Are 529 Tax Breaks Working?

In order to incentivize families to save for their children’s college education, Minnesota and other states are exploring income tax credits and deductions for 529 plans. Named after section 529 of the Internal Revenue Code, these investment vehicles were designed to encourage parents to save for college by granting tax breaks on higher education savings accounts. The track record of these plans in terms of encouraging increased savings, particularly among low income households, is not particularly impressive.

According to 2013 Survey of Consumer Finance (SCF) data compiled by the Board of Governors of the Federal Reserve System (FRS), only one in forty U.S. families that are eligible to take advantage of 529 savings plans actually do so. The extent to which families do take advantage of 529 plans is heavily skewed in favor of higher income households.

Based on SCF data, 16.0 percent of families within the top five percent by income had 529 plans in 2013, compared to 7.9 percent in the 90th to 95th percentile by income, 2.9 percent in the 50 to 90th percentile, and 0.3 percent in the zero to 50th percentile. Furthermore, participation in 529 plans has diminished since 2007 among all groups except the top five percent. Some of this reduction is likely the result of a decline in income during the Great Recession, although the FRS Board of Governors notes that the SCF data is based on a measure of income* that is designed to “circumvent the temporary drop of incomes that many families experienced during the financial crisis.”

Not only is the rate of participation in 529 plans greater among high-income families than among low- and moderate-income families, but the average balance in a 529 account tends to be four times greater among families in the top five percent by income than among other families. The tax advantages associated with current 529 plans likely accrue primarily to high-income households by virtue of the higher participation rate and account balances among high-income households—and as a result of the higher marginal income tax rates paid by high-income households and estate tax planning benefits associated with 529 plans (which will only accrue to a tiny sliver of the wealthiest households subject to the estate tax). The FRS Board of Governors concludes that:

Although 529 plans have increased their presence in the educational-savings space over the past decade, only a very small percentage of families save in these plans, and those who save typically tend to be at the higher end of the income and wealth distributions.

A recent examination of 529’s published by Governing magazine further notes that:

…participation in the [529] plans skewed toward wealthy parents who had college degrees, were already likely to send their children to college, and stood to benefit the most from tax breaks on their investments.

Growth in the cost of attending a public college or university in Minnesota has skyrocketed in recent years, largely due to plummeting state support for public higher education. While the trend of escalating tuition and diminishing state support for higher education is not unique to Minnesota, it has been significantly more pronounced here than in the rest of the nation. These trends have not only created greater barriers to obtaining a higher education—especially among low-income households—but have also contributed to an escalating student debt crisis.

Tax credits and deductions, such as the section 529 credits, are difficult to craft in a way that provide meaningful incentives for low-income households due to their limited income tax liability, whereas restoring past cuts to higher education funding would help all Minnesota students get a quality, affordable education.

 

*This analysis, including the income percentile breakdown in the chart, is based on “usual income,” which is defined by the FRS Board of Governors as follows:

Usual income is designed to capture a version of family income with transitory fluctuations smoothed away in order to approximate the economic concept of “permanent” income. Usual income is measured in the SCF after actual income has been reported, when respondents were given the option to report their usual income if they believe they experienced a temporary deviation.