Part of what lies at the heart of the heated debate in state capitals and Washington over the last couple of weeks is a legitimate concern about a pretty simple question: have governments made too many promises about what they should provide without collecting enough money to fulfill them all? www.wdalaw.com The discussion of this question often leads to a look at income tax rates. Not enough of it, however, focuses on income tax breaks.
So amid all the hubbub, it’s worth stopping to consider how many of these deals you are eligible for (and if you’re old enough, recalling how many of them didn’t exist a few decades ago). On the state level, for instance, it’s possible that a tax deduction or credit for your child’s college savings account is contributing to a shortfall.
At the federal level, the money from 529 savings accounts can come out tax-free as long as they are used for education expenses. Then there’s the $5,000 or $10,000 you might have managed to shield from the tax man in health care, dependent care and commuter accounts, if you’re lucky enough to work for an employer that offers them.
And if President Obama gets his way, the income tax deduction for mortgage interest and charitable contributions for people in the highest tax brackets may get smaller.
If you’re upper middle class and above, take a look at your tax return and consider just how many deductions, set-asides and other breaks you took advantage of. I added up mine and found tens of thousands of dollars, leading to many thousands in tax savings.
Then look at the income figure on your tax forms and ask yourself this: Isn’t it likely that a bunch of legislators are going to figure out how much this is costing and take some of the benefits away? And if so, shouldn’t you be trying to take advantage of them before they disappear?
Reading between the lines in President Obama’s introduction to the 2012 budget, it’s clear how he feels about the policy decisions that gave rise to this crazy quilt. “For too long,” he wrote, “we have tolerated a tax system that’s a complex, inefficient and loophole-riddled mess.”
In fairness, it’s not as if there was some master plan here. Who, after all, would have declared that there should be income caps on taking deductions for student loan interest but that the wealthy should still get all sorts of tax incentives to save for college?
Take those 529 plans, for example, because the tax breaks exist on the federal level and in many states. The tax rules here did not emerge fully formed from the head of some legislator either. Instead, they began mostly as a way to prepay tuition at state universities and evolved into investment accounts that anyone, of any income, could use for any higher education, public or private. Federal taxes on the growth in money that people deposited into these accounts were simply deferred at first; years later, the rules changed and families suddenly did not have to pay any taxes on the gains as long as they used the money for qualified educational expenses. And it didn’t matter how much the money had grown.
As of June 30, 2010, 529 plans contained about $135 billion, according to the College Savings Plans Network, with just $21 billion or so in prepaid plans. And according to the Joint Committee on Taxation, which took a careful look at the plans when it last addressed the rules governing them in 2006, the federal tax waiver on the gains was going to cause a nearly $1 billion annual hit to the federal budget by the middle of this decade.
That number may end up being lower because of the roller-coaster stock market of the last four years. But the amazing thing about 529 accounts is that they often offer tax benefits on the way in as well as on the way out.
How does this work? As of today, most of the states that levy an income tax offer a deduction or credit of varying size to families when they make deposits in their own state’s (and sometimes any state’s) 529 plan. While the deduction generally has an annual dollar cap, you can often take advantage of it no matter how much money you make.
In Indiana, for instance, the 48,167 taxpayers who took the credit on their 2009 returns saved about $33 million.
The more you make — or the more a kind grandparent has given to you for your child — the more you can save. That means more opportunities to max out the state tax deductions. Moreover, wealthier people who can save more money earlier in their children’s lives benefit from the compounding of earnings over 15 or 20 years before tuition bills come due. (And by the way, the 15 percent capital gains rate they don’t have to pay upon withdrawal today will probably be higher before too long.)
Joseph Hurley, who runs savingforcollege.com, the leading resource for people doing research on 529 plans, understood why many states offered tax deductions. They needed to increase total balances to get economies of scale so they could drive down the 529 program fees that state residents pay. “But states cannot afford to offer these deductions now,” he said. “It’s free money to people who can take advantage of it, and it is higher-income families who can.”
According to Joan Marshall, who runs Maryland’s 529 savings plans and is chairwoman of the College Savings Plans Network, the states can’t afford not to offer the deductions. Without them, she says, people wouldn’t save in the first place, as is evident from the fact that so many deposits arrive late in the year, near the tax deadline. “And if we have a culture of savings, there is less need for aid later,” she said. “There is a real gain to be had down the road as we help to change behavior. It’s not only a negative drain on state budgets.”
Ms. Marshall added that if 529 plans were truly a tax-free plaything for the well-to-do, it wouldn’t be the case that just 0.67 percent of accounts had more than $100,000 in them. (That said, it’s possible that some wealthy families have more than one account.)
Legislators in North Carolina may have a chance to debate all of this soon. The state once had income restrictions on who could take state tax deductions for contributions to its 529 plan. The cap went away but is scheduled to return in January if elected leaders do not act before then.
This is just one front in the larger battle, though. There has already been plenty of discussion about the possibility of reducing the amount of deductions that higher-income people can claim for charitable contributions and mortgage interest. This is where many of the big budget opportunities lie. In fact, the changes are already coming. One new one is in health care flexible spending accounts, where people can set aside money free of income taxes to pay for expenses that insurance does not. Starting in 2013, you’ll only be able to put $2,500 in those accounts each year. This will hurt middle-class people with chronic conditions; an income cap on who could participate would have made the change more progressive.
But at least this is one sign that legislators are taking government debt seriously. And until more changes arrive, I’d take advantage of every last break and max it out if you’re affluent enough to do so. Because pretty soon, many of them may no longer be available to you.