Obama's college savings plan would cut tax breaks for 529s

Fewer than 3% of families use the plans, and those who do tend to be wealthy. The President proposes giving tax credits to familes making under $180,000 instead.

By Bloomberg News

Jan 21, 2015 @ 2:36 pm EST

A simpler and better-targeted system. Those are the terms the White House is using to describe President Obama's State of the Union proposal for revamping tax-based financial aid for college students and their parents. Anyone who has tried to sort through the jumble of programs—or groused about the tax breaks favoring the wealthy—will appreciate the impulse to improve programs aimed at helping more families afford college.

Every year, the federal government forgoes almost $34 billion in taxes through various credits and deductions intended to help families afford higher education. Obama's new proposal would eliminate several tax programs, including the Lifetime Learning Credit and deductions for tuition, fees, and student loan interest, which collectively cost about $2.2 billion. It also would roll back tax benefits for new contributions to 529 college savings plans, which since 2001 have let families avoid paying taxes on any investment gains in the accounts. The 529 programs cost another almost $2 billion a year.

The 529 plans are emblematic of why Obama would want to cut back these programs. Two years ago, the Government Accountability Office found that fewer than 3% of families use a 529 plan, and that those who do use the plan are relatively wealthy. Almost half of the families with 529 plans make more than $150,000 a year, and their median total financial assets are about 25 times more than those who don't have 529s. Wealthier families get a larger benefit, too. Families making more than $150,00 saved an average of $3,132 a year on taxes, compared with $561 for families who earned under $100,000.

Obama pairs these reductions with expanding the remaining education incentive, the American Opportunity Tax Credit, which is set to expire in 2017. Obama signed the AOTC into law in 2009 as part of the federal stimulus program, and it gives up to $2,500 in credits to families with incomes as high as $180,000. The AOTC does share some of the regressive nature of the tax programs—about a quarter of families that claim the credit make more than $100,000—so Obama's new proposal would make the AOTC permanent and take steps to boost how the AOTC helps lower-income families.

In particular, the plan would increase how much of the credit is “refundable," which means that more of it will count in a family's tax refund if they don't earn enough to owe federal taxes. It also makes it easier for students who receive Pell Grants to get the AOTC credit, which was so complicated before it required a five-page fact sheet from the IRS just to show how it can most help families.

A White House spokesperson says the expansion of the AOTC will far outweigh the elimination of the other tax benefits, saying Obama's plan amounts to "nearly $50 million more" in additional tax cuts over the next decade. There are compelling arguments that direct grants are a more effective way to help low-income students than tinkering with the tax code. Overall tax incentives don't actually increase the likelihood a student attends college, for example. But these changes at least try to give more aid, however inefficient, to the families most in need.

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