President Proposes to Impose Tax on College Savings Plans

To help pay for other student aid initiatives, President Barack Obama is proposing to eliminate tax breaks on 529 college savings plans, prepaid tuition plans and Coverdell education savings accounts. The proposed changes would have a chilling effect on contributions to these college savings vehicles.

Under current law, earnings in these three qualified education benefits accumulate on a tax-deferred basis. Qualified distributions are tax-free. Non-qualified distributions are taxed at the beneficiary’s rate, plus a 10% tax penalty.

Under President Obama’s proposal, qualified distributions would be treated as ordinary income to the beneficiary, rolling back changes enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Non-qualified distributions would continue to be taxed at the beneficiary’s rate, plus a 10% tax penalty.

Most of the growth in college savings is attributable to the EGTRRA changes. Total assets in 529 college savings plans and prepaid tuition plans increased from $14 billion in 2001 to about $265 billion in 2014, as illustrated in this chart, which is based on data from the College Savings Plan Network.

529 Plan Assets in Billions Chart

Tax-free distributions provide a strong incentive for people to save for college in 529 college savings plans and prepaid tuition plans. Ninety-five percent of assets in 529 college savings plans and prepaid tuition plans were accumulated since the 2001 EGTRRA changes.

Severe Impact on Tax Liability and Student Aid Eligibility

The impact of the President’s proposal is more severe than it would seem, when one considers the impact on tax liability and eligibility for need-based student financial aid.

Up until 2005, the so-called Kiddie Tax taxed most of a child’s unearned income at the parent’s rate if the child was under age 14. Since most college students were 14 years old or older, qualified distributions were taxed at the student’s rate, which was much lower than the parent’s rate.

Legislative changes since then have increased the age threshold for the Kiddie Tax. The Tax Increase Prevention and Reconciliation Act of 2005 raised the age threshold from 14 to 18 and the U.S. Troop Readiness, Veterans’ Care, Katrina Recovery and Iraq Accountability Appropriations Act of 2007 raised the age threshold from 18 to 19 (and to age 24 for full-time students). Today, the first $1,000 in a student’s unearned income is tax-free, the second $1,000 is taxed at the child’s rate, and any remaining unearned income is taxed at the parent’s rate.

Thus, the President’s proposal would not really be reverting the tax treatment back to the way things were in 2001; it would be much worse. Most of the earnings would be taxed at the parent’s rate, not the student’s rate.

In addition, because the earnings portion of distributions from college savings plans would be reported as taxable income on the beneficiary’s federal income tax return, the increase in income would affect eligibility for need-based financial aid on the subsequent year’s FAFSA (Free Application for Federal Student Aid). A student’s eligibility for need-based financial aid is reduced by as much as half of the student’s total income. Also, college savings plans owned by the student or a dependent student’s parent are reported as parent assets on the FAFSA, reducing aid eligibility by as much as 5.64% of the net worth of the assets.

If the parents began saving for a child’s college education from birth, typically about a third of the assets in the college savings plan come from earnings. The President’s proposal would cost the family more than a third of the qualified distributions when the impact of federal income taxes are combined with the loss of eligibility for need-based student financial aid. The President’s proposal consumes all or almost all of the earnings, except for students who don’t qualify for need-based financial aid. The next table illustrates the worst-case financial impact of the proposed changes on several scenarios, each of which assumes that there are four equal annual qualified distributions, a 10% child tax bracket and a 25% parent tax bracket, and that the student qualifies for need-based aid.


Scenario A

Scenario B

Scenario C

Scenario D

Scenario E

Monthly Contribution






Interest Rate






Number of Years






Total Contributions






Total Earnings






Total Savings






Earnings/Savings Ratio






Tax Liability






Financial Aid Impact (Income)






Financial Aid Impact (Assets)






Total Financial Impact






Impact as Percentage of Savings






If the President’s proposal is enacted, most parents would be better off financially if they invested in taxable accounts in the parents’ names, since the tax and student financial aid impact would be lower. Long-term capital gains are usually taxed at a lower rate than ordinary income. Short-term capital gains are taxed as ordinary income and long-term capital gains are taxed at a 15% rate for single filers with taxable income up to $413,200 ($464,850 for married filing jointly) and at a 20% rate over that income threshold. The parents would also have the flexibility to use the money for any purpose, not just their children’s college education.

Remaining Benefits

If the President’s proposal were to become law, the main remaining financial benefits of college savings plans would include:

  • State income tax deductions for contributions to college savings plans. Three states offer state income tax credits and 32 states offer state income tax deductions.
  • Earnings in 529 college savings plans grow on a tax-deferred basis.
  • Contributions to qualified education benefits are immediately removed from the contributor’s estate, up to the annual gift-tax exclusion. Contributions that take advantage of 5-year gift-tax averaging are removed from the contributor’s estate on a pro-rata basis.
  • If a parent expects to lose eligibility for the Education Savings Bond program, where interest on certain U.S. Savings Bonds is tax-free, the parent can roll the bonds over into a 529 college savings plan before the parents’ income exceeds the income phase-outs. There are no income phase-outs for 529 college savings plans.
  • Custodial 529 college savings plans are treated as though they were a parent asset on the FAFSA. Parent assets have a much lower impact on aid eligibility than student assets. So, a parent can roll the cash proceeds from liquidating a child’s UGMA and UTMA bank and brokerage accounts into a custodial 529 college savings plan account to reduce the impact of the assets on the child’s eligibility for need-based financial aid.

Except for the state income tax benefits, these benefits are unlikely to be enough of an incentive for investors to invest in qualified education benefits, given the restrictions on use of funds, restrictions on investment selections and the coordination restrictions with other education tax benefits.

Affects Families at All Income Levels

The President has argued that his proposal mainly affects wealthy families. This assertion is based on a 2010 GAO report, A Small Percentage of Families Save in 529 Plans. That report found that only 3% of families invest in 529 plans and that their median income is three times the median income of families who don’t invest in 529 plans ($142,400 vs. $45,100).

However, a 2014 report from the College Savings Foundation found that more than 70% of 529 college savings plans are owned by families with income under $150,000 and about 10% are owned by families with income under $50,000. There is similar data in Sallie Mae’s report, How America Saves for College. So, the President’s proposal appears to affect families at all income levels, while also providing a significant disincentive to saving for college.


President Obama’s proposal to tax distributions from qualified education benefits would eliminate the most important reason why people use 529 college savings plans and other qualified education benefits to save for college. Accordingly, it would wipe out most new investment in college savings plans.

Overall, while the President claims that his proposals will make college more affordable, it may be little more than a shell game where the federal government gives with one hand and takes back more with the other. The increase in federal income tax liability and the decrease in eligibility for need-based financial aid exceed the earnings in a 529 college savings plan. Similarly, free community college tuition would limit the ability of low- and moderate-income students to claim the expanded American Opportunity Tax Credit (AOTC). Qualified higher education expenses for the AOTC are limited to tuition and textbooks. Textbooks may be a big part of the cost of attendance at a low-cost community college, but community college students are unlikely to derive full benefit from the AOTC based on textbooks alone.

In 2001, the federal government encouraged families to save for college by promising that the college savings would be tax-free. People saved money in 529 plans because of the expectation that the favorable tax treatment would continue. President Obama is proposing to break this promise to families who responsibly saved for their children’s college education.

[Update: The White House announced on January 27, 2015 that it will drop the proposal to tax 529 college savings plans, in response to opposition from the public and both Democratic and Republican lawmakers.]

The Student Survival Guide: The perfect tool for navigating high school & college!
Try it!