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June 22, 2006

Education Savings Accounts: Giving Families Ownership in Education

EDUCATION NOTEBOOK: 
Education Savings Accounts: Giving Families Ownership in Education

June 22, 2006

With college tuitions soaring, parents are beginning to save for their children's education earlier and earlier. A growing number of families are putting their savings in education savings accounts (ESA), which enjoy certain tax advantages. The popularity of these accounts suggests that parents want to control the resources spent on their children's education. Policymakers should consider how these accounts could be used to expand school choice and improve American education.

 

Federal law provides two kinds of educations savings accounts. So-called 529 plans allow for tax-protected savings for higher education through state-managed plans. Coverdell ESAs allow for tax-free savings in privately-managed accounts for K-12 and higher education expenses.

 

529 accounts-named after a section in the IRS code-offer families two ways to save for college expenses. This first option is to lock in today's tuition rates and prepay tuition at a participating higher education institution. The second is to invest in a state-managed investment account where earnings grow tax-free and can be used for tuition when a child enrolls.

 

Under 529 plans, annual contributions can range from $10,000 up to $300,000 in some states. States contract with financial institutions to manage the 529 accounts, and each state offers families different investment options. Most states don't require residency to invest in a 529 plan, and so families are free to shop the state plans to find the best investment. This is important, because some states offer different fees and rates of returns, and competition ensures that families can get the best deal.

 

The Financial Research Corporation reports that total assets in 529 college savings plans totaled $68 billion at the end of 2005-30 percent over 2004 levels. One reason for the growing use of 529 plans is that 25 states provide various tax incentives-credits or deductions-for investment contributions. (Learn more about 529 accounts here and whether your state offers tax incentives incentive here.)

 

Until now, states have limited tax incentives for contributions to the state's own plan. But this year, the Maine state legislature enacted a per-beneficiary deduction worth $250 per year for a contribution to any state's 529 plan. This could pave the way for more states to provide tax breaks for out-of-state plans. If so, families can look forward to greater competition among providers and better investment options and returns.

 

Unlike 529 plans, Coverdell Education Savings Accounts (ESAs)-named after the late Georgia Senator-let families contribute up to $2,000 per child annually in a tax-free savings account that can be used for K-12 or higher education expenses. Eligible expenses include K-12 private school tuition, books, school supplies, tutoring, and after-school programs. Unlike 529 college savings plans, Coverdell ESAs can be opened and managed by banks and brokerage firms, similar to 401(k) accounts.

 

No state currently offers tax incentives for Coverdell ESAs. And since the tax benefits of Coverdell ESAs are deferred, few families are using them. But many American families could make good use of this opportunity to save for their children's education.

 

As familiarity with education savings accounts grows, supporters of parental choice in education should consider reforms that give families control of education resources.

 

One option would be for states to level the playing field between 529 accounts and Coverdell ESAs by evening out the tax breaks for contributions to either savings vehicle. Another option would be for Congress to reform 529 accounts to include K-12 education expenses, like Coverdell ESAs do today. At a minimum, federal lawmakers could increase contribution limits for Coverdell ESAs to give families greater ability to save.

 

The promise of a system of widespread ESAs is great. Parents, grandparents, and other relatives would have greater opportunities to save for a child's education. Charities, corporations, and individuals could be given incentives to make contributions to low-income children's accounts, which could be used to pay school or college tuition or any other legitimate educational expense. State governments could create matching-funds plans to help needy children-seven states are already doing this with their 529 plans.

 

Widespread use of education savings accounts would improve the efficiency of education spending. According to the Department of Education, U.S. taxpayers spend approximately $500 billion annually on K-12 education. Government officials and bureaucrat largely dictate how it's spent. Expanding access to education savings accounts would begin to return control of education decisions to parents. With parents in charge, educators would compete for students and tailor their products and services to individual children's needs.

 

Choice and competition are keys to improving American education. By giving parents greater power to direct their children's education, education savings accounts could make widespread choice and competition a reality.

 

Dan Lips is Education Analyst at the Heritage Foundation, www.Heritage.org.

 

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