High-Income Families Benefit Most from New Education Savings Incentives

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High-Income Families Benefit Most from New Education Savings Incentives

Susan Dynarski

Published: February 28, 2005 || Availability: PDF | Printer-Friendly Version

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Note: This report is available in its entirety in the Portable Document Format (PDF).

A new breed of tax-advantaged savings vehicle has emerged for the college bound. Earnings on both the federal Coverdell Education Savings Account (ESA) and the state-level 529 savings plan are tax-free if the funds are used for postsecondary education. About half of states also allow an income tax deduction for contributions to their 529 plans, subject to an annual limit. The advantages of these education plans rise sharply with income for several reasons. Most obviously, those with the highest marginal tax rates benefit the most from sheltering income. A less obvious advantage lies in how the accounts are penalized if withdrawals are not used for schooling. Penalties more than offset tax benefits for lower-income families, but not for those with higher incomes, so higher-income families gain even if their children do not go to college. Finally, the reduction in college financial aid as a result of holding these assets takes a toll on many families, but especially low- to middle-income families who might otherwise qualify for more tuition assistance.

This brief explains how these new college plans work, comparing benefits between education savings and other savings vehicles. Although 529 plans and ESAs are still novel investment options, the 2001 Survey of Consumer Finances offers characteristics of the first investors to choose tax-advantaged college saving. Most important, the analysis presented here illustrates how the education savings plans deliver financial returns to families across the income brackets, from the lowest earners to the highest.

The Education IRA was established in 1997 and in 2001 renamed the Coverdell ESA. Much like Roth IRA contributions, ESA contributions are not tax deductible, but earnings accumulate tax-free. If withdrawals are used for postsecondary education, ESA earnings are never taxed. Likewise, Roth IRA earnings remain untaxed if the retiree reaches age 591/2 before taking any funds. Annual contributions to the ESA were capped at $500 per child until 2001, when the contribution limit was raised to $2,000 and educational expenses were expanded to include primary and secondary education.¹

While the ESA is a product of federal legislation, the 529 savings plan is a state innovation. Michigan created the first in 1986, a prepaid tuition plan with a rate of return linked to tuition costs at the state's public postsecondary schools. Those who purchased shares were insured against the risk of rising tuition prices. Michigan exempted investment returns from state taxes, and, in 1994, won a battle against the Internal Revenue Service to also exempt returns from federal taxes.

Several other states introduced their own plans, with some variants, as the Michigan case moved through the courts. So when Congress codified the federal tax treatment of tuition plans in 1997, the taxadvantaged college savings plan was also recognized. Like the ESA, these new savings plans allowed after-tax investments to grow free of federal and state taxes; however, withdrawals used for postsecondary costs were exempt only from state taxation until legislation enacted in 2001 eliminated the federal tax on withdrawals.² The growth of the 529 savings plans quickly outstripped that of the prepaid plans. As of summer 2003, every state except Washington had a 529 savings plan, as did the District of Columbia.

Notes from this section:

1. This increase sunsets in 2010.

2. This federal tax treatment of the 529 savings plans sunsets in 2010. The present analysis assumes that the provision will be extended indefinitely.

Note: This report is available in its entirety in the Portable Document Format (PDF).