Tax breaks for out-of-state 529 plans unlikely

The Department of the Treasury wants all states that have an income tax and also sponsor a Section 529 college savings plan to offer residents a tax break, no matter what plan they choose, even if it is one from another state. Nice try, but it isn't going to happen, industry observers say. But eliminating what the Treasury Department calls “home state bias” — only five states offer a tax deduction or credit for residents who contribute to an out-of-state plan — would most likely have to be implemented by the federal government, and Congress is distinctly unreceptive to treading on the states' toes, according to industry insiders. “Having a uniform tax policy would be a more consumer-friendly approach,” said Joe Hurley, president and chief executive of Savingforcollege.com LLC. “It would allow parents to choose a 529 plan based on factors other than a state's income tax deduction,” he said. “However, I don't see any appetite in Congress to battle the states on this front right now.”

"OVERREACHING'

“Congressional action is not likely at all,” said James Canup, an attorney for 529 Counsel PLC and a veteran observer of 529 issues in Washington. “The states are against it, and I think it's seen as overreaching on Treasury's part.” The states' arguments come down to wanting to keep control of their programs — and their coffers. “All decisions on a state tax policy with regard to investment in 529 plans should be left to individual states,” said Joan Marshall, executive director of College Savings Plans of Maryland and spokeswoman for the College Savings Plans Network, an association of state 529 plan administrators. Many industry observers point out that if states were forced to give a tax deduction to every resident contributing to an out-of-state plan, they would lose significant revenue, which would be a bitter pill to swallow during a recession. A number of states may think that their plans would be threatened by a uniform policy, Mr. Hurley said. “I think the states would rather eliminate deductions altogether rather than weaken their own plans,” he said. “Equalizing the state tax treatment of all 529 plans could lead cash-constrained states to eliminate those benefits altogether,” said Andrea Feirstein, managing member of AKF Consulting LLC.
Even Jeff Troutman, vice president of college savings for Fidelity Investments Institutional Services, which oversees the $2.4 billion New Hampshire Fidelity Advisor 529 Plan, which would arguably benefit from a uniform national tax policy because it is sold by advisers nationally, said he doesn't support the Treasury Department recommendation. “We think this is a state issue,” he said. “Treasury recommendations should be about policy, not financing, and we strongly believe [tax deductions] should be in the states' bailiwick.” Another key recommendation from the Treasury Department's report on 529 plans, a cap on contributions for each beneficiary, is likely to be implemented, but is unlikely to have much effect on 529 programs.
“We think it's a reasonable recommendation and we support it. The number still has to be decided, but I think it will most likely be a number that reflects the cost of four years of college and three years of graduate school,” Ms. Marshall said. “We wouldn't have a problem with a national cap,” Mr. Troutman said. States have limits that range from $224,465 to $368,600 per beneficiary. However, a beneficiary can have accounts in as many as 44 different states. Placing limits on contributions per beneficiary rather than per beneficiary per state, would “reduce the tax benefits to high-income families” and potentially free up resources for lower- and middle-income families, the Treasury report said. Although industry executives acknowledge that the loophole that benefits high-income families exists, they say that there is no evidence that is being widely used. “Although we don't see any evidence of any abuse, it is a big loophole and it makes sense for Treasury to want to close it,” Mr. Troutman said. “But because this is something that affects so few people, I don't think it will be a big grassroots issue.” Many in the industry point out that persuading parents to invest more money in 529 accounts is a far greater challenge than excessive contributions. Indeed, the average account balance for all 529 plans was only $8,949 as of March 31, according to the CSPN. And though the recommendation for a national cap on contributions is widely accepted, the devil may be in the details, industry observers say. “It could be paperwork nightmare. I think people will want to see the specifics and determine how feasible it will be to implement this,” Mr. Hurley said. “I don't think you're going to see a lot of people out there funding an account to the max, but a new cap could add a layer of reporting that could increase costs,” Ms. Feirstein said. Most industry sources who are familiar with the issue expect the Treasury Department to begin to implement the cap recommendation sometime next year. A spokeswoman for the department didn't return calls seeking comment. In the report, which was released this month, the department also recommended that age-based index funds be included in all 529 plans. The report noted that five of the 48 states that offer a direct-sold savings plan don't offer an age-based fund. “Equally troubling is the fact that only 23 of the 43 states that do offer an age-based fund offer it in the form of index funds,” the report said. Index funds have historically performed well relative to actively managed funds and are “especially well-suited” for investors who aren't able to spend a lot of time researching active managers, according to the report, officially titled “An Analysis of Section 529 College Savings and Prepaid Tuition Plans.” Although any push by the Treasury Department to implement the index-fund recommendation is considered unlikely, it was nonetheless received coolly by the industry. Ms. Marshall said that she worries that the recommendation could be interpreted as potentially “restricting states from offering actively managed funds.” “The idea of an age-based indexed option is interesting,” Ms. Feirstein said. “But it is very important that we do not overlook stand-alone index options by guiding all investors into preset age-based allocations.” Overall, Ms. Marshall said that the Treasury Department and state 529 plans share the same goals. “We both want to make a college education affordable for middle-class families,” she said. E-mail Charles Paikert at cpaikert@investmentnews.com.