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The Tax Policy Center's

Briefing Book

A citizen’s guide to the fascinating (though often complex) elements of the US tax system.

Tax Policy Center Briefing Book

Key Elements of the U.S. Tax System

  • Briefing Book
  • Taxes and Education
  • What tax incentives exist to help families save for education expenses?
  • Chapters
    • Introduction
      • Introduction
        • Introduction
    • Some Background
      • Federal Budget
        • What are the sources of revenue for the federal government?
        • How does the federal government spend its money?
        • What is the breakdown of revenues among federal, state, and local governments?
        • How do US taxes compare internationally?
      • Federal Budget Process
        • How does the federal budget process work?
        • What is the history of the federal budget process?
        • What is the schedule for the federal budget process?
        • What is reconciliation?
        • How is a budget resolution enforced?
        • What is PAYGO?
        • What are rescissions?
      • Federal Budget Outlook
        • How accurate are long-run budget projections?
        • What have budget trends been over the short and long term?
        • How much spending is uncontrollable?
        • What are tax extenders?
        • What options would increase federal revenues?
        • What does it mean for a government program to be off-budget?
        • How did the TCJA affect the federal budget outlook?
      • Taxes and the Economy
        • How do taxes affect the economy in the short run?
        • How do taxes affect the economy in the long run?
        • What are dynamic scoring and dynamic analysis?
        • Do tax cuts pay for themselves?
        • On what do economists agree and disagree about the effects of taxes on economic growth?
        • What are the economic effects of the Tax Cuts and Jobs Act?
      • Economic Stimulus
        • What is the role of monetary policy in alleviating economic downturns?
        • What are automatic stabilizers and how do they work?
        • What characteristics make fiscal stimulus most effective?
      • Distribution of Tax Burdens
        • How are federal taxes distributed?
        • Are federal taxes progressive?
        • How should progressivity be measured?
        • What is the difference between marginal and average tax rates?
        • What criticisms are levied against standard distributional analysis?
        • How should distributional tables be interpreted?
        • Who bears the burden of the corporate income tax?
        • Who bears the burden of federal excise taxes?
        • How do financing methods affect the distributional analyses of tax cuts?
        • How do taxes affect income inequality?
      • Tax Expenditures
        • What are tax expenditures and how are they structured?
        • What is the tax expenditure budget?
        • Why are tax expenditures controversial?
        • What are the largest tax expenditures?
        • How did the TCJA affect tax expenditures?
      • Tax Gap and Tax Shelters
        • What is the tax gap?
        • What does the IRS do and how can it be improved?
        • What is a tax shelter?
      • Recent History of the Tax Code
        • What did the 2008–10 tax stimulus acts do?
        • What did the American Taxpayer Relief Act of 2012 do?
        • How did the Tax Cuts and Jobs Act change personal taxes?
        • How did the Tax Cuts and Jobs Act change business taxes?
    • Key Elements of the U.S. Tax System
      • Individual Income Tax
        • What is the standard deduction?
        • What are itemized deductions and who claims them?
        • How did the TCJA change the standard deduction and itemized deductions?
        • What are personal exemptions?
        • How do federal income tax rates work?
        • What are tax credits and how do they differ from tax deductions?
        • How do phaseouts of tax provisions affect taxpayers?
      • Capital Gains and Dividends
        • How are capital gains taxed?
        • What is the effect of a lower tax rate for capital gains?
        • What is carried interest, and how is it taxed?
        • How might the taxation of capital gains be improved?
      • AMT
        • What is the AMT?
        • Who pays the AMT?
        • How much revenue does the AMT raise?
        • How did the TCJA change the AMT?
      • Taxes and the Family
        • What is the child tax credit?
        • What is the adoption tax credit?
        • What is the earned income tax credit?
        • Do all people eligible for the EITC participate?
        • How does the tax system subsidize child care expenses?
        • What are marriage penalties and bonuses?
        • How did the TCJA change taxes of families with children?
      • Taxes and the Poor
        • How does the federal tax system affect low-income households?
        • What is the difference between refundable and nonrefundable credits?
        • Can poor families benefit from the child tax credit?
        • Why do low-income families use tax preparers?
        • How does the earned income tax credit affect poor families?
        • What are error rates for refundable credits and what causes them?
        • How do IRS audits affect low-income families?
      • Taxes and Retirement Saving
        • What kinds of tax-favored retirement arrangements are there?
        • How large are the tax expenditures for retirement saving?
        • What are defined benefit retirement plans?
        • What are defined contribution retirement plans?
        • What types of nonemployer-sponsored retirement savings accounts are available?
        • What are Roth individual retirement accounts?
        • Who uses individual retirement accounts?
        • How does the availability of tax-favored retirement saving affect national saving?
        • What’s the difference between front-loaded and back-loaded retirement accounts?
        • What is an automatic 401(k)?
        • How might low- and middle-income households be encouraged to save?
      • Taxes and Charitable Giving
        • What is the tax treatment of charitable contributions?
        • What entities are tax-exempt?
        • Who benefits from the deduction for charitable contributions?
        • How would various proposals affect incentives for charitable giving?
        • How large are individual income tax incentives for charitable giving?
        • How did the TCJA affect incentives for charitable giving?
      • Taxes and Health Care
        • How much does the federal government spend on health care?
        • Who has health insurance coverage?
        • Which tax provisions subsidize the cost of health care?
        • How does the tax exclusion for employer-sponsored health insurance work?
        • What are premium tax credits?
        • What tax changes did the Affordable Care Act make?
        • How do health savings accounts work?
        • How do flexible spending accounts for health care expenses work?
        • What are health reimbursement arrangements and how do they work?
        • How might the tax exclusion for employer-sponsored health insurance (ESI) be reformed?
      • Taxes and Homeownership
        • What are the tax benefits of homeownership?
        • Do existing tax incentives increase homeownership?
      • Taxes and Education
        • What tax incentives exist for higher education?
        • What tax incentives exist to help families pay for college?
        • What tax incentives exist to help families save for education expenses?
        • What is the tax treatment of college and university endowments?
      • Tax Complexity
        • Why are taxes so complicated?
        • What are the benefits of simpler taxes?
        • What policy reforms could simplify the tax code?
      • Wealth Transfer Taxes
        • How do the estate, gift, and generation-skipping transfer taxes work?
        • Who pays the estate tax?
        • How many people pay the estate tax?
        • What is the difference between carryover basis and a step-up in basis?
        • How could we reform the estate tax?
        • What are the options for taxing wealth transfers?
        • What is an inheritance tax?
      • Payroll Taxes
        • What are the major federal payroll taxes, and how much money do they raise?
        • What is the unemployment insurance trust fund, and how is it financed?
        • What are the Social Security trust funds, and how are they financed?
        • Are the Social Security trust funds real?
        • What is the Medicare trust fund, and how is it financed?
      • Excise Taxes
        • What are the major federal excise taxes, and how much money do they raise?
        • What is the Highway Trust Fund, and how is it financed?
      • Energy and Environmental Taxes
        • What tax incentives encourage energy production from fossil fuels?
        • What tax incentives encourage alternatives to fossil fuels?
        • What is a carbon tax?
      • Business Taxes
        • How does the corporate income tax work?
        • What are pass-through businesses?
        • How are pass-through businesses taxed?
        • Is corporate income double-taxed?
      • Tax Incentives for Economic Development
        • What is the new markets tax credit, and how does it work?
        • What is the Low-Income Housing Tax Credit and how does it work?
        • What are Opportunity Zones and how do they work?
      • Taxes and Multinational Corporations
        • How does the current system of international taxation work?
        • How do US corporate income tax rates and revenues compare with other countries’?
        • What are the consequences of the new US international tax system?
        • How does the tax system affect US competitiveness?
        • How would formulary apportionment work?
        • What are inversions, and how will TCJA affect them?
        • What is a territorial tax and does the United States have one now?
        • What is the TCJA repatriation tax and how does it work?
        • What is the TCJA base erosion and anti-abuse tax and how does it work?
        • What is global intangible low-taxed income and how is it taxed under the TCJA?
        • What is foreign-derived intangible income and how is it taxed under the TCJA?
    • How Could We Improve the Federal Tax System?
      • Comprehensive Tax Reform
        • What is comprehensive tax reform?
        • What are the major options for comprehensive tax reform?
      • Broad-Based Income Tax
        • What is a broad-based income tax?
        • What would and would not be taxed under a broad-based income tax?
        • What would the tax rate be under a broad-based income tax?
      • National Retail Sales Tax
        • What is a national retail sales tax?
        • What would and would not be taxed under a national retail sales tax?
        • What would the tax rate be under a national retail sales tax?
        • What is the difference between a tax-exclusive and tax-inclusive sales tax rate?
        • Who bears the burden of a national retail sales tax?
        • Would tax evasion and avoidance be a significant problem for a national retail sales tax?
        • What would be the effect of a national retail sales tax on economic growth?
        • What transition rules would be needed for a national retail sales tax?
        • Would a national retail sales tax simplify the tax code?
        • What can state and local sales taxes tell us about a national retail sales tax?
        • What is the experience of other countries with national retail sales taxes?
        • What did the President’s Advisory Panel on Federal Tax Reform say about the national retail sales tax?
      • Value Added Tax (VAT)
        • What is a VAT?
        • How would a VAT be collected?
        • What would and would not be taxed under a VAT?
        • What would the tax rate be under a VAT?
        • What is the difference between zero rating and exempting a good in the VAT?
        • Who would bear the burden of a VAT?
        • Is the VAT a money machine?
        • How would small businesses be treated under a VAT?
        • What is the Canadian experience with a VAT?
        • Why is the VAT administratively superior to a retail sales tax?
        • What is the history of the VAT?
        • How are different consumption taxes related?
      • Other Comprehensive Tax Reforms
        • What is the flat tax?
        • What is the X-tax?
      • Recent Comprehensive Tax Reform Proposals
        • Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System, Report of the President’s Advisory Panel on Federal Tax Reform, November 2005
        • The Moment of Truth: Report of the National Commission on Fiscal Responsibility and Reform, December 2010
        • Debt Reduction Task Force, “Restoring America’s Future,” Bipartisan Policy Center, November 2010
        • The Tax Reform Act of 2014: Fixing Our Broken Tax Code So That It Works for American Families and Job Creators, House Ways and Means Committee
        • The Graetz Competitive Tax Plan, Updated for 2015
      • Return-Free Tax Filing
        • What is return-free filing and how would it work?
        • What are the benefits of return-free filing?
        • What are the drawbacks of return-free filing?
        • How would the tax system need to change with return-free filing?
        • Who would qualify for return-free filing?
        • Would return-free filing raise taxes?
        • What was the experience with return-free filing in California?
        • What other countries use return-free filing?
    • The State of State (and Local) Tax Policy
      • State and Local Revenues
        • What are the sources of revenue for state governments?
        • What are the sources of revenue for local governments?
      • Specific State and Local Taxes
        • How do state and local individual income taxes work?
        • How do state and local sales taxes work?
        • How do state and local property taxes work?
        • How do state and local corporate income taxes work?
        • How do state estate and inheritance taxes work?
        • How do state earned income tax credits work?
        • How do state and local severance taxes work?
        • How do state and local soda taxes work?
        • How do marijuana taxes work?
      • Fiscal Federalism and Fiscal Institutions
        • How does the deduction for state and local taxes work?
        • What are municipal bonds and how are they used?
        • What types of federal grants are made to state and local governments and how do they work?
        • What are state rainy day funds, and how do they work?
        • What are tax and expenditure limits?
        • What are state balanced budget requirements and how do they work?
    • Glossary
      • Glossary
        • Glossary

What tax incentives exist to help families save for education expenses?

Taxes and Education

<3/4>
Q.

What tax incentives exist to help families save for education expenses?

A.

Three tax-favored saving instruments encourage families to save for education expenses: Coverdell savings accounts, qualified tuition programs (commonly known as 529 plans), and the education savings bond program. The first two can be used for elementary, secondary, and postsecondary education. In contrast the much smaller education savings bond program is limited to postsecondary education.

Tax-favored accounts encourage families to save for education expenses by reducing or eliminating the tax normally owed. But there’s a catch: to reap significant benefits, families who use these accounts to save for college must invest in sheltered savings accounts years before they know whether their children will attend college. While these funds can be redirected toward another person’s educational expenses if the child does not go to college, savers must pay penalties to divert the money for noneducation purposes. The resulting uncertainty is greatest for low-income families because their children are least likely to attend college. 

Recent law changes allow families to make nontaxable withdrawals from 529 plans to pay for qualified expenses at public or private K–12 schools—an existing feature of Coverdell savings accounts. 

Higher-income families benefit more from tax-favored accounts because they avoid more taxes for each dollar contributed to a sheltered account. All families must pay income tax and a 10 percent penalty on money withdrawn from an account if the funds are used for purposes other than permitted educational expenses. However, even after paying the penalties, high-income families can still come out ahead because of the size of their tax savings and because the accounts let them shift ownership to their children, who typically face lower income tax rates. That benefit, of course, does not extend to low-income families, who are likely to be in the same tax bracket as their children. Tax-free accounts hold no benefit for families whose incomes are too low to require them to pay income taxes, but they are still subject to the penalty for using the funds for other purposes.

COVERDELL ACCOUNTS

In 2019 families with adjusted gross income (AGI) below $110,000 ($220,000 if filing a joint return) can 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. Coverdell account funds can be used for K–12 expenses as well as higher education. 

QUALIFIED TUITION PROGRAMS (529 PLANS)

Anyone, regardless of income, may contribute to a 529 plan for a designated beneficiary. As of 2019, a donor may contribute up to $15,000 annually for each beneficiary without triggering a gift tax, with the option of making up to five years of contributions in a single payment as long as no additional gifts are made during the five-year period. Income in 529 plans accumulates untaxed. 

Since passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, funds are not taxed when withdrawn from 529s, provided they are used to pay qualified expenses for postsecondary education (tuition, room and board, books and supplies, and technology). Donors retain ownership of the accounts but may use the funds to pay educational expenses only for the named beneficiary. The donor may, however, change beneficiaries if the new beneficiary is a member of the same family as the old beneficiary.

The 2017 Tax Cuts and Jobs Act expanded the qualified uses for tax- and penalty-free withdrawals from 529 plans to also cover K–12 elementary and secondary school tuition for public, private, and religious schools. 

Assets in 529 plans have grown considerably in the last two decades. In 1996, only 500,000 accounts existed and contained only $2.4 billion in assets. As of December 2019, there were over 14 million 529 plan accounts containing $372 billion in assets (figure 1).

Bar chart showing total assets in 529 College Savings Plan each year from 1996 to 2019 in billions of dollars.

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 plans often receive a state tax break for at least part of their investment. Families can choose to invest in plans from other states, which may be the best option for them—especially when contributions are not tax deductible. Some states, moreover, provide matching funds for contributions to 529 accounts. Beyond the state plans, there is also a separate private college 529 plan.

States that offer income tax credits or deductions for contributions to 529 college saving plans and exempt qualified distributions from 529 plans from state income taxes must decide whether they will follow the recent changes in federal rules for qualified withdrawals. Some states have decided to allow qualified withdrawals for K–12 tuition while others have not. For example, New York and Nebraska have issued public statements saying that only higher education expenses would qualify. In contrast, Pennsylvania will allow payment for K–12 tuition expenses to be processed through the PA 529 College Savings Program. 

EDUCATION SAVINGS BOND PROGRAM

The federal government allows buyers to exclude interest on designated government bonds from income tax if the money is used to pay for postsecondary education. In 2018, however, families can only cash in these bonds tax free if their modified AGI (MAGI) is less than certain limits. The tax exclusion phases out for MAGI between $81,100 and $96,100 in 2019 (and between $121,600 and $151,600 for married couples). The income limits are indexed for inflation. This program is substantially smaller than the Coverdell and 529 programs.

Updated May 2020
Further Reading

College Savings Plans Network. 2019. “529 Savings Plans 2019 Year-End Data.” Lexington, KY: College Savings Plans Network.

Dynarski, Susan. 2005. “High-Income Families Benefit Most from New Education Savings Incentives.” Tax Policy Issues and Options brief 9. Washington, DC: Urban-Brookings Tax Policy Center.

Institute on Taxation and Economic Policy. 2018. “Preventing State Tax Subsidies for Private K–12 in the Wake of the New Federal 529 Law.” Washington, DC: ITEP.

Internal Revenue Service. 2020. ”Tax Benefits for Education (For Use in Preparing 2019 Returns).” Publication 970. Washington, DC: Internal Revenue Service.

Maag, Elaine M., and Katie Fitzpatrick. 2004. “Federal Financial Aid for Higher Education: Programs and Prospects.” Washington, DC: Urban-Brookings Tax Policy Center.

New America Atlas. 2015. “Higher Ed Tax Benefits.” Updated May 15, 2015.

Rueben, Kim. 2015. “What Can We Learn from Obama’s Failure to Curb Sec. 529 College Savings Accounts?” Tax Vox (blog). February 2.

Rueben, Kim, and Sandy Baum. 2015. “Obama Would Improve Tax Subsidies for Higher Education.” Tax Vox (blog). January 26.

US Government Accountability Office. 2012. “Higher Education: A Small Percentage of Families Save in 529 Plans.” Washington, DC: US Government Accountability Office.

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