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A public policy blog from AEI
Tax-advantaged college savings plans, known as 529 plans, enjoy considerable support on the political right and left. Who could be against a policy that helps families save for college by waiving federal income taxes on the earnings? Well, it turns out 529 plans have a big vulnerability that other federally-subsidized savings plans do not: The families who use 529s are almost all upper-income.
So when progressives argue that lawmakers ought to end this $1.1 billion annual “giveaway to the rich,” it’s hard to argue with them. They even convinced President Barack Obama to propose ending 529 plans in his 2015 budget. The president dropped the proposal after fierce bipartisan opposition. Nevertheless, 529s remain an easy target for both progressives and populists.
We argue in a new AEI report that while 529 plans are overwhelmingly used by wealthy families, the federal student loan program stands to provide these same families with larger benefits. Two features provide the bulk of the subsidy: loan forgiveness through an income-based repayment plan, and an income tax deduction for student loan interest. Yet these benefits do not come under the same scrutiny as 529 plans.
Our analysis compares benefits under each federally-subsidized program for a hypothetical (but typical) upper-income family. We detail an example of a student who uses $68,000 to pay for four years of an undergraduate education and two years of graduate school. If our student’s family uses a 529 plan to pay those expenses, they will receive federal tax benefits to the tune of $10,572.
However, if our student’s family forgoes a savings account and instead finances education with federal loans, the benefits are much greater. Assuming our student goes on to earn a typical income for someone with a graduate degree, he will receive a federal subsidy of $17,106 on his loans. Add in the secondary benefit, a tax deduction for interest paid on student loans, and the government subsidy for this method of financing education jumps to $23,773.
In other words, a typical upper-income household can gain 2.3 times the federal benefits from using the federal student loan program instead of a 529 plan to pay for college. While critics are correct that 529 plans provide a subsidy to upper-income families, they often do not realize the federal student loan program does too. But in contrast to the calls to end 529 plans, lawmakers have only made federal student loans more generous in recent years as they seek to address a perceived student debt crisis.
How can the federal loan program provide larger benefits than 529s? For one, the benefits that 529 plans provide, while still significant, are only a small share of the amount of funds a family invests through a 529. The federal government does not provide a tax deduction for contributions; only the investment earnings from those contributions are tax-free. Therefore, a family could accumulate a large amount of funds in a 529 plan to finance educational expenses, but derive tax benefits that are only a fraction of the account’s value.
The federal student loan program, however, can deliver much larger benefits if students use it to finance both an undergraduate and graduate education. Like 529 plans, the student loan program allows students from any income background to borrow money. Under the income-based repayment program, borrowers’ payments are so low and repayment periods so short, relative to what would be needed to repay even typical loan balances, that they are likely to have debt forgiven.
None of this is to suggest policymakers should ignore what critics say about 529 plans. To limit the benefits flowing to upper-income families, Congress could consider making 529 withdrawals tax-free for undergraduate educational expenses only, thus ending the tax subsidy for graduate study.
However, our analysis reveals that policymakers concerned about the magnitude of federal benefits going to upper-income households should concentrate their efforts on reforming federal student loans. Possibilities for reform include requiring borrowers to repay loans for longer before receiving forgiveness and capping the amount graduate students can borrow.
While 529 plans have their flaws, they are far from the biggest problem with the federal government’s approach to higher education. In this era of limited political capital, federal student loan forgiveness deserves more attention.
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