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taxes (although many states offer in-state tax deductions for contributions), compound internally tax-free, and are withdrawn tax-free for “qualified higher education expenses.”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.
Wouldn’t this effectively allow you to place as much as you want into a 529 with no real fear of over-contributing? There’s nothing stopping you from taking out a large student loan, larger than your could ever really need, and then immediately paying it off with your 529 funds. When my wife was getting her doctorate, there was nothing stopping her from taking out student loans far and above what she required for tuition and living expenses, I always thought it was pretty alarming how a student could request 30k in loans every 4 months with just a few clicks, even when tuition and expenses didn’t come close to that. Now obviously a bank is not going to expend more money than they can realistically expect to collect, but when this loophole exists, I can foresee unscrupulous lenders pairing up with 529 opportunists to hand out exorbitant loans with the understanding that they would be paid off almost immediately with 529 funds. Lenders could even screen for this very scenario through income and asset verification during the loan approval process. i.e. this student has access to a 529 with 2M in assets, approve them for any loan up to that amount. Is there anything preventing this from happening?
Luke,
As currently proposed, the SECURE backdoor would only cover $10,000 in lifetime withdrawals per student for student loan payments. The risk is that once it’s created, it will be quickly expanded to allow unlimited student loan withdrawals allowing wealthy people unlimited free access to their 529 balance, precisely as you describe.
—Indy
One can’t over-contribute. Total 529 plan contribution limits are set by the states and can be as high as $380,000.
Good write up. There is one caveat the numbers you ran up are on specific exact scenario Although this seems terrible, the cap of $10,000 seems to make it an attempt to help out on those student loans without turning it into a full fledged loophole. 10k for an investor is not to much and any student loans above 10k would be taxed at the regular rate.
solomon,
I actually agree with you in terms of the framing, but that’s a purely strategic approach. The $10k annual loophole for private elementary and secondary tuition is also intended to limit the cost to taxpayers, but it’s obviously just a matter of time until wealthy parents start lobbying to raise the limit. “$10,000 doesn’t even pay for a single semester of tuition at my child’s school, why is Congress punishing parents who just want their children to receive a good education?”
In the same way, if the SECURE backdoor is created it will just be a matter of time before it gets cracked all the way open. “$10,000 is barely a tenth of my student loan balance, why does Congress insist on punishing students who are already being punished by student loans?”
—Indy
The sad thing is all they needed to do to fix this problem is remove two words: “principal or.” If they just allowed 529 money to be used tax and penalty free for the interest portion of the student loan payments, this loophole would be closed. Student loan servicers are already required to send out tax forms stating the interest portion of payments made (for the student loan interest deduction), so it wouldn’t create any more burden in that respect either.