Treasury Department Recommends Changes to Tax Code Section 529 College Savings and Tuition Plan

A September 9, 2009 report issued by the Department of Treasury (”Department”) discussed the benefits of 529s as a way to build savings for this critically important investment, the extent to which Section 529 plans serve various income groups, and how well the plans keep costs low so as to maximize returns to savers. In addition, as requested by U.S. Vice President Joseph Biden,  the report highlights exemplary practices and makes a set of recommendations on how to make Section 529 plans more effective and reliable.

By way of background, the Internal Revenue Service (“IRS”) on its website defines a 529 plan as investment vehicles designed to help families pay for future expenses associated with college or other qualified post-secondary training. Though contributions to a 529 plan are not deductible, these plans offer other tax advantages and are named after Section 529 of the Internal Revenue Code (“IRC”). All 50states and the District of Columbia sponsor at least one type of 529 plan.

A Section 529 plan is formally a “qualified tuition program.” Section 529 of the IRC provides rules by which qualified tuition programs must abide in order to receive favorable federal tax treatment. Such programs can be administered by the 50 states and the District of Columbia, and by one or more eligible educational institutions.

The American Recovery and Reinvestment Act of 2009 (“ARRA”) has added computer technology to the list of college expenses (tuition, books, etc.) that can be paid for by a 529 plan. For 2009 and 2010, the law expands the definition of qualified higher education expenses to include expenses for computer technology and equipment or Internet access and related services to be used by the designated beneficiary of the 529 plan while enrolled at an eligible educational institution. Software designed for sports, games or hobbies does not qualify, unless it is predominantly educational in nature.

The September 9 Treasury Department report recommends five approaches to making Section 529 savings plans more attractive, effective and reliable for middle class families, and those who aspire to join the middle class through college attendance. Among the recommendations are the following:

• Provision of Age-Based Index Funds. According to the Department,  age-based investment funds are very popular and are well suited to the circumstances of many middle class families that are saving for college. Yet five of the 48 states offering a direct sold savings plan do not offer an age-based fund, according to the Department. Moreover, only 23 of the 43 states that do offer an age-based fund offer it in the form of index funds. Historically, index funds have performed well relative to actively managed funds because they have low fees, and they are especially well suited for investors who do not wish to spend time acquiring information and evaluating the investment philosophy and track records of actively managed funds, the Department found.

• Eliminate Home-State Bias. The Department wrote that if home-state bias in state tax and student aid policies were eliminated, the result would be more investment options for consumers, more intense competition between plans, and very likely lower fees. To the extent that there are economies of scale in plan administration, consumers will also benefit from additional scale and lower costs.

• Per Beneficiary Contribution Limits. The Department found that currently,  there are effectively no limits on Section 529 account balances. Because 43 states offer plans open to residents in other states, a beneficiary can have accounts in as many as 44 states, each state with a limit exceeding $224,465. Putting an effective limit on Section 529 contributions requires making the limits per beneficiary rather than per beneficiary per state, the Department stated in its report. Per beneficiary limits would reduce the tax benefits to high income families and, by lowering federal tax expenditures for the program, would potentially free up federal resources for education aid that could be targeted to low and middle income families.

Per beneficiary limits, the Department added,  would best be enforced at the time distributions are made. Specifically, each distribution for a particular beneficiary’s qualified educational expenses would be divided into a principal portion counting against the contribution limit and an earnings portion. At such time as a beneficiary reaches the contribution limit, distributions would be nonqualified and subject to penalty.

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