, rather than a way for the wealthy to shield their assets from taxation.

Like the mortgage interest, the state and local tax, and charitable contribution deductions, the actual benefits of 529 plans accrue to a tiny population of wealthy heirs and heiresses, who are protected from blowback by a large population of earnest upper-middle-class professionals.

What are the benefits of 529 college savings plans?

There is so much nonsense out there about 529 college savings plans that it’s important to understand what the actual benefits of the plans are. There are only three:

• Internal tax-free compounding. Dividends and capital gains from the underlying investments are untaxed as long as they remain in the account, while they would be taxed if held in a taxable brokerage account.
• Tax-free withdrawals. Under certain conditions, withdrawals from the accounts are tax-free, while they would be taxable if the securities were instead held in a taxable brokerage account.
• Transfer of ownership of a 529 account is not a taxable event at the death of the account’s owner, while it might be if the owner of a taxable brokerage account dies (although in that case the heir would benefit from the stepped up basis rule).

What are the limits on 529 college savings plans?

It is commonly believed that there is a limit of $14,000 in annual contributions to 529 college savings plans, or $70,000 if contributions are made upfront and reported over a 5-year period. This is precisely false.

$14,000 ($70,000) is the annual (quinquennial) amount you can contribute without filing a “Gift (and Generation-Skipping Transfer) Tax Return.”

The actual limit on the amount you can contribute to a 529 college savings plan is the plan’s maximum contribution balance. For my preferred 529 plan, the Utah Educational Savings Plan, the maximum contribution is $430,000. You can’t contribute any more to the plan as long as your balance is at least that amount, but in case of a decline in the value of the account, you can “top up” the account to $430,000 again. As UESP helpfully explains:

“UESP will accept contributions for a beneficiary until all UESP account balances for that beneficiary reach $430,000. It is possible that balances may exceed $430,000 because of market performance. Contributions or portions of contributions that exceed this maximum will be returned to the contributor.”

How would repeal of the estate tax affect the 529 scam?

In the absence of the estate tax, there would be no reason for our beloved oligarchs not to contribute the maximum account value to every 529 plan in the country. Without an estate tax, there would be no estate tax exclusion that such contributions could count against, and there would be no return that would need to be filed to record such transactions.

To use UESP as an example again, in the absence of the estate tax, at birth every wealthy child in the country could receive a $430,000 transfer, invested in the stock market, that would compound tax-free forever, and with tax-free withdrawals when spent on eligible expenses.

About those eligible expenses

Here readers think they have caught me in some kind of trap. “A-ha,” you say, “what good is an enormous tax-free inheritance that can only be spent on certain eligible expenses?”

Don’t worry, Ted Cruz is on the case. Senator Cruz included in the Senate version of the Republican tax reform bill a provision allowing $130,000 to be withdrawn for K-12 private school expenses, in addition to the undergraduate and graduate school withdrawals that were already allowed tax-free.

Even if you’re a responsible middle class professional, think about the logic of this provision. A diligent middle class saver starts investing money at the birth of their child and starts withdrawing it a few years later for private kindergarten expenses, so it’s had perhaps 2 or 3 years of tax-free internal compounding. A wealthy person inherits a multi-million dollar 529 plan and is able to withdraw $10,000 per year for 13 years that has never been and will never be taxed. Then they can withdraw an unlimited additional amount, also tax-free, up to the total cost of attendance at their kid’s private college and graduate school.

Finally, as I mentioned in my original post, it’s important to understand that a huge portion of the intergenerational transfer of wealth is precisely the transfer of educational opportunities and credentials. Far from being a “restricted” or “limited” form of inheritance, “forcing” your heirs to use a portion of their inheritance on the best private schools is far from a drawback of the 529 plan scam. For many of our oligarchs, it’s the whole point.