Is Obama's proposal to tax 529 plan withdrawals really just a ploy to boost savings?

Hoping to address the burgeoning student loan debt crisis, Rep. John Delaney, D-Md., introduced legislation Thursday to allow student debt to be discharged in bankruptcy.

Delaney’s bill, the Discharge Student Loans in Bankruptcy Act, H.R. 449, addresses what Delaney sees as a “huge student loan loophole in bankruptcy law that’s hurting real people.”

The bankruptcy law, he said in a statement, needs to be reformed “to help those with the absolute greatest need,” noting that student debt is currently the only type of debt that’s not dischargeable in bankruptcy.

Student loan debt, Delaney argued, “is dragging down economic growth, keeping the American Dream out of reach for many and is a monthly strain for millions.” He noted that addressing such debt “is a complex problem that will require many solutions,” but that “it doesn’t make sense for students with heavy debt burdens to be worse than someone with credit card, auto loan debt or mortgage debt.”

Delaney cites research by The Institute for College Access & Success finding that 69% of college graduates from the class of 2013 graduated with student loan debt, owing an average of $28,400.

Lawmakers from “every state in the country have constituents who are struggling severely because of student loan debt,” he continued. “At the very least we should have some basic fairness in the law.”

President Barack Obama noted Tuesday in his State of the Union speech that one of his goals is to help students reduce their college debt load by making community college free. “I want to spread that idea all across America, so that two years of college becomes as free and universal in America as high school is today,” Obama said, adding that he also wants to work with the new Congress “to make sure those already burdened with student loans can reduce their monthly payments.”

Obama has offered two such ways to lower students’ debt load — eliminating the tax on student loan debt forgiveness under Pay-As-You-Earn (PAYE) and other income-based repayment programs, and replacing the complicated student loan interest deduction for new borrowers with “more generous and more targeted tax relief” through other programs.

College savings proponents, however, are rebelling against Obama’s plan to impose a tax on qualified distributions from 529 college savings plans.

Joe Hurley, founder of Savingforollege.com, writes in his Wednesday blog that he was initially “perplexed and angry” about Obama’s plan, writing that 529 plans “have succeeded in getting millions of mostly-middle-class American families to save toward future college expenses. Why penalize such families under the guise of paying for free community college and other government programs?”

But upon closer review, Hurley concludes that Obama’s plan is actually “a brilliant ploy to increase savings” in 529 plans.

Imposing a tax on 529 distributions “can never come close to paying the tab for free community college,” Hurley says, because such a tax would cause contributions to 529 plans to “simply dry up” as Americans “won’t put assets in a 529 plan if it were taxable. There can be no tax revenues when there are no assets to be taxed.”

Hurley says that while Obama and his “closest advisors know this, … they are not letting on because they are hoping that parents and grandparents will rush to increase their 529 college savings and receive grandfathered tax-free status before any change is actually made,” as his proposal would impose tax only on new contributions.

While Hurley predicts that Obama’s 529 proposal “will be dropped,” he argues that higher taxes on capital gains or other income will have to pay for the free community college concept.

“Such tax increases will serve to increase the attractiveness of 529 plans relative to other college-savings vehicles,” Hurley writes. “So even more money will pour into 529 plans, and American families will be even better prepared to pay for college.”

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