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How to Improve College Savings Plans

Last week, President Barack Obama dropped his proposal to tax college savings plans out of existence. This presents an opportunity to consider ways to make college savings plans more effective.

Families are currently not saving enough for their children’s college educations. Even with the tax-free treatment, only about a third of low-income parents and half of middle-income parents are saving for their children’s college educations. The cumulative savings average less than a year’s tuition.

The federal government should be encouraging more families to save for college. Every dollar saved is a dollar less borrowed. Given that every dollar borrowed will cost about two dollars, on average, by the time the debt is repaid, even families who start saving late will save money. It is cheaper to save than to borrow. Getting more families to save for college and increasing the amount they save will help slow the growth of student loan debt.

Eliminate Penalties for Saving

The federal government should eliminate actual and perceived penalties for saving for college. Currently, a college savings plan that is owned by a dependent student or the dependent student’s parent is reported as a parent asset on the FAFSA (Free Application for Federal Student Aid). (Qualified distributions from such a college savings plan are ignored.) This reduces the student’s eligibility for need-based financial aid by at most 5.64%. While this is a small penalty, having any kind of a penalty acts as a disincentive for saving.

The penalties for college savings plans owned by grandparents, aunts, uncles and other relatives (including the non-custodial parent, if the parents are divorced) are much more severe. If a college savings plan is not owned by the student or a dependent student’s parent, it is not reported as an asset on the FAFSA, but any qualified distributions count as untaxed income to the student, reducing aid eligibility by as much as half of the distribution amount in the following academic year. Families are often unaware that the owner of a college savings plan account can have a big impact on eligibility for need-based financial aid.

Congress could address these problems by excluding all 529 college savings plans as assets on the FAFSA and ignoring qualified distributions. Non-qualified distributions would continue to be counted as part of adjusted gross income.

Expand Definition of Qualified Education Expenses

To help reduce student loan debt, Congress should add qualified education loans to the list of qualified education expenses for 529 college savings plans. This would allow students who have money left-over in their 529 plans after graduation to use distributions to pay down their student loans. Currently, students must take a non-qualified distribution to pay down their student loan debt.

Computer and software purchases were allowed as qualified higher education expenses in 2009 and 2010, even if not required by the student’s college. This provision should be restored and made permanent, regardless of whether the computer or software is required by the student’s college.

The definition of qualified higher education expense should be expanded to include college admissions expenses, such as application fees, admission test fees and the cost of test preparation courses. Such expenses are not currently considered qualified higher education expenses because they occur prior to enrollment in college. Similarly, post-enrollment costs, such as professional licensing fees, should be allowed as qualified higher education expenses.

Streamline College Savings Plans

Currently, there are three main types of college savings plans: 529 college savings plans, prepaid tuition plans and Coverdell education savings accounts. Congress should merge the prepaid tuition plans and Coverdell education savings accounts into 529 college savings plans, thereby, providing a single option for college savings.

Prepaid tuition plans provide families with peace of mind by claiming that they allow families to lock in future tuition rates at current prices. But, families usually have to pay a premium on top of current tuition rates and the prepaid tuition plan guarantees may be worthless. The need for prepaid tuition plans could be eliminated by offering guaranteed investment options within 529 college savings plans.

The need for Coverdell education savings accounts could be eliminated by allowing qualified elementary and secondary school expenses to count as qualified education expenses for 529 plan distributions.

Enable and Encourage Matching Contributions

Employers would like to encourage employees to save for college by matching their contributions to 529 college savings plans. But, current law treats such matching contributions as taxable income to the employee. Congress should allow employers to match employee contributions to 529 college savings plans on a tax-free basis. This could be modeled after the $5,250 exclusion from income for employer-paid tuition assistance. Employee contributions would continue to be made from after-tax income.

Several states provide matching grants to low- and moderate-income families that participate in the state’s college savings plans. Some states provide seed money for 529 college savings plans established by state residents when the parents enroll in the state’s 529 plan before the baby’s first birthday. The city of San Francisco provides a college savings account for children who enter kindergarten in one of the city’s public schools, as does the Nevada Kick Start program. Congress should explore ways of encouraging these efforts, perhaps by matching city and state contributions, since children who have a college savings plan are more likely to enroll in college.

Blend College Savings with Retirement Savings

Some families do not save for college because of concerns about the tradeoffs between saving for college and saving for retirement. Congress could address these concerns by allowing tax-free rollovers between 529 college savings plans and Roth IRAs. If the student does not go to college or has leftover money after graduating from college, the account owner could use the remaining funds for his or her own retirement.