COLLEGE SAVING'S PARADOX
June 15, 2004
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. This is because financial aid plans weight assets differently, says a new paper from the National Bureau of Economic Research.
Generally, reducing aid when students or parents save for college effectively penalizes those savings, discouraging saving altogether.
Furthermore, there is a considerable variation in the treatment of assets by the federal formula that determines college aid depending on the savings vehicle. Thus, a dollar saved in one plan is not equivalent to a dollar saved in another plan. For example:
- 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.
- Students lose 26 to 39 cents if the funds are held in an Individual Retirement Account, and 40 cents if the funds are held in a mutual fund account in the parents? name.
Some savings plans are counterproductive; they cost more in federal aid than any dollar saved:
- Funds held in a Coverdell educational savings account can reduce need-based aid by $1.22 per dollar saved.
- 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. The author recommends treating all assets equally, including home equity and retirement savings. This would reduce the waste caused when families hide assets to avoid the aid taxes.
Source: Linda Gorman, "How College Savings Can Reduce Wealth," National Bureau of Economic Research, NBER Digest, April 2004; based on Susan Dynarski, "Tax Policy and Education Policy: Collusion or Coordination?" National Bureau of Economic Research, Working Paper No. 10357, March 2004.
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