How College Savings Can Reduce Wealth

Funds held in a Uniform Transfer to Minors Act account can reduce aid by as much as $1.24 per dollar saved.

Under current tax and financial aid policies, saving for their children's college education can make parents worse off than if they had never saved at all. Although tax-advantaged education savings accounts are intended to increase assets, people with more assets, or with assets of the "wrong" sort, can get less financial aid. The treatment of assets by the federal formula that determines college aid depends heavily on the savings vehicle, and the name in which assets are held.

In Tax Policy and Education Policy: Collusion or Coordination? A Case Study of the 529 and Coverdell Saving Incentives (NBER Working Paper No. 10357), author Susan Dynarski picks her way through two labyrinths, taxes and financial aid, to calculate how much financial aid may be lost for each dollar held in various savings vehicles. Given the historically high levels of tuition nowadays, even relatively well-off families can qualify for need-based aid, and thus be affected by the aid rules. Dynarski finds that about half of families with income between $40,000 and $100,000 are affected by the aid tax.

Further, she finds that the parents of a high school senior who attends four years of college can face a per dollar reduction in need-based aid of 15 cents if the funds are held in a 529 savings plan, between 26 and 39 cents if the funds are held in an IRA, and 40 cents if the funds are held in a mutual fund account in the parents' name. Funds held in a Coverdell educational savings account can reduce need-based aid by $1.22 per dollar saved. (The treatment of Coverdell savings accounts changed in early 2004, after this paper was completed.) Funds held in a Uniform Transfer to Minors Act account can reduce aid by as much as $1.24 per dollar saved.

This variation in asset treatment has a cost, because it distorts decisions about the composition of savings. There is no concomitant benefit, however, because these wildly varying tax rates do not improve the targeting of aid toward needy students. Dynarski lays out a variety of policies that could better balance the goals of encouraging saving and steering financial aid toward those with fewer resources. She argues that taxing equally all assets in the aid calculation, including home equity and retirement savings, would reduce the waste caused when families hide assets to avoid the aid tax. It would also treat different sections of the country more equally. At present, homeowners on the East and West coasts can shield more assets because of their higher home values.

Unless assets and asset income are completely disregarded in the distribution of need-based aid, the aid determination process inevitably reduces asset returns and perhaps saving rates. At present, the aid tax distorts savings decisions without improving the targeting of need-based aid. Dynarski writes "[A]rbitrary tax variation undermines the goals of need-based aid, in that families with identical financial positions receive very different levels of aid, depending on whether they are savvy enough to steer their savings toward the right vehicles."

-- Linda Gorman