In defense of 529s — and a culture of saving

The big news on the domestic policy front is that the Obama administration proposed a plan to tax the education-related withdrawals from 529 investment plans — then withdrew it when Democrats let him know just how unpopular this was among the upwardly mobile liberal base of the party.

For the uninitiated, 529 plans are a little like an IRA for education expenses. People who open 529 accounts usually do so for their children. They deposit some of their post-tax earnings into them, and invest those monies into mutual funds. The advantage of 529 accounts is that the accumulated income is not subject to normal capital gains taxes if the money is used for education purposes.

When it proposed taxing these, the Obama administration pointed out that very few people use them, and that 70 percent of tax benefits go to households earning over $200,000 a year. Taxes on these could be used to help fund free community college for those on the lower end of the income ladder.

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Why does the top 1 percent get about half the benefits? First, having more money means having more money to save. That’s how being rich works. Further, the largest balances will naturally be in older accounts. A household that has had a 529 for 18 years and is about to send a daughter to college will often be led by parents at just about the peak of their lifetime annual earning power.

Also, these plans allow people to front-load five years worth of contributions on the day they open the account. That’s something the truly rich are able to do, but upper-middle-class people usually cannot. The Obamas did this, dumping $240,000 into 529 accounts for their two daughters. That’s a very different way of using this vehicle than a middle-class parent contributing a few hundred dollars a month. The Obamas can’t contribute again for five years, but that lump sum grows.

My colleague Ryan Cooper calls 529s garbage policy. And on the terms he sets, of course they are. Because college saving is on a shorter timeline than retirement, the beneficiaries of 529 accounts are more vulnerable to market fluctuations. But most damagingly, whenever the government sets aside more money for education through federally guaranteed loans and grants, or through education-savings tax preferences, tuition at schools keeps rising to capture it.

In fact, that’s where the critics of 529 accounts and some of its defenders are likely to agree. Annual tuition at schools is galloping past annual median income. If a student has the academic merits to get into a good private college, matriculation should not require great amassed wealth through two decades of saving and investing, nor should it require effective post-collegiate debt slavery.

This is all the more appalling when the very top colleges are, financially speaking, more like enormous hedge funds, with a small, archaic education component. The investment income made by colleges is such that they could make attendance tuition-free and still be in the black.

And yet, I find myself instinctively defending 529s. Why? Because I believe saving is good.

The debate about 529s is driven only partly by the numbers in the ledgers. At the bottom of it are two different attitudes towards money and social goods. There are those, like myself, who think it is a good thing for families to plan and save for major purchases of social goods like higher education. And there are those who favor a more social-democratic model, who think it is a bad thing that anyone should have to save for a social good like higher education. Similar instincts are at play in debates about health-care reform.

Some will say that the middle-class devotion to 529s represents an ugly, “I’ve got mine” mentality. In fact, it’s something like the opposite. To borrow a page from my own biography, I grew up the child of a single mother who earned a good income as a secretary at a major corporation. I was strongly encouraged by guidance counselors and others to apply to private schools, based on my grades (which were ok). But my college dreams were completely dependent on receiving Pell grants, a generous financial package, a generous scholarship, and student loans, which I, as a financially illiterate 18-year-old, did not understand. Bard College, whose annual tuition and room and board then was over 100 percent of my mother’s pre-tax income, made the best offer.

And I benefited from it immensely. I’m grateful. Now my wife and I earn more individually than my mother did. We used our extra income to pay off our student loans quickly. Opening up a 529 account for my recently born daughter would be one of the primary experiences of upward mobility for me. Perhaps she wouldn’t have to be so dependent on the generosity of institutions, or on public money. Or at least she wouldn’t face student loan debt. This is an attitude of paying it forward.

I want a social arrangement where I’m expected to save and to contribute from my earnings for the future, whether that is education, health expenses, or retirement. And I loathe the drift toward a more social-democratic policy, where provision for these is done almost entirely by the government. We’re rapidly heading toward a social arrangement in which almost all post-tax income for the middle class is immediately consumed.

There are a number of measures by which 529s are not great policy. But they are one of the few policies that encourage and reward saving rather than penalizing it. The earned interest on a savings account is taxed as income. The mortgage-interest deduction encourages people to be in debt and spend more on their property. Even in social-democratic Europe, households typically save 10 percent of their income. In the United States, that figure is closer to 4 percent.

It’s obvious that the problems with health and education are out-of-control inflation. Limiting one of the few policies by which Americans save would never address that.