What tax incentives exist to help families save for college? Taxes and the Family <8/10>

What tax incentives exist to help families save for college?

Taxes and the Family

What tax incentives exist to help families save for college?

Three tax-favored saving instruments encourage families to save for college: Coverdell savings accounts, qualified tuition programs (commonly known as 529 plans), and the education savings bond program. Because of their characteristics, the first two direct most of the benefit to higher-income families.

Tax-favored accounts encourage families to save for college expenses by reducing or eliminating the tax normally owed. But there’s a catch: to reap significant benefits, families must invest in sheltered college 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 other non-education purposes. The resulting uncertainty is greatest for low-income families because their children are least likely to attend college.

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 All families must pay income tax and a 10 percent penalty on money withdrawn from an account if the funds are used for purposes other than permitted educational expenses.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 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.

In 2017 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 Funds grow untaxed and may be withdrawn tax free if used to pay educational expenses.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.

Anyone, regardless of income, may contribute to a 529 plan for a designated beneficiary. A donor may contribute up to $14,000 annually for each beneficiary without triggering a gift tax, with the option of  making up to five years of contributions in a single payment so 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 for postsecondary education. 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 as long as the new beneficiary is a member of the same family as the old beneficiary.

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. As of June 2016, there were 12.7 million 529 plan accounts containing $266 billion in assets (figure 1).

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 2017, however, families can only cash in these bonds tax free if their AGI is less than $93,150 ($147,250 if filing a joint return). The income limits are indexed for inflation. This program is substantially smaller than the Coverdell and 529 programs.

College Savings Plans Network. 2016. “529 Report: An Exclusive Mid-Year Review of 529 Plan Activity.” 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.

Internal Revenue Service. 2017. ”Tax Benefits for Education (For Use in Preparing 2016 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 Education 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.

What tax incentives exist to help families save for college?

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