High-Income Families Benefit Most from New Education Savings Incentives

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.
2
How They Work
and Who Invests
The tax advantages of the ESA and
529 are similar: earnings and after-tax
dollars put into savings are not taxed
as they accrue or at withdrawal, if
used for educational purposes. There
are also key differences between the
two plans:
While there is no income limit on
contributions to a 529 savings plan,3
contributions to an ESA are restricted
to joint-filer households with
adjusted gross income (AGI) below
$220,000 and single-filer households
with AGI below $110,000.
Contribution limits are much
higher on the 529 than on the ESA.
Families contributing to an ESA
face an annual limit of $2,000 per
child. A 529 plan has no annual
contribution limit, and annual
deposits of up to $11,000 per child
are free from federal gift tax. States
bar further contributions to 529
plans when the account balance
exceeds a certain amount, which is
typically about $250,000 and can
be as high as $305,000.
Investment options are more
restrictive in the 529. Families can
invest their ESAs as they wish.
Families with 529 plans, however,
are restricted to the investment
choices determined by their state
and, by federal law, can reallocate
their assets only once a year. Until
recently, most 529 savings plans
provided only one investment
option, an age-based portfolio that
grew less aggressive as the child
neared college age. Most plans now
offer several investment options.
Parental control is another difference.
A parent, grandparent,
or other relative establishing a
529 account for a child can withdraw
funds at any time, but would
pay a penalty if the funds are not
spent on college expenses. By contrast,
the establisher of an ESA cannot
withdraw the funds, since the
beneficiary technically owns the
account.
With each state sponsoring its own
plan, the 529s vary on contribution
deductions and fees. Individuals
are free to participate in any
state?s plan. Many states encourage
residents to invest in their own
state?s plan by allowing them to
deduct contributions from state
taxable income. Another crossstate
variation is fees, which appear
higher, on average, than those
on retail mutual funds, IRAs, or
ESAs. In some states, fees can wipe
out the tax advantages.
The profile that emerges of the
earliest education savings investors
reveals an elite group. The 2001
Survey of Consumer Finances, the
first representative survey to gather
information on the type of household
that invests in education savings
plans, finds 3 percent of households
with children holding an ESA or 529.4
Education savers (those who hold an
ESA or 529) have incomes, educations,
and wealth higher than those of
both retirement savers (those who
hold an IRA or Keogh) and the general
population.
Education savers? median income
is $91,000, nearly double the median
($50,000) for all households with children
and considerably higher than
the $75,000 reported for those who
save in an IRA or Keogh. Education
savers also have accumulated over
four times more wealth than other
families with children have?
$281,200 compared with $61,830. The
median net worth of retirement
savers is $227,600.
The data suggest that education
savers are not new savers, but those
who already have substantial investments
in other tax-advantaged plans,
such as IRAs or Keoghs. In fact, they
have more retirement savings than
the general population. The average
balance in an IRA among education
savers is nearly $90,000, compared
with $56,523 for all retirement savers
and $20,132 for all households with
children.
Education Savings Compared
with Other Savings
Education savings accounts provide
substantial tax advantages. The 529
with an up-front tax reduction offers a
higher return than any other existing
investment option. The 529 and ESA
substantially expand the assets that
can be shielded from taxation. Since
the 529 has no eligibility requirements,
these state-sponsored plans provide
the first tax-advantaged saving opportunity
for families ineligible for IRAs
or ESAs because of high incomes and
access to pension programs at work.
Below, the two education savings
plans are compared with a non?taxadvantaged
mutual fund account in
the parent?s name, a Uniform Transfer
to Minors Act (UTMA) account in the
student?s name, and a traditional IRA.5
The returns were calculated using a
single household type: a married couple,
filing jointly, with two dependent
children, and no itemized deductions.
The findings assume a one-time
investment of $1,000 at the benefi-
ciary?s birth, with all after-tax earnings
reinvested in a standard investment
portfolio over 18 years. Any variation
in returns is the result of income tax
and aid system treatment.
Figure 1 shows how returns on
the $1,000 investment for a family
with $50,000 in taxable income would
vary among the savings options. The
UTMAyields slightly more than the
non-advantaged mutual fund account,
with the small advantage explained by
higher taxes levied on the parents than
on the children. Both the ESA and the
IRA confer the same tax advantages as
the 529, and therefore yield the same
return. Akey difference, however, is
that much larger amounts can be
deposited into a 529 than an ESA. The
greatest returns are realized with the
529 in a state that allows state tax deductions
on deposits.
Tax Rates
The progressivity of the U.S. tax system
generally assures that taxes rise
as a share of income as income
increases. So, a lower-income family,
with lower marginal tax rates, retains
more of its $1,000 pre-tax investment.
Higher earners would pay more in
taxes, leaving less of the $1,000 to
invest. The lower earners also face the
lowest marginal tax rates on capital
gains, dividends, and interest. For
Urban?Brookings Tax Policy Center ISSUES AND OPTIONS
Urban?Brookings Tax Policy Center ISSUES AND OPTIONS
3
both reasons, returns drop on nonadvantaged
savings as income rises.
Education savings plans counteract
this progressivity by removing
some taxes. Figure 2 shows the ratio
of the net return on education savings
accounts to the return on nonadvantaged
accounts for households
in various tax brackets. For lowerincome
(low-tax) earners, the new
education savings accounts offer
after-tax returns only slightly higher
than those on a non-advantaged
account. As income (and tax rate)
rises, the education savings accounts
become more attractive. For those in
the top federal tax bracket, the 529
with an up-front deduction delivers a
net return more than twice as high as
that of a non-advantaged account.
Penalties
Education savings accounts have a
downside that distinguishes them
from other investments: their tax
benefits are contingent on the funds
being used for educational expenses.
For both the 529 and ESA, the earnings
portion of a withdrawal not used
for qualified education expenses is
taxed as ordinary income, plus a federal
penalty of 10 percent of the
account?s earnings.6
Those in the lower brackets especially
suffer if the money is not used
for schooling. The 10 percent penalty
is moderated for higher earners by
the large tax savings of shifting income
into their children?s tax bracket.
Because only the beneficiary can
make ESA withdrawals, the nonqualified
funds are taxed at the benefi-
ciary?s lower tax rate.
Figure 3 shows how the returns
on the noneducational use of the ESA
compare with returns on the savings
account without tax advantages.
Even after the penalty is assessed, the
upper four income brackets are still
better off in an ESA than in a nonadvantaged
account. By contrast,
those in the two lower brackets are
worse off in the ESA than they would
have been in a non-advantaged account.
Most striking, those in the top
bracket gain a larger advantage from
an ESA with the penalties than those
in the bottom bracket gain from saving
for college.
As these calculations make clear,
program design is quite important
here. The penalty was created out of
a concern that some households
might strategically shelter large sums
in the education savings accounts
without any intent of using them for
college. Given that families in the top
brackets are more likely to have significant
assets to shelter, it is sensible
to create a penalty structure that discourages
them from using education
saving accounts for unintended purposes.
However, as the ESA penalty
(and the 529 penalty in those states
that assign non-qualified withdrawals
to the child?s income) is
structured, those in the upper brackets
can still benefit substantially from
the education savings accounts when
they do not use them for their intended
purposes. By contrast, those
in the lower brackets, who generally
have few assets to shelter and are
unlikely to engage in such strategic
tax avoidance, always face a lower
return if the accounts are not used for
educational purposes.
Financial Aid Tax
The financial aid system for college
?taxes? the savings, including education
savings accounts, of many
families. Given the historically high
level of tuition prices, even relatively
well-off families can qualify for
need-based aid, and so face this tax.
Families at the extremes, either the
wealthiest who receive no aid or the
ones needy enough to qualify for
maximum aid, face a zero aid tax.
Because low- to middle-income
families are more likely to be on the
aid margin than high-income families,
the aid tax becomes another contributor
to the concentration of
education savings benefits among
higher earners.7
The aid tax has two components: a
tax on asset balances and a tax on
asset earnings, with the magnitude of
each tax depending on the type of
asset. Asset balances in both educational
savings plans are taxed annually
at a maximum rate of 5.64 percent.
Each asset dollar is therefore taxed at a
cumulative rate of 21 percent for a student
who attends college for four
years. By contrast, balances in
accounts owned by the student
(UTMAs) are taxed at an annual rate
of 35 percent, or 82 percent over four
years. Earnings are also taxed if they
arrive in a year whose income is considered
in determining college. In particular,
as accounts are drawn down
for college, earnings may be realized
and after-income-tax realizations
assessed by the aid formula.
Figure 4 shows that college savings
vehicles provide higher net
returns than any other investment
option for those who are on the aid
margin. Over the course of a college
FIGURE 1. After-Tax Return to College Savings Options for a Family with $50,000 Taxable Income
Source: Author?s calculations.
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
Nonadvantaged
account,
parent
529
(with state
deduction)
529
(no state
deduction)
ESA Traditional
IRA
UTMA
Urban?Brookings Tax Policy Center ISSUES AND OPTIONS
4
career, students with an ESA or 529
will lose about 15 cents in aid for each
dollar invested. Most dramatically,
each dollar held in a UTMA would
reduce aid over a dollar during the
college period, effectively confiscating
those students? savings.
Until early 2004, the ESA was
treated like the UTMA in the calculation
of financial aid. This resulted in
the same confiscatory treatment of the
ESA for aid-marginal families, with all
principal and earnings lost to income
and aid taxes. New U.S. Department
of Education rules alter the treatment
of the ESA, with assets now considered
the parent?s rather than the
child?s, like the 529. Further, the earnings
portion of ESA withdrawals no
longer counts as income for the purposes
of calculating financial aid. As a
result of these provisions, both education
savings plans now receive the
most favorable treatment by the aid
system of all investment options
considered.
Discussion and Conclusion
Education savings accounts are a
good deal for many prospective students.
Yet, for some parents, the
desire to control how savings are
spent may trump the tax advantages.
For example, if funds in an ESA are
not spent on college, they still go to
the child eventually; the parent cannot
take back ESA funds. When an
ESA beneficiary reaches age 30, having
not gone to college, the funds
FIGURE 2. After-Tax Return to College Savings Options Compared with After-Tax Return to Non-Advantaged Account
Source: Author?s calculations.
0.00
0.50
1.00
1.50
2.00
2.50
3.00
$35K $50K $100K $150K $200K $335K+
Household income
529 (with state deduction)
529 (no state deduction), ESA, or traditional IRA
UTMA
Non-advantaged account, parent
FIGURE 3. After-Tax Return to Non-College Use of Education Savings Compared with After-Tax Return to Non-Advantaged Account
Source: Author?s calculations.
0.00
0.50
1.00
1.50
2.00
$35K $50K $100K $150K $200K $335K+
Household income
ESA
Non-advantaged account, parent
5
automatically release to the benefi-
ciary as a nonqualified withdrawal.
A parent holds more control over the
funds with a 529 savings account, as
the account holder can liquidate the
account?albeit after paying taxes
and a penalty?or transfer it to
another relative tax- and penalty-free.
From a behavioral standpoint, the
penalty tied to the education savings
accounts can be perceived as a benefit
rather than a drawback, as it helps
commit parents to hold funds for college
rather than use them for immediate
consumption. This incentive is
similar to that of the worker who invests
in an IRA or 401(k) as a commitment
to retirement savings. Yet, the
treatment of nonqualified withdrawals
on the ESA and, in some states, the
529 favors the wealthy. Withdrawals
are taxed at the child?s tax rate rather
than at the parent?s much higher rate.
Given that the penalty was created
out of concern that some households
might strategically shelter
large sums in education savings
accounts, the choice of penalty
structure should be reexamined.
Right now, families in the top tax
brackets, who are more likely to
have significant assets to shelter, can
still benefit substantially from the
ESA (and the 529, in some states)
when the money is not used for its
intended purpose. Yet, those with
fewer assets to shelter and those less
likely to engage in any strategic tax
avoidance consistently face a lower
return if the accounts are not used for
educational purposes. One way to
undo this perverse penalty structure
would be to require that the earnings
portion of any nonqualified
withdrawal be taxed at the parent?s
rate. An additional option would be
to assess a penalty proportional to
the account owner?s tax rate, rather
than the current flat penalty of
10 percent of earnings.
While the income tax system disproportionately
penalizes lowincome
529 and ESA beneficiaries
who do not go to college, the college
financial aid system reduces returns
for those who do go. Again, unfortunately,
this most hurts the low- to
middle-income families who are on
the aid margin. With college savings,
some children are being left
behind.
Notes
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.
3. No state has an income cap on eligibility for
excluding 529 earnings from taxation. Only
Georgia has an income cap on eligibility for
deducting contributions from state taxable
income; it is $100,000 for joint-filer households.
4. The Survey of Consumer Finances is a relatively
small survey. Once the sample is limited
to households with children under age
16, there are just 1,500 observations. The
3 percent holding an ESA or 529 translates
into fewer than 50 households. Thus, these
estimates may be imprecise.
5. The complete analysis is available at the
author?s web site, http://ksgfaculty.har
vard.edu/Susan_Dynarski.
6. An exception is granted if the child attends
college and receives a scholarship. In this
case, the value of the scholarship is treated
as a qualified expense. If a child chooses
not to attend college, the parent can also
change the beneficiary of the 529 or ESA to
a relative.
7. For those on the aid margin, an increase in
financial resources will decrease the amount
of financial aid for which they are eligible.
See Susan Dynarski, ?Tax Policy and
Education Policy: Collision or Coordination?
A Case Study of the 529 and Coverdell
Saving Incentives,? Tax Policy and the
Economy 18 (2004) for data on families that
are aid-eligible or on the margin.
About the Author
Susan Dynarski is an
assistant professor at
Harvard University?s
Kennedy School of
Government.
Urban?Brookings Tax Policy Center ISSUES AND OPTIONS
FIGURE 4. Return to College Savings Options, Net of Aid Lost and Income Tax
Source: Author?s calculations.
Note: Figure assumes those in bottom four brackets are on aid margin; in top two brackets, assumed aid tax is zero.
$0
$1,500
?$1,500
$1,000
?$1,000
$500
?$500
$35K $50K $100K $150K $200K $335K+
Household income
529 (with state deduction)
529 (no state deduction) and ESA
Traditional IRA
UTMA
Non-advantaged account, parent
THE URBAN INSTITUTE
2100 M Street, NW
Washington, DC 20037
Address Service Requested
Nonprofit Org.
U.S. Postage
PAID
Permit No. 8098
Ridgely, MD
THE URBAN INSTITUTE
2100 M Street, NW
Washington, DC 20037
Copyright ? 2005
Phone: 202-833-7200
Fax: 202-467-5775
E-mail: pubs@ui.urban.org
http://www.urban.org
To order additional copies
of this publication, call
202-261-5687
or visit our online bookstore,
http://www.uipress.org.
THE TAX POLICY CENTER
The Tax Policy Center (TPC) aims to clarify and analyze the nation?s tax policy choices by
providing timely and accessible facts, analyses, and commentary to policymakers, journalists,
citizens, and researchers. TPC?s nationally recognized experts in tax, budget, and
social policy carry out an integrated program of research and communication on four
overarching issues: fair, simple, and efficient taxation; long-term implications of tax policy
choices; social policy in the tax code; and state tax issues.
A joint venture of the Urban Institute and the Brookings Institution, the TPC receives support
from a generous consortium of funders, including the Annie E. Casey Foundation,
Charles Stewart Mott Foundation, Cummings Foundation, Ford Foundation, George Gund
Foundation, and Lumina Foundation for Education.
The views expressed do not necessarily reflect those of the Urban Institute, the
Brookings Institution, their boards of trustees, or their funders.
http://www.taxpolicycenter.org
Permission is granted for reproduction of this document, with attribution to the
Urban Institute.
THE BROOKINGS
INSTITUTION
1775 Massachusetts Avenue, NW
Washington, DC 20036
Phone: 202-797-6000
Fax: 202-797-6004
E-mail: info@brookings.edu
http://www.brookings.edu