Tax Policy and Education Policy: Collision or Coordination? A Case Study of the 529 and Coverdell Saving Incentives

Abstract

Coverdell Educational Savings Accounts and 529 saving plans are marketed as attractive vehicles for college savings. The main finding of this paper is that college savings plans can actually harm some families. The joint treatment by the income tax code and financial aid system of college savings creates tax rates that exceed 100 percent for those families on the margin of receiving additional financial aid. Because even families with incomes above $100,000 receive need-based aid, the impact of these very high taxes is quite broad. I find that an aid-marginal family with funds in a Coverdell is worse off than if it did not save at all. Simulations show that $1,000 of pretax income placed in a Coverdell for a newborn and left to accumulate until college will face income and aid taxes that consume all of the principal, all of the earnings, and an additional several hundred dollars. This perverse outcome is the product of poor coordination between the income tax code and the financial aid system.