Obama drops proposal to tax 529 college savings plans

The Obama administration has decided to scrap a plan to tax 529 college savings plan withdrawals.

A White House official called the proposed change a "distraction" and said there are plenty of other ways to raise revenue as part of their budget.

According to a source familiar with the matter, in addition to GOP complaints, House Minority Leader Nancy Pelosi had pressed Obama to drop the 529 plan.

Read MoreObama's middle class dilemma on 529s

Obama had proposed raising $1 billion over 10 years by taxing capital gains realized in withdrawals from 529 college savings accounts. The White House cited surveys showing that 70 percent of the assets in such accounts are held by families earning more than $200,000 per year, and noted that higher-income families benefit most from the current tax exemption for such gains.

In an aim to help the middle class, the White House proposal would then have made permanent the American Opportunity Tax Credit, which provides up to $2,500 per year for families with incomes up to $180,000. It would extend that credit, which is refundable (distributed as a government check) for some families who don't owe federal income taxes, to new categories of students such as those attending classes part time.

There was considerable political debate over whether this plan would in fact help or hurt the middle class.

—CNBC's John Harwood and Matt Cuddy contributed to this report.

Eri Morita | Photodisc | Getty Images