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We’re from the Government and We’re Here to Help Finance Your Education

President Obama’s recent proposal to offer two free years of community college tuition has garnered a lot of attention. But like my favorite finance guru Dave Ramsey likes to say, “When the government says ‘free’, pull out your wallet.”

Along with the idea of ‘free’ college tuition, the President’s proposal includes some tax hikes. One of the most alarming, at least to me as a parent of a young child with a 529 college savings account, is the President’s proposal to start taxing the earnings on those college savings accounts. A 529 Plan is an educational savings plan designed to help families set aside funds for future college costs. Earnings in the plan are allowed to grow tax free and distributions from the account are tax-free as well, provided they are used to pay for tuition, fees, books, supplies, and sometimes room and board while the student beneficiary is enrolled in an accredited college, university, or vocational school.

The administration has tried to frame the proposal as a way to redirect more money to middle class families, but 529 accounts are used almost exclusively by middle class families. Poor households don’t have the extra income to contribute to the plans, and very wealthy families don’t need them. The College Savings Foundation is calling on the White House to recall and Congress to oppose the proposal, citing research that shows over 70% of 529 plans are owned by households with income below $150,000 and almost 95% of 529 accounts are held by households with income below $250,000. For many families, taxing distributions from the plans would eliminate a significant incentive to save for college, and perhaps result in more families using student loan debt to finance higher education. A bad idea when the nation’s outstanding student loan debt stands at more than $1 trillion.

Under the proposal, withdrawals from 529 plans would be taxed at ordinary income rates, which can go as high as 39.6%. If this proposal were to go through, taxpayers would be better off saving for college by investing in mutual funds than in a 529 plan, since long-term capital gains tax rates are lower than ordinary income tax rates. Experts predict that 529 plan contributions would dry up immediately, hurting the plans’ financial positions. Most plans are administered by states, so states that are unable to retain sufficient assets in their plans would have a difficult time keeping them open.

But wait, in exchange for getting taxed on our college savings accounts, we’re getting two free years of community college? Not such a great trade-off, if you ask me. According to a study by the National Student Clearinghouse, only 15% of community college students utilize those institutions as a stepping stone to a 4 year degree. Most drop out; community colleges only have a 22% graduation rate. Those who do complete community college often wind up in the work force with a degree unlikely to lead to a highly skilled job after graduation.

Would free tuition change these statistics? Unlikely. Proponents of free community college argue that direct federal funding will compel community colleges to improve student achievement. But we need only look at the difficulty that the federal Title 1 program in K-12 has had in improving underperforming public schools, even with the stringent accountability provisions of No Child Left Behind.

So thanks but no thanks, Washington. As one of my Facebook friends ranted when I shared this information, “We’re saving so [our kids] can go anywhere they want . . . not community college.”

By Janet Berry-Johnson, CPA