Enhancing Tax Credits to Encourage Saving for Higher Education

The federal tax system contains numerous credits, deductions, and incentives for individuals and families to build wealth and make goals like higher education more accessible and affordable. By May 2010, over 129 million American taxpayers filed federal income tax returns from the previous year, ninety-six million – or three-fourths – of which resulted in a federal refund. The average federal refund was $2,887 for all taxpayers, and low- and moderate-income (LMI) families in particular tend to receive larger tax refunds relative to annual income. In short, tax credits and incentives represent one of the few touch points each year for LMI families to set aside money for wealth building and future aspirations, particularly for higher education.

For education savings in particular, the federal government allows tax-free growth and tax-free qualified withdrawals through 529 college savings plans, Coverdells, and other savings vehicles. Many states also offer tax-free distribution, tax deductions, and other incentives for saving in 529 plans. These incentives were created to help families keep pace with the rising cost of college education.

However, incentives such as tax-free growth and non-refundable tax credits carry little weight with LMI families who struggle the most with college affordability, since many have little or no tax liability. Furthermore, extensive research has demonstrated LMI students are less likely to enroll in college or complete degrees, despite decades of nominal increases in federal financial aid.

Finally, a postsecondary credential is one of the most consistent predictors of upward economic mobility: only 16 percent of Americans born in the bottom income quintile who earn a college degree stay at the bottom, compared to 45 percent of those without a college degree. Moreover, an emerging body of research has found a relationship between savings and account ownership and important aspirational benefits such as high school graduation, college attendance and completion. Account ownership in particular, controlling for income and other factors, has a particularly strong relationship to college attendance.Savings can provide financial benefits as well, in the form of long-term growth and earnings, in addition to the aspirational benefits listed above.

Better-targeted incentives – particularly via existing tax credits – could positively impact savings behaviors, as well as make higher education a more concrete possibility for LMI families in ways that simply increasing financial aid packages may not.

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