I hate to admit it, but 529 savings plans are too sweet a deal

My daughter finishes the eighth grade next week. While she anxiously prepares for her new role as a high school freshman, her father and I continue to prepare for our role four years from now—writing really big checks for her college costs.

We’re getting a head start, in part with a Section 529 savings plan. It offers us tax-free earnings accumulation and tax-free withdrawals when we pay for our children’s qualified education expenses. While we’ll use it for her college expenses, the Tax Cuts and Jobs Act broadened allowable uses to include distributions of up to $10,000 annually for private K-12 education.

But as welcome as the 529 benefits are, we don’t need them, and we should not have them.

It’s hard to admit this, especially since we’re among the two-thirds of American parents who expect their children to attend college and save or plan for college costs, and among the 29% of parents who invest in a 529. These plans started out as a tax-deferred investment vehicle in 1996, but since 2001 investment gains can be withdrawn tax-free. The Joint Committee on Taxation projects that this will cost the federal government $5.4 billion between fiscal years 2017 and 2021.

529s aren’t a big federal program, but they’re growing in popularity, thanks to states

This is the time of year when states aggressively market the plans. May 29 was National 529 College Savings Plan Day, when states offered sweepstakes, contests, and other incentives to encourage people to open accounts. Thirty-one states and the District of Columbia (including my state of Michigan) allow taxpayers to deduct contributions from state taxable income. Six states offer tax credits for contributions, which generally are worth more than a tax deduction, especially for low- and moderate-income households.

States manage and oversee 529 savings plans and collect fees to do it. University of Virginia law professor Quinn Curtis argues that since states use some of those management fees for other programs, they have little incentive to keep costs down.

But the subsidies at both the state and federal level are having an impact. Between 2010 and 2017, the number of 529 accounts grew 30% to 13.6 million. The accounts now hold 30% of all college savings—with plan assets in 2017 totaling $294 billion.

But is this tax expenditure doing what it ought to do?

A tax expenditure designed to encourage saving for education should be aimed at those who need it most and who might not otherwise be able to afford college. And it should be big enough to make a difference for those who are struggling to pay for college. It appears that 529s fall short on both counts.

Almost 70% of account balances are owned by the 6.4% of households earning over $200,000.

Because low-income families pay little or no federal income tax, they get little or no tax benefit from 529s. Instead, the federal exemption for investment earnings helps those with the largest incomes. Data from the 2013 Survey of Current Finance data show that almost 70% of account balances are owned by the 6.4% of households earning over $200,000.

For many who have 529 accounts, the account balances are too small to pay for college. The average annual contribution in 2018 was $5,441. And the average account balance was $24,153. The average 529 balance held by parents with a child 18 or over was $27,778. But four years of public university tuition for an in-state student averages around $37,640. For an out-of-state student it is $95,560. Add to that the cost of housing, books, and other living expenses.

Consequently, many families will need more than their 529 balances. They’ll either have to deplete savings, which many low- and moderate-income households do not have, or take out loans, which college graduates would like to minimize. The federal government does offer tax credits for education expenses such as the American Opportunity Tax Credit, or Pell grants for low- and moderate-income students. But because a 529 savings plan is treated as an asset when applying for federal financial aid, it can reduce the amount of aid a student can receive.

And what about 529s for private K-12 education? The Institute for Taxation and Economic Policy (ITEP) argues that these 529 plans are little more than a tax shelter. Families won’t be able to contribute far enough in advance for K-12 tuition to enjoy meaningful federal tax savings on investment earnings. Instead, taxpayers can contribute to a 529 account in exchange for a state income tax deduction or credit, and then immediately withdraw funds to pay for private-school tuition with pre-state-tax dollars. States vary in their treatment of such contributions on their state income-tax returns.

We know how to improve the 529 savings plan. But we don’t want to.

Just over three years ago, President Obama proposed a plan that would have reverted Section 529 plans back to their pre-2001 state as a tax-deferred investment vehicle. Withdrawals would again have been subject to income tax on their accumulated earnings. But Obama abandoned the idea in the face of bipartisan opposition. As my TPC colleague Kim Rueben explained at the time, he may have been more successful if he tried to limit contributions to low- and middle-income families or cap the value of the tax exemption.

States, meanwhile, should not be extending their tax subsidies to the new federally allowable K-12 expenses, though they’ll be under heavy pressure from some parents (and private schools) to do so.

In Michigan, our state tax deduction for our 529 contributions reduced our taxes by about $300 in 2018. We took the deduction, but wouldn’t mind if Michigan used the extra tax dollars for public schools or roads.

I asked a couple dozen of my friends whether they held 529 savings plans for their children. About three-quarters did, though half did not know that their state offered tax breaks for their plan contributions. And all of them said they’d still save for their children’s education even without the tax-subsidized 529s. But for those of us with the income to contribute, the 529’s tax breaks are a sweet deal. We’d be foolish not to use them.

Sweet or not, they still leave a really bad taste in my mouth.

Renu Zaretsky is a writer for the Urban-Brookings Tax Policy Center. This was first published on TaxVox, the Tax Policy Center’s blog, and reflects the opinion of the author, and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.

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