Obama urges middle-class help, but calls for ending vital college tax break

President Obama used his State of the Union address Tuesday night to tout “middle-class economics” – including tax breaks for child care and free community college.

But while it went unmentioned in his speech, the White House also is proposing rolling back a vital tax break for college savings plans that directly impacts the middle class.

The proposal would change the tax treatment of so-called 529 plans, which allow college savings to grow tax-free. Under the change, Americans eventually would have to pay taxes on the earnings when they’re withdrawn.

The 529 plans mostly are used by upper-middle- and middle-class families -- low-income families typically don’t have thousands of dollars saved up for college, while very wealthy families are more likely to have trust funds in place for their children’s education.

The proposal has drawn criticism, particularly as the administration claims to be gearing its agenda toward the middle class.

Taxpayer watchdog group Americans for Tax Reform called it a “tax increase on families saving for college.”

The College Savings Foundation, a nonprofit, warned the change would “undercut the effectiveness of 529 plans – the most effective and by far the most popular college savings vehicle available to middle income” families.

"We in the college savings industry, CSF and the College Savings Plans Network (CSPN), are united in our opposition to the tax incentive rollback that will impact American families and their saving for education,” Mary Morris, chairwoman of the College Savings Foundation, said in a written statement.

But administration officials claim they are going after the 529 accounts because they unfairly benefit high-income people.

A White House fact sheet on a range of new tax ideas, released over the weekend, described the current treatment as “upside-down education savings incentives.”

One official told The Wall Street Journal that 80 percent of the benefit from the 529 tax breaks goes to households making more than $250,000 a year. Other estimates put that figure much lower.

The tax-free 529 accounts were introduced as part of then-President George W. Bush’s 2001 tax-cut package.

The 529 college savings plans, which are named after the Internal Revenue Service code that created them, are among the most popular ways for families to save for college.

The move to strip 529s of the key tax break allows the administration to offset the cost of other changes, including an expansion of the American Opportunity Tax Credit, which provides tax relief for higher-education expenses of up to $2,500 per student. The president also is pushing a costly program to provide two years of free community college to students who keep up their grades.

According to the Investment Company Institute, there are close to 12 million 529 accounts open, with an average balance of $21,000. In all, Americans accumulated $245 billion in 529 plans in 2014.

The 529 college savings plans allow families to invest without the earnings being taxed as long as the money goes toward paying for college expenses. If the president’s plan goes through, the earnings on new contributions would be viewed as ordinary income which is subject to taxes when withdrawn.

According to the White House, families could defer paying taxes on the plans as the earnings grow but as soon as they start drawing down the account, the earnings would be treated as student income and taxed -- which also could hurt a student’s chance at receiving financial aid.

Kansas Republican Rep. Lynn Jenkins reportedly said that by taxing 529 plans, “the president is essentially forcing many middle-class families into a huge federal program to attend community college.”

Jenkins told The Wall Street Journal she’s worried that Obama’s proposal could create a “21st century caste system where the wealthy send their kids to four-year colleges and the middle class send their kids to community colleges.”