The Heritage Foundation

Executive Memorandum #539

July 13, 1998

July 13, 1998 | Executive Memorandum on

Another Chance to Help Families to Afford College

Last year, Congress took a big step to help American families to save for the huge cost of their children's education. Thanks to the Taxpayers' Relief Act of 1997 (Public Law 105-34), families now are able to establish Education Individual Retirement Accounts (Education IRAs) and deposit up to $500 annually for use later to pay for higher education expenses without taxes being levied on the accrued interest. But in passing this measure, Congress placed undue restrictions on the amount of money families could place in such accounts, and it favored public colleges over private institutions.

Now, as the Senate moves to reauthorize the Higher Education Act, and as Congress considers a tax bill, there is another opportunity to help those families with college-bound students while dealing with the deficiencies in current law. An effective policy would:

  1. Extend to all private tuition savings and prepaid tuition plans the same tax treatment public plans receive
    Currently, 28 states have established special programs that allow resident families to save for future college costs. Federal income tax on the accrued interest in these accounts is deferred until the account is cashed in to pay for college. There are drawbacks to these plans, however, including the fact that they do not effectively meet the needs of families interested in sending their children to private colleges and universities because the plans are designed specifically to benefit public institutions. Nearly 25 percent of families choose to send their children to a private college or university, yet few state plans serve the needs of this population. Nor do state plans provide a nationwide network of institutions from which participating families may choose, although 20 percent of students decide to attend an institution outside their home state. Congress can help to fix these deficiencies by giving private colleges and universities that establish plans similar to those of the states--or nationwide consortia of these private institutions--the same tax treatment enjoyed by state-sponsored accounts for public colleges.

  2. Make all interest earned through tuition savings and prepaid plans tax-free
    Not only should all tuition savings and prepaid plans receive equal tax treatment, they also should be relieved of the double taxation that currently exists within the tax code (the money being saved is taxed when earned, and the interest on the savings also is taxed). In the case of IRAs, Roth IRAs, and similar retirement plans, Congress has ended double taxation, but not on money placed in education accounts. Ending the double taxation of money in education accounts would both encourage savings for college and be consistent with long-term tax reform.

Although these two provisions would provide significant relief to the more than 2.5 million students and their families who plan to take advantage of tuition savings and prepaid plans, there would not be a significant revenue loss to the federal government. The Joint Committee on Taxation has estimated that granting state tuition savings and prepaid plans tax-free withdrawals would result in a loss to the federal government of just $339 million over the next five years. Because even the most enthusiastic industry estimates of the private market do not project greater participation than is anticipated in the state plans, the total impact on federal revenues for both the above proposals would be well below $800 million over five years. And even if it is assumed that families saving in private plans were, on average, in a higher tax bracket than those participating in state plans, the total revenue loss would not exceed $1.2 billion over the next five years.

It is, in any case, erroneous to assume that tuition savings and prepaid plans benefit mainly the wealthy. In fact, the experience of existing state plans indicates that working, middle-income families benefit most. For example, families with an annual income of less than $35,000 purchased 62 percent of the prepaid tuition contracts sold by Pennsylvania in 1996. The average monthly contribution to a family's college savings account during 1995 in Kentucky was $43.

Several Members of Congress have proposed tax-free savings for college. Senator Paul Coverdell (R-GA), House Ways and Means chairman Bill Archer (R-TX), and Representatives Dick Armey (R-TX) and Kay Granger (R-TX) included a provision in the Education Savings Act for Public and Private Schools (H.R. 2646)--also known as the A+ Education Accounts Act--that not only would accomplish the above two goals for good tax policy but also would make interest earned on family savings for primary and secondary education tax-free. H.R. 2646 would place a $5,000 annual contribution limit, however, on private tuition savings and prepaid plans.

Recently, Senators Jeff Sessions (R-AL), Bob Graham (D-FL), and Mitch McConnell (R-KY) proposed an amendment to the reauthorization of the Higher Education Act (S. 1882) that would accomplish these two goals without any annual contribution limit. The result of these tax measures would be in line with the overarching goal of the bill: to make attainment of a college diploma a reality for more American students.

American families accumulated more college debt during the first five years of the 1990s than in the previous three decades combined. Recognizing that this trend cannot continue, several states have established tuition savings and prepaid tuition plans. Now, a nationwide consortium of more than 50 private schools, with more than 1 million alumni, has launched a similar plan for private institutions. These plans are extremely popular with parents, students, and alumni. They make it easier for families to save for college, and the prepaid tuition plans also take the uncertainty out of the future cost of college. It is time for Congress and President Clinton to recognize the value of such plans and eliminate the double taxation that exists on interest earned through the programs--and to end the disparity that currently exists between public and private colleges.

-- Stuart M. Butler, Ph.D. , is Vice President for Domestic and Economic Policy Studies at The Heritage Foundation.

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