Don’t Tax College Savings Yet

President Obama is right that 529 accounts benefit the wealthy. But they could become an important tool for the middle class.

Obama outlined a new plan for taxing 529 accounts in his State of the Union address.

Mandel Ngan-Pool / Getty Images

President Obama’s message in the State of the Union was clear: Wealth should be taxed to ease the burden on the middle class. Then why would the president propose taxing earnings in 529 college savings plans, a move that’s been criticized for going after the middle class and as an “assault on the American Dream”? The president’s most vociferous opponents on this question are using misleading data and making bad arguments to support their case, but that doesn’t mean that the plan should be approved. (Update, 6:24 p.m.: The White House is dropping the plan, it said late Tuesday afternoon.)

What’s a 529? They’re tax-advantaged investment accounts offered by the states to create a dedicated vehicle for college savings. They’ve been around since the 1980s, and many offer state-level tax advantages. But 529s didn’t really take off until Congress, in 2001, made the earnings nontaxable. They’ve become much more popular since then, but like every other tax-advantaged savings vehicle, they are most popular with and work better for those with high incomes.

That’s substantiated by this Government Accountability Office report from December 2012, which outlined who has 529s and who benefits. Here are the key findings:

  • In 2010, “less than 3 percent of families saved in a 529 plan or Coverdell Education Savings Account.” (Coverdells are a similar, less popular account that can also be used for K-12 expenses.)
  • The median wealth for families with 529 plans or Coverdells was about $413,500, about 25 times the median wealth value for families without 529 plans or Coverdells (about $15,400).
  • The average tax benefit for families with more than $150,000 in annual income was $3,132, compared with $561 for a family with income less than $100,000.

Opponents of the president’s plan, including the 529 industry group, are claiming that 529s are an essential middle-class savings product and that the industry won’t survive this change. They might be right on the second part, but their claims that 529s are a mainstream product don’t stand up to much scrutiny. Just 3 percent of American households own a 529, and 70 percent of Americans don’t know that 529s are a college savings account. Proponents tout that the “average account holding is a modest $19,774,” but that figure isn’t modest. It’s $4,000 more than the median total wealth of families without 529s.

These plans are still a niche product, used mostly by the wealthy, who get bigger tax subsidies through the plans than any middle- or low-income family ever would. So decrying the president’s proposal as an assault on the middle class just doesn’t hold water.

Despite all of that, right now would be a very bad time to do away with the tax benefit. Here’s why.

States are developing innovative ways for all parents, including the very poor, to save for college in 529s. Just as the 529 could be transformed into a widespread middle-class tool, it’s getting whisked offstage.

Why are states investing in these accounts? Recent research has found that having access to savings, particularly in the child’s name, is associated with a range of positive outcomes, including better academic performance, higher rates of college matriculation, and higher rates of college completion. One important study found that youth who expect to attend college and have savings are four times more likely to attend college as similar children with similar expectations but no savings. The SEED for Oklahoma Kids experimental test randomly assigned 529s to infants and found that low-income children who received child savings accounts demonstrated significantly higher social-emotional skills at age 4 than their control-group counterparts. Those kinds of social-emotional skills are strongly related to higher educational achievement. These strong results even appeared in some studies where the savings amount to $500 or even less. (SEED OK deposited $1,000 into each child’s 529.) The evidence doesn’t suggest that everyone will save enough to pay for college outright, but that saving and a sense of ownership give parents and kids a boost in confidence that helps them perceive college attendance as an attainable goal.

Inspired by this evidence, states and municipalities have started broadly investing in children’s savings as part of an explicit strategy to boost college enrollment, completion, and achievement. In 2014, Maine became the first state in the nation to automatically enroll every child born in the state in a 529, seeded with $500 from philanthropic donations. Nevada’s state treasurer launched a plan, College Kick Start, that uses a cross-subsidy model to provide every kindergartner in the state with a 529 seeded with $50. This year Rhode Island adopted a new policy allowing a parent to open a 529 account and have $100 deposited into it by checking a box on his or her newborn’s birth certificate worksheet.

The president’s plan to raise revenue from generally very wealthy holders of 529 accounts, consolidate credits, and simplify tax support for college is well-intentioned. But evidence suggests that while tax credits may help pay tuition bills, they do little to convince young people that college is achievable and affordable. We should focus on building an inclusive and progressive college savings system that helps get more kids to, and through, college. Another option is to replace 529s with a new system of child savings accounts, such as the one endorsed by former Senate Finance Committee Chairman Ron Wyden (D-Oregon), that is universal, progressive, and flexible. Every family and community in America deserves a fair chance to invest in the future of its children. Savings accounts like 529s don’t readily provide that chance yet, but Maine, Nevada, and Rhode Island are showing us their innovative promise. We shouldn’t squander it by taxing them now.