The Heritage Foundation

Executive Memorandum on Taxes

September 3, 1997

September 3, 1997 | Executive Memorandum on Taxes

Why Congress Must Fix the Tax Bill's Educational Savings Plans

The recently enacted tax bill includes three positive provisions that will make saving for college education easier for many American families. However, some design features of these provisions could undermine their intent. Specifically, the new law (1) expands the definition of education-related costs that can be covered under state-sponsored education savings plans, (2) establishes "back ended" education savings accounts, and (3) permits parents to withdraw money from their individual retirement accounts (IRAs) penalty-free to pay for college expenses. But while these provisions are solid steps toward achieving debt-free college degrees and helping control the costs of higher education, several shortcomings in the new law could have damaging effects on private colleges - particularly smaller institutions. To deal with the problem, Congress should:

  • Correct the unequal treatment of savings plans
    Congress should extend the same tax treatment granted to state-sponsored tuition savings plans to privately sponsored education savings plans. Under the new law, families will not pay federal income tax on interest they earn through state-sponsored plans until the money is withdrawn to pay for college. However, savings through private plans or private accounts are taxed each year. Private colleges and institutions are at a distinct disadvantage. This could be disastrous for some private colleges faced with stiff competition from state institutions able to offer tax-advantaged tuition plans. This disparity in treatment under the law should be corrected to extend broader flexibility to families who wish to save for college and to ensure that America's strong private higher education system survives.

According to the U.S. Department of Education, private colleges and universities educated nearly 50 percent of college students in 1965. Today, it is only about 28 percent. An important reason for this decline in the numbers of students choosing private higher education institutions is the large taxpayer subsidy that public institutions receive from state governments. In an August 1997 study, the Cato Institute found that state governments spent more than $44 billion on public higher education during the 1995/1996 school year. The new tax law favoring state-sponsored savings plans over private plans will further stack the deck against private colleges.

Private schools located in states that maintain such publicly supported savings plans are feeling the pinch through reduced student enrollment. They have responded as expected: Many have designed similar savings plans. These schools believe they can offer a significant discount (as much as 25 percent) in the cost of attending their institution to families who save through the plans, but the plans are thwarted by unequal treatment in the federal tax code.

  • Remove disincentives to save
    Congress should make earnings in state-sponsored and private education savings and in pre-paid plans completely tax-free. Currently, all interest earned by families saving for college is taxed twice (whether the tax is deferred or not). On the other hand, students whose parents have not saved can obtain subsidized federal student loans that defer interest payments until graduation and are guaranteed against default. It is no wonder that families are choosing not to save for college, but instead go heavily into debt. According to the Education Resources Institute, American families incurred more debt to finance college between 1990 and 1995 than during the 1960s, 1970s, and 1980s combined. This trend, supported by the adverse federal policy toward family savings and subsidized policy toward debt, cannot continue.

Despite the inherent disadvantage at which college savings plans find themselves, they are proving to be very popular. To date, more than 42 states have established or are studying the feasibility of implementing tuition savings plans. Through these programs, American families investing some $3.2 billion have established more than 700,000 savings contracts. Private companies and universities are interested in similar savings plans. All plans should be granted the same tax-free status so that, regardless of how families choose to save for higher education, they will not be penalized by the tax code.

  • Eliminate the contribution limits Congress should eliminate the new law's annual contribution limits, which would apply to education IRAs and traditional IRAs used for educational purposes. The new law limits contributions to education IRAs to $500 per year. Even after investing the maximum amount (a mere $42 per month) for 16 years, families would have saved only $15,000-not nearly enough to pay for a college education at many schools. Students therefore would be limited in choice regardless of academic achievement and determination. The inherent goal of education IRAs should be to allow maximum flexibility to families and students who are preparing for college. The current $500 limit falls far short of this goal.

Similarly, contributions to traditional IRAs are limited to $2,000 annually. Many Americans depend on the savings accumulated in IRAs to pay for necessary living expenses during their retirement years. Allowing penalty-free withdrawals for higher education may deplete the retirement savings of these individuals. Therefore, Congress and the President should make sure that these individuals have every opportunity to replenish their retirement accounts after making a substantial withdrawal for college expenses. Alternatively, the $2,000-per-year limit on contributions could be increased to allow taxpayers enough of a buffer to save for retirement as well as education, health, and home expenses.

The Benefits of Improving Education Savings Account Legislation
The benefits that can be realized by incorporating equal private/public tax treatment and a tax-free status for all higher education savings could go well beyond mere equity and flexibility. An open market dealing in savings contracts likely will emerge. Families would be able to trade a savings contract purchased from one institution for a similar contract at another if they moved to another state or their family circumstances changed. In a market environment, private financial institutions that facilitate such tradable savings vehicles will align themselves with the needs of families and ensure that their costs will be controlled and the quality of their education maintained. If the institutions themselves issued such bonds, they also would benefit from being able to raise money to build additional classrooms, upgrade computer systems, or pay for any number of capital-intensive projects.

On July 31, 1997, Senator William Roth (R-DE) introduced S. 1116 to address several of the concerns outlined above. Representative Kay Granger (R-TX) and other Members of the House of Representatives are expected to introduce similar legislation. The goal of education tax reform in future legislation should be to help financially strapped families afford college, and to do so without violating sound tax policy, encouraging debt, or inducing colleges to raise tuition. The legislation introduced in both chambers of Congress would do just that. The approach embodied in these measures deserves the full support of Congress and the President.

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