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Education: What tax incentives exist to help families save for college?

Three tax-favored savings instruments encourage families to save for college: Coverdell savings accounts, qualified tuition programs (commonly referred to as 529 plans), and the education savings bond program. Use of funds from any of these three programs for other than permitted educational expenses subjects those funds to income taxes and penalties. In addition, certain retirement savings vehicles such as Roth Individual Retirement Accounts (IRAs) may be used to pay for higher education without penalty. Because the benefits of each of these programs are proportional to the family’s marginal tax rate, they give greater saving incentives to higher-income than to lower-income families.

  • Anyone, regardless of income, may contribute to a 529 plan for a named beneficiary. A donor may contribute up to $12,000 annually for each beneficiary without triggering a gift tax and may make up to five years of contributions in a lump sum without triggering a gift tax so long as no additional gifts are given to the beneficiary during the five-year period. Funds in a 529 plan grow untaxed. Since the passage of EGTRRA, funds used to pay for postsecondary education are not taxed when withdrawn. Donors retain ownership of the accounts but may use the funds to pay educational expenses only for the named beneficiary. They may, however, transfer funds to another beneficiary, subject to relationship requirements between the original and the new beneficiary.
  • Growth of 529 plans since 1996 has been tremendous. At that time only 500,000 accounts existed, containing $2.4 billion in assets (see figure). As of September 2007 there were 10.2 million 529 plan accounts, containing $127 billion in assets.
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  • Every state except Wyoming sponsors a 529 plan (but Wyoming residents receive preferred treatment in the Colorado 529 plan). In states with a personal income tax, residents investing in their state-sponsored 529 plan often receive a state tax break for at least part of their investment.
  • In 2007 families with adjusted gross income (AGI) below $110,000 ($220,000 if filing a joint return) may deposit up to $2,000 per beneficiary in a Coverdell account on an after-tax basis. Funds grow untaxed and may be withdrawn tax free if used to pay educational expenses.
  • The education savings bond program allows users to exclude interest on certain bonds from income tax if the money is used to pay for postsecondary education. In 2007 families could cash in these bonds tax free only if their AGI was less than $80,600 ($128,400 if filing a joint return; income limits are indexed for inflation). This program is substantially smaller than the other two.
  • All families face the same 10 percent penalty if account funds are used for other than permitted educational expenses, regardless of how much benefit they would receive if they used the money for education. Even with the penalty, high-income families can benefit from 529 plans and Coverdell accounts because the accounts let them shift money to their children, who typically face lower tax rates. That benefit does not extend to low-income families, who already face lower tax rates.
  • The benefits of 529 plans and Coverdell accounts are also less for low-income families because they can reduce financial aid for which they would otherwise qualify.
  • Benefits in college savings accounts accumulate over time. To reap the maximum benefit, families must invest well before they know whether a child will attend college. That uncertainty is greatest for low-income families, whose children are least likely to attend college, and this increases their risk of penalties for using the funds for noneducational purposes.
  • The tax incentives that these programs provide are of greatest benefit to families whose children are most likely to attend college even without a subsidy. As a result, it is unlikely that these programs significantly increase college attendance.
 
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