In his 2007 budget proposal, President George Bush is looking to expand tax-free savings opportunities for investors in Coverdell education savings accounts and 529 college savings plans and at the same time permanently increase the amount workers can save in tax-qualified plans.

According to the Department of the Treasury's proposed bill, the underlying reason for the change is to encourage investors to save more by simplifying the wide array of educational savings choices and tax breaks available to them, while easing current restrictions in 529 and Coverdell plans.

If put into practice, the proposed rule change would allow participants in Coverdell and 529 qualified tuition plans (QTPs) to transfer their assets into lifetime savings accounts (LSAs) that the contributor could use for any purpose and tap into at any time without incurring taxes on accumulated interest, dividends or capital gains. However, the contributor would be subject to income tax on the income portion of the withdrawal, but distributions used for the defined beneficiary's qualified expenses would not trigger an income tax.

The new measure would permanently extend the Federal tax exclusion for qualified withdrawals from 529 plans beyond 2010, when the tax breaks are due to expire.

Those individuals who do not make a lot of money are often worried about making contributions to a plan that locks in their money. With this new plan, they would be able to take the money out whenever they need it and not be penalized for withdrawals.

Nonetheless, the American Counsel of Life Insurers opposes the LSA proposal because of this very flexibility. "LSAs, which would provide tax-free savings but allow easy access to funds saved in such accounts, would effectively discourage long-term savings," the organization said in a written statement. "With no restraints on access to funds in LSAs, research shows that people would tap into these accounts to meet short-term expenses. At a time when millions of Americans are preparing inadequately for retirement, providing more disincentives to long-term savings represents a misguided policy."

Under the proposed law, an individual who was the beneficiary of a QTP as of Dec. 31, 2005, be it a prepared 529 or a savings 529, would be able to transfer up to $50,000 of those assets to an LSA. All conversions made before Jan. 8, 2008 would be on a tax-free basis. Any rollovers in 2006 and annual contributions in years thereafter would be limited to $5,000, without any restriction on age or income. And, like a Roth IRA, there would be no minimum required distribution rules applied during the account holder's lifetime.

This does not mark, however, the end of QTPs. They will remain as a separate kind of account, and could even be offered inside of LSAs.

For example, state agencies that administer QTPs could offer LSAs with the same investment options available under the QTP. The plan administrator would also be free from any additional reporting requirements of a QTP for investments in an LSA.

Contributions would be nondeductible, but earnings would accumulate tax free, and all distributions would be excluded from gross income, regardless of the individual's age or use of the distribution. However, states would be allowed to provide state tax incentives, and administrators will be allowed to provide investment recommendations for savings used for educational purposes.

When asked whether he thought companies would be quick to offer QTPs inside LSAs, Oppenheimer Funds Vice President and National Sales Director for 529 Plans William Raynor said, "I sincerely doubt that many companies will be offering the QTP within an LSA. However, I do believe that LSAs will be offered and will be popular if approved." He added that the reason behind his assumption is the fact that LSAs have little or almost no restrictions.

The purpose of these types of accounts, as explained by the Bush administration, is that individuals get to place after-tax money into accounts with no restrictions in regards to income and taxes. LSAs are seen as something of a safety net, since if individuals decide they don't want to use the funds for higher education, they can use it for any other purpose without being penalized.

Proponents of the change also note that the current tax treatment of section 529 accounts is unclear and creates opportunities for inappropriate use of 529s. For example, taxpayers may seek to avoid gift and generation-skipping transfer taxes by changing the designated beneficiary. Taxpayers may also try to use 529 accounts as retirement accounts with all of the tax benefits but none of the restrictions of qualified retirement accounts.

"There's been a longstanding view by some elected officials that these LSA accounts are somehow vehicles for the wealthy and that they will be used to skip paying taxes," Raynor said.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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