Executive Summary: Ending the Double Taxation of College Savings

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Executive Summary: Ending the Double Taxation of College Savings

June 24, 1999 4 min read Download Report
Stuart Butler

As Congress considers a tax bill this year, lawmakers can contribute significantly to the efforts of struggling families to save for college costs by removing the tax barriers to investing in state and private higher-education financing plans. Such plans encourage parents to put money in special accounts to pay for their children's college education in advance. Bipartisan bills now before Congress propose such changes, which also should be considered as part of the larger tax bill.

These tuition pre-paid programs achieve three crucial goals:

  • They provide families with a way to save for the cost of a college education, and in some cases provide some relief from double taxation.
    The price of higher education has been rising sharply. According to the U.S. General Accounting Office, between 1980 and 1995, average tuition costs at public universities increased 234 percent; tuition expenses at private universities increased even more rapidly. Over the same period, the general rate of inflation and the average household income increased only about 80 percent.

  • They help take the uncertainty out of saving for college by "locking in" a price for the education well in advance.
    It is very hard for families to know how much they must put aside or what debt they or their children will have to incur to pay for a college education. For instance, if tuition and fees at a private university continue to rise at the same rate they have risen for the past few years, parents with a new child today will have to come up with just over $100,000 (in today's dollars) when that child goes to college. If those costs rose two percentage points faster than they do today, more like the average increase since 1980, the tab would be more than $150,000. Two points less than today's rate of increase would mean that parents must save about $75,000. Such uncertainty makes financial planning extremely difficult.

  • They help achieve a general public policy objective of encouraging more family savings and less family debt.
    Current federal policy gives large inducements for students and families to incur huge debts as a result of college costs. Savings and prepaid tuition plans help redress that imbalance between encouraging debt and encouraging savings.

Unfortunately, by not giving private plans the same tax breaks as state-sponsored plans, the tax code unfairly discriminates against families who choose to send their children to private colleges and universities. Moreover, even though the federal tax on interest earnings in state-sponsored plans is deferred, it is still payable. What is needed is tax treatment much like the treatment that applies to so-called Roth individual retirement accounts (IRAs), in which money saved is taxed once as earned income and interest earned on the savings accounts is tax-free.

To remove the current bias against tuition savings plans and reform the tax system, Congress and the President should:

  1. Extend current law tax treatment to tuition savings and prepaid plans established by private colleges and universities and private investment firms.
    The law discriminates against families wishing to send their children to private colleges, because the deferring of taxes on state-sponsored plans does not apply to plans sponsored by private colleges. At the very least, Washington should extend deferred-income tax treatment to tuition prepaid and savings plans established and maintained by private colleges and universities, and even those established by private investment companies. This would place all savings and prepaid plans and all schools on an equal playing field.

  2. Make all interest earned through tuition savings and prepaid plans tax-free.
    All tuition prepaid and savings plans should be extended the same tax treatment as regular education IRAs. In other words, the accrued interest earned through these plans--state and private--should be tax-free when the student redeems the savings to pay for college costs. This would eliminate double taxation on interest earnings applied to this form of education savings under the current tax code.

  3. Make it easier for families to transfer education savings from one savings or prepaid plan to another.
    Families that move from state to state often must cash out their plans and lose tax benefits, unlike the tax protection they get when they roll over an IRA. Congress should defer tax on interest generated by plans--or preferably make it tax-free--if the plan is cashed out and the funds transferred promptly to another plan. In addition, the federal government and states should explore ways to make such transfers easier to accomplish.

Lawmakers across the political spectrum, including Representative Bill Archer (R-TX), chairman of the House Ways and Means Committee; Representative Charles Rangel (D-NY), ranking minority member of the House Ways and Means Committee; and Senator William Roth (R-DE), chairman of the Senate Finance Committee, have introduced proposals to encourage states and the private sector to develop college savings and prepaid tuition plans. As Vice President Albert Gore remarked in a recent speech at Graceland College in Iowa, "We help people save for retirement tax-free, and help them pay their mortgages tax-free. Now we must help them save tax-free for one of the biggest expenses most families will ever face in life--sending a child to college."

The Joint Committee on Taxation estimates that leveling the playing field between state and private plans, granting all tuition prepaid and savings plans tax-free treatment, and permitting transferability would cost the federal government just $166 million over the next five years and only $925 million over the next 10 years.

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


Stuart Butler