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Obama doesn't want to tax college savings plans after all

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  1. The White House is dropping a plan to make the earnings on new investments in college savings plans taxable, according to the New York Times.
  2. The Times reports that Democrats, including Rep. Nancy Pelosi, pushed the president to drop the proposal, which would have helped pay for an expansion of higher education tax credits for lower-income people.
  3. Although college savings plans are typically used by wealthier Americans, the proposed tax change was widely protested by commentators and elected officials who argued it would hurt the middle class.

What the president initially proposed

A week ago, President Obama proposed taxing college savings accounts and set off an uproar.

Since 2001, if you invest money through a college savings account — known as a 529 account — and ultimately use it to pay for educational expenses, you can avoid all capital gains taxes on your investment. 529 plans have become much more popular since 2001, when the George W. Bush tax cuts made their earnings tax-free.

Obama proposed reversing the changes from 2001 and taxing the investment earnings on new contributions to 529 plans. When the money is withdrawn, investment earnings would be taxed as income. He would also get rid of tax preferences for Coverdell savings accounts, a less common type of savings account that can be used to pay for either college or private K-12 schooling.

Both types of accounts are much more common among wealthy, highly educated families, although some states offer matching funds as an incentive for families of lesser means to save, and there are some innovative programs that would open the accounts for young children from low-income families.

A 2012 report from the Government Accountability Office found that 47 percent of all families with Coverdell or 529 accounts made more than $150,000 per year, and an additional 24 percent made more than $100,000.

The typical family with a Coverdell or 529 account had more than $400,000 in assets — 15 times as much as families without college savings accounts — and an income of about $142,000 per year.

Why the plan provoked outrage

This proposal, like the rest of Obama's tax plan, was extraordinarily unlikely to happen. But the idea of taxing college savings accounts attracted special outrage.

Most of the tax increases Obama's tax plan involved banks and capital gains taxes. But the changes to 529s focused on a savings plan also used by people who consider themselves middle class or upper middle class. As MSNBC's Suzy Khimm put it:

Some commentators also argued it would discourage saving for college, although it's not clear whether tax preferences actually increase savings rates.

The challenge of financial aid for the wealthy

Most wealthier families would swear they don't get any government help to pay for college. And, strictly speaking, they don't: Pell Grants, the main grant program for low-income students, go overwhelmingly to students from making less than $60,000 per year.

But families making much more than that still receive help through the tax code and student loans — part of what Cornell government professor Suzanne Mettler calls "the submerged state," because its benefits aren't widely visible.

This kind of help to pay for college might not look like financial aid, but it's there all the same. Wealthier families get the tax preferences for 529 plans,  which will cost the government about $1 billion over the next 10 years. There are also other deductions Obama has proposed eliminating, including a deduction for college tuition and fees and a deduction that can apply to graduate school tuition. The American Opportunity Tax Credit, which Obama wants to expand, is available to families making up to $160,000 per year and costs about half as much as Pell Grants every year. And undergraduate loans are available from the government at lower interest rates than the private market can offer.

But these benefits, unlike a Pell Grant, don't show up until long after tuition bills are due. That's one reason they're not particularly effective at changing whether students are likely to enroll in or graduate from college. And it also makes them a benefit that most people only notice when it's about to be taken away.