The 529 College Savings Plan Needs an Update

In this economy, a college education is more important than ever: The unemployment rate for college graduates is 3.8 percent, compared to 7.8 percent for everyone else. Yet, the exploding costs of education are causing some students to graduate with heavy debt burdens.

The federal government has a multi-pronged agenda for dealing with this crisis, including loans and grants. To bolster this agenda, policymakers should direct their attention towards another pillar of education policy: increasing individual savings for college.

Currently, the federal government encourages individual college savings by authorizing states to run so-called “529 plans.” 529 plans receive a significant tax subsidy: investment gains are free of tax, so long as the proceeds are used to fund higher education expenses. Adding to their appeal, many states also grant a credit or deduction for contributions to a 529 plan.

Despite these attractive features, 529 plans haven’t caught on with the public at large. A report by the General Accountability Office (GAO), the federal government’s watchdog, found that only 6 percent of families with children own either a 529 account or its cousin, a Coverdell account. A report by Sallie Mae found that only one quarter of college savers used a 529 plan.

Furthermore, 529 savers tend to be well-off. The GAO report discovered that the median 529 plan account-holder had yearly income of $140,000, compared to about $40,000 for everyone else. Thus, the tax benefits of 529 plans, to the tune of roughly $2 billion per year, disproportionately go to well-off households.

Updating the 529 Plan Model

Why do few middle income families use 529 plans? To some extent, the slow economy has caused college savings to take a backseat to retirement savings or pressing needs. This economic reality will pose challenges to any educations savings scheme.

Nevertheless, some modest reforms to 529 plans could make them more attractive to middle-income families. Most critically, the government should do a better job at spreading the word about these plans. According to the Sallie Mae report, only 37 percent of those without a 529 account even knew of the plans’ existence. At no great expense, the federal government could expand the mandate of the Department of Education (ED) to include marketing 529 plans.

As part of this marketing campaign, ED should guide people through the sometimes confusing choices that people face when they consider investing in a 529 plan. These choices can be overwhelming to many families. Currently, an individual can invest in the 529 plan of almost any state, each of which has several separate investment options and widely varying fees.

The ED should make clear that the choice is actually relatively simple for many people. If you live in one of the 29 states (plus the District of Columbia) that offers special tax breaks to contributions to that state’s 529 plan, you should contribute to your state’s own plan. State tax deductions or credits typically outweigh any differences in fees.

For everyone else, the ED should establish a consumer-friendly website that compares the 529 plans of all states—with a prominent emphasis on fees. While there are already private websites that analyze plans of different states, a standardized method for comparing these plans would be useful.

Flexibility Is Needed

Lastly, the federal government should provide more flexibility to 529 account-holders whose children decide not to attend college. If the 529 account is ultimately not needed for education, the earnings will be taxed at regular tax rates plus 10 percent—a hefty penalty. While parents should start a college savings plan when their children are very young, they might fear that none of their children will attend college years later. (Parents may freely switch beneficiaries between family members in the same generation.)

To reduce this risk, the government should allow parents—if none of their children attend college by age 30—to transfer the investments in a 529 account into a Roth IRA for their own retirement. That way, parents could be confident that their savings could be used whether or not their children decide to go to college.

The government could make up for any lost revenue by phasing out the tax-advantaged Coverdell education savings account. Currently, Coverdell accounts are used by a very small number of sophisticated investors, mostly to save for private secondary school expenses. Eliminating the Coverdell account would also reduce the overwhelming number of decisions that middle class families must make when establishing a college savings plan.

In short, the tough economy is making it hard for families to save for education, preventing some young people from attending college and saddling the rest with too much debt. While 529 plans are not a panacea, better marketing and design of these plans can generate more college savings.