In our last entry we gave a brief example of the complexity of the structure and choices of 529 plans. In this post we will explain the often misunderstood advantage provided by states in the form of tax deductions.
 
529 plans are a well-known vehicle for saving for a child’s higher education. Although established by the federal government, they are administered by the states, with the assistance of an assortment of financial institutions. Some plans are seen as better than others, but they all allow savings to grow free of capital gains taxes until the plan ceiling is reached (the lowest limit being $235k – not an issue for most families).
 
529 plans are also known for offering state tax advantages. Most states offer a state income tax deduction as an incentive to save. The deduction amounts vary, but one detail remains the same: the deduction fails to incentivize saving across all income groups. We believe strongly in the need to create incentives to save, especially for one’s child, but we think it’s worth asking the question: Are tax deductions really the most effective means of promoting college savings across all income groups?

 
 

First, a few things…

Deduction vs. Credit

A deduction is a reduction in your taxable income.

A credit is a reduction in the taxes you owe.

Of the many states that have created an income tax incentive for 529 savings, the vast majority offer deductions (a few offer credits). These deductions create an increased incentive to save for your child’s education, but not every family can save enough to take advantage of the full deduction. And in states with progressive income taxes, families with higher incomes pay higher state taxes which translates into a greater benefit for those families.

Here’s an example to illustrate the point:

Let’s say there are two families living in New York: the Johnsons and the Smiths. Each family has one child for whom they’re saving.

The Johnsons are successful professionals with a household income of $600,000. They save the maximum allowed per couple in NY for a 529 plan: $10,000.

The Smiths are teachers with a combined household income of $100,000. They are able to save $2,000 as a couple each year.

First, we need to determine each family’s highest state tax rate (since this deduction is subtracted off the top).

Johnsons’ highest state tax rate = 8.97%
Smiths’ highest state tax rate = 6.85%

Saving $10,000 each year, the Johnsons are seeing a tax savings of $897. At a savings level of $2,000 each year, the Smiths are seeing a tax savings of $137.

 

 

Annual Household Income

Annual 529 Plan Contribution

Tax Rate

Savings

Johnsons $600,000 $10,000 8.97% $897.00
Smiths 100,000 2,000 6.85% 137.00
NY Median Income ‘09 54,554 1,000 6.85%   68.50

In this scenario, the state of New York is awarding an additional $760 to the higher-income family, the family that probably doesn’t need any financial incentive to save for their children. (Notice also the Johnsons will receive a tax benefit thirteen times the size of the tax savings offered to the family at the median household income level in this example.)

Some states have higher deductions and some lower (almost all state tax tables are different).  Pennsylvania provides the highest per couple annual 529 deduction at $26,000. Some states don’t have an annual, but a total deduction per plan. South Carolina having the highest at $318,000 (with a top state tax rate of 7%, some South Carolina families would be rewarded with an extra $22,600).

It’s fair to say that 529 plans were created to encourage saving for a child’s higher education for all families, but the current system does not deliver effective incentives across the board. This is something that’s been recognized by the policy experts at the New America Foundation. In a recent column, Reid Cramer and William Elliot III note:

In the U.S., 529 College Savings Plans have proven to be popular vehicles as earnings on deposits are tax-free. Unfortunately, to date they have had a limited reach among many households with modest incomes. That’s largely because the strength of the incentive to save is based on how much a family earns. If the family has a small tax bill or gets a refund, the incentive is particularly weak.


We couldn’t agree more. The goal of any incentive should be to encourage all families to save. Providing small matching amounts through a program like the UK CTF program or via targeted tax credits would provide a better and more equitable foundation for college savings. Couple a more universal incentive with an ultra-simple savings product like the soon-to-be-unveiled TrustEgg account, and we could start creating an asset-building environment that’s much more optimal for all Americans.