Can the Government Retroactively Take Tax Breaks Away?
That's the conundrum that many college savers find themselves in after the latest State of the Union address. Among the numerous tax proposals that President Obama included in his speech, one stands out as potentially having a big impact on the tax planning of parents trying to save toward their children's college education. With the administration threatening to take away the tax break on two popular types of college savings accounts, one question many Americans are asking is whether the government can actually change the tax rules even after millions of families have relied on those rules in their financial planning.
The Controversy Over College Savings Plans
The State of the Union address included provisions to expand tax credits for education, increasing their maximum amount for some families and simplifying the patchwork of different breaks available for college and other educational costs. To help pay for these additional tax breaks, the proposal would take away some of the current tax breaks on 529 college savings plans and Coverdell Education Savings Accounts. Under current law, if you use 529 plan or Coverdell ESA money to pay for education, then any income and capital gains that the money in the account earned between the time you contributed it and when you used it is entirely free of tax.
What wasn't immediately clear from the proposal is whether these changes would apply only to future contributions, or would be retroactively applied even to existing accounts. Interestingly, although many would see failing to grandfather existing 529 accounts and Coverdell ESAs as being unfair, there's legal precedent to support the idea that the government could indeed change the tax rules.
The History of Retroactive Taxes
Indeed, if the administration's proposal took the more aggressive approach, it wouldn't be the first time Americans faced a retroactive tax.
- In August 1993, President Clinton signed a law raising tax rates on high-income earners and estates. The new rates applied back to the beginning of 1993, and although disgruntled taxpayers went to federal court seeking to have the retroactive application of the rules invalidated, those arguments proved fruitless.
- In 1987, Congress passed laws retroactively repealing an estate-tax provision, a repeal which cost one taxpayer $2.5 million. The Supreme Court ruled that taxpayers have no right to rely on tax legislation being permanent, with the majority arguing that as long as lawmakers act with "a legitimate legislative purpose," retroactive application is constitutional. Even though one Supreme Court justice argued that the government had used "bait and switch taxation," he nevertheless concurred with the unanimous holding of the Court.
- A 1976 tax-law change affected homeowners' ability to shelter capital gains from the sale of a home from taxation. One homeowner took advantage of rules that allowed half of all gains to be free of tax, but six months later, President Ford signed a law retroactively limiting the taxable amount. Just as it did more than a decade later, the Supreme Court upheld the law as being constitutional.
Even if retroactive legislation is constitutional, the more important question the government always faces is whether it's politically viable. In general, retroactive tax increases seem unfair, and public opinion will often prevent politicians from advocating such measures. With college savings plans, the administration is arguing that the accounts primarily help upper-income taxpayers, seeking to build political consensus to drive support for the measure and sweep any concerns over fairness under the rug of public opinion.
Regardless of what happens with 529 plans and other education savings accounts, the lesson taxpayers need to heed is that tax laws that seem to be written in stone provide no guarantees of surviving future changes. With lawmakers having the right to rewrite tax laws at will, you must always remain mindful of possible revisions that can gut your financial planning.
Motley Fool contributor Dan Caplinger wishes he could do a lot of things retroactively. You can follow him on Twitter @DanCaplinger or on Google+. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.