Higher Education: A Small Percentage of Families Save in 529 Plans
Released: 2012-12-12T00:00:00

Letter

Background

History of 529 Plans

529 plans are a college savings vehicle that originated in the states. In 1986, Michigan created the Michigan Education Trust to operate what is generally considered the first state prepaid tuition plan. In 1996, Congress enacted Section 529 of the Internal Revenue Code, setting out requirements that state 529 plans must meet to be exempt from federal tax. The Economic Growth and Tax Relief Reconciliation Act of 2001 included a provision making earnings included in distributions from 529 plan accounts entirely tax-exempt as long as they are used to pay for qualified higher education expenses. For other key legislative actions and the value of assets invested in these plans, see fig. 1.

The number of 529 plan accounts has also increased since the plans were granted expanded federal tax advantages in 2001 (see fig. 2). 529 plans are a state-sponsored investment or savings vehicle whose purpose is to encourage people to save for college. Contributions to 529 plans are made with after-tax dollars and are not deductible for federal tax purposes. Annual contributions in excess of $13,000 are generally subject to federal gift taxes.necessary to provide for the qualified education expenses of the Total contributions may not exceed the amount beneficiary, which is determined by each state; however, individuals may open 529 plan accounts in multiple states. Earnings on contributions grow tax-deferred. When a distribution is made from a 529 plan, the earnings portion is tax-exempt as long as it is used to pay for qualified education expenses. Taxpayers must report to the Internal Revenue Service (IRS) whether the distribution was for qualified higher education expenses. Distributions not used for qualified higher education expenses can be made to either the account owner or beneficiary, but the portion of the nonqualified distribution consisting of investment earnings is taxable and subject to an additional 10 percent penalty. The federal penalty does not apply in some circumstances, for example if the distribution was considered nonqualified because the beneficiary died or received a scholarship.

While section 529 provides that account owners and beneficiaries may not directly or indirectly control how contributions or earnings are invested, in 2001, IRS issued a notice setting out a rule permitting a change in investment strategy once per year and upon a change in the designated beneficiary of the account. For 2009 only, this was increased to twice per year.

There are few federal restrictions on 529 plan participation. For example, there are no income limits and almost anyone can initially be named as a beneficiary—an individual may open a 529 plan account for a child, grandchild, friend, spouse, or for themselves. Further, the 529 plan account owner may change the beneficiary at any time, though the subsequent beneficiary must be a member of the family of the original beneficiary in order for this change to be tax-exempt.

529 Plan Operation and Features

Because 529 plans are state-sponsored investments, states determine whether and what type of plans to offer (i.e., prepaid tuition or savings) as well as the eligibility criteria (for example, at the time of application prepaid tuition plans may require either the account owner or beneficiary to be a resident of the state administering the plan whereas residents and nonresidents can invest in most states’ college savings plans); administrative and investment fees; and associated state tax benefits. Almost all states offer a college savings plan. In these plans, individuals purchase interests or shares in a trust established by the state. In most cases, the trust assets are invested in mutual funds. The shares in college savings plans can be sold directly by the state or through an external program manager hired by the state (direct-sold) as well as through a financial advisor or broker (advisor-sold). College savings plans may offer a number of investment options, which often include stock mutual funds, bond mutual funds, and money market funds. These investment options can vary in terms of risk and return, ranging, for example, from investments that are insured by the Federal Deposit Insurance Corporation (FDIC) to options that are almost completely invested in aggressive-growth funds. Many plans offer age-based portfolios that shift automatically into more conservative investments as the beneficiary approaches college age. Fifteen states also offer prepaid To help run their plans, states may tuition plans to their state residents.employ marketing staff, advisors, financial consultants, or other experts.

Some states offer a variety of tax advantages that can include a state deduction or non-refundable credit for plan contributions and tax-deferred earnings. These benefits may apply only to residents who make contributions to their own state’s plan or, in a few states, may include contributions made to other states’ plans.

Plan Disclosures

Although most 529 college savings plans have been modeled after mutual funds, 529 plans are regulated differently than mutual funds under the federal securities laws because they are regulated as municipal securities. As municipal securities, 529 plans are exempt from the registration and reporting requirements of the federal securities laws. However, broker-dealers selling 529 plans (advisor-sold plans) must comply with the rules of the Municipal Securities Rulemaking Board (MSRB). Specifically, MSRB requires broker-dealers who sell 529 plans to follow certain guidelines, such as having reasonable grounds to believe that the recommended product is suitable for the customer; disclosing certain information, such as plan fees and state tax implications; following certain requirements when advertising; and posting disclosure documents on its Electronic Municipal Market Access Website. However, MSRB rules do not apply to state issuers when they market their 529 plans directly to the investor without the assistance of a broker-dealer (direct- sold plans). In 2004, in response to concerns that 529 plan disclosures were inadequate, CSPN, after working with the Securities and Exchange Commission, the MSRB, and the National Association of Securities Dealers, developed voluntary disclosure principles to be adopted by state issuers on plan performance, fees, and state tax information, among other things. These principles were designed to enhance investors’ ability to compare information across plans. Since 2004, the principles have been updated several times with the most recent update in May 2011.

Student Financial Aid

As authorized under Title IV of the Higher Education Act of 1965, as amended, the Department of Education provides assistance to help millions of students and families meet the costs of higher education through grants, work-study, and loans. A substantial portion of this federal financial aid is awarded based on the amount of a student’s financial need, which is generally the difference between a student’s cost of attendance and an estimate of his family’s ability to pay these costs, known as the expected family contribution (EFC). In addition to the student’s income and assets, parents’ income and assets are also used to determine the student’s EFC unless the student is classified as independent. Independent students have their income and assets included in the EFC and their spouses’ income and assets, if applicable. Several criteria are used to determine if a student is independent, such as the student’s age, and if he or she is married or separated, enrolled in a master’s or doctoral degree program, or serving on active duty in the military, among other things.

To apply for federal financial aid, students and, in the case of dependent students, parents submit information on income, assets, and the number of children enrolled in college through the Free Application for Federal Student Aid (FAFSA). This information is then used to determine the student’s eligibility for federal student aid by calculating the EFC through a process known as federal methodology, which is set out in statute. In terms of assets, figure 3 shows the information required by the FAFSA regarding the net worth of students’ and parents’ investments, which includes savings in 529 plans along with other investments such as Coverdells, money market funds, stocks, and mutual funds (for a full copy of the FAFSA see app. II).

States and institutions may also offer financial aid. To determine the amount of such aid, some states and institutions choose to gather information in addition to what is required by the FAFSA. One form used by some institutions is the College Board’s PROFILE form. The PROFILE asks for information not included on the FAFSA, such as home equity and medical expenses, as well as more detail about information that is included on the FAFSA. The institutions may then use an individualized institutional methodology to determine the student’s EFC for institutional financial aid.

Few Families Have 529 Plans and Those Who Do Tend to Be Wealthier

A Small Percentage of Families Have 529 Plans

According to the 2010 Survey of Consumer Finances (SCF), less than 3 percent of U.S. families had 529 plans or Coverdells, a similar but less often used education savings account. Even among families who acknowledged upcoming education expenses, 529 plans were not widely used. Of the approximately 25 percent of families who said they expected major education expenses in 5-10 years, about 7 percent of them had 529 plans or Coverdells. Similarly, of the approximately 18 percent of families who reported saving for education was a priority, only about 9 percent had 529 plans or Coverdells. 529 plans are also less commonly used than other savings vehicles among those saving for college. For example, a 2010 Sallie Mae survey found that most parents saved for college in general savings accounts or certificates of deposit and, of those who did invest, more used general investment vehicles than 529 plans. Based on our analysis of SCF data, the median amount in 529 plan or Coverdell accounts was about $14,700.

Families with 529 Plans Generally Have More Wealth and Education than Those without 529 Plans

Families with 529 plans or Coverdells typically had much more wealth than families without these accounts, according to our analysis of SCF data. Based on our analysis of the 2010 SCF, we estimate that the median financial asset value for families with 529 plans or Coverdells was about $413,500, which is about twenty-five times the median financial asset value for families without 529 plans or Coverdells (about $15,400).retirement assets than other families. Of families with 529 plans or For example, families with 529 plans or Coverdells had more Coverdells, about 94 percent had retirement assets, such as those in 401(k) accounts or traditional pensions. In contrast, approximately 49 percent of families without 529 plans or Coverdells had these retirement assets. Further, the median value of retirement assets was much greater for those with 529 plans or Coverdells. Specifically, the median value in retirement accounts was about $213,600 for families with 529 plans or Coverdells, while the median value for families without 529 plans or Coverdells was about $40,300. A larger share of families with 529 plans or Coverdells (27 percent) also believed they will have more than enough retirement income from pensions and Social Security to maintain current living standards than the share of families without 529 plans or Coverdells (16 percent), which may put them in a better position to save for college.

In 2012, we reported similar findings using data from the 2007 SCF. GAO-12-560.

States’ 529 Plan Features and Other Factors Can Affect Participation

Tax Benefits, Fees, and Investment Options Vary Across State 529 Plans

Officials in every state and most experts and representatives we interviewed identified tax benefits, fees, and investment options as some of the most important features consumers consider when choosing whether or not to participate in a 529 plan and, if so, which plan to choose. These features vary by state and plan. All states offer at least one plan and many offer a combination of college savings (either direct- sold, advisor-sold, or both) and prepaid plans. For example, 14 states offer a direct-sold plan only, 22 states offer both direct-sold and advisor- sold plans, and 6 states offer all three plan types: direct-sold, advisor- sold, and prepaid. The popularity of direct-sold college savings plans has grown over time and in 2011 total assets were essentially evenly split between those and advisor-sold plans.

States offer a range of tax benefits for 529 plans, and these benefits are a primary incentive to investing in a 529 plan, according to many state officials we interviewed. In addition to earnings growing tax-deferred, our analysis of CSPN data shows the majority of states with an income tax offer some form of benefits: 33 offer a tax deduction and 3 offer a nonrefundable tax credit to residents who participate in their state’s Five states also extend benefits to residents who participate in any plan. state’s plan. Almost all states limit tax benefits to the account owners, but one state extends those benefits to grandparents, aunts, and uncles who contribute to the plan. Officials in some states we interviewed said they provide additional tax benefits, for example, one state offers an exemption from the state inheritance tax. Others allow contribution amounts that exceed the annual deduction limit to be carried over to the following year’s return.

Various fees and expenses may be associated with 529 plans, including administrative and investment fees. Administrative fees, which are charged by the state and/or the program manager hired by the state, cover administration of the 529 program, including customer service and marketing. Investment fees are charged by the investment company to manage the funds. The aggregate of these administrative and investment fees is often referred to as “annual asset-based fees,” which are expressed as a percentage of the fund’s average net assets. In addition, advisor-sold plans may also charge a “sales load”—that is, a fee paid to the selling broker when the fund is purchased or redeemed—and direct- sold and advisor-sold plans may also charge participants additional fees for services such as enrolling or changing the account owner.

Fees among 529 plans vary widely; total annual asset-based fees among plans nationwide ranged from 0 percent to 1.97 percent for direct-sold plans and 0 percent to 2.78 percent for advisor-sold plans, as of July 2012. As seen in table 2, there is variation among states in both administrative and investment fees. Such variation occurred even among states with similar administrative structures. For example, among three of the states we reviewed where most administrative functions were conducted in-house, one state charged administrative fees of between 0.44 percent and 0.46 percent of the balance annually, another charged between 0.15 percent and 0.20 percent, and a third charged no administrative fees, instead covering operational costs and salaries through an annual state appropriation. Investment fees also varied: for example, underlying mutual fund fees ranged from 0 percent to 1.82 percent of the balance annually, depending on the type of investment option a participant chooses. For advisor-sold funds, sales loads also varied, ranging from 0 percent to 5.75 percent, in part based on the fund class. In addition, among the five states we reviewed, four did not charge an enrollment or application fee, while one charged $25, although the fee may be waived through promotions to encourage participation. 529 plan fees remain higher than fees for similar mutual funds an investor might purchase outside of a 529 plan. According to a 2011 study by Morningstar, 529 plan mutual funds charged, on average, an additional 0.31 percent of the account balance annually in investment fees compared with their respective mutual fund categories in the open market. The administrative fees charged by most 529 funds raise the cost even higher. However, Morningstar does note that fees for 529 plans have declined in recent years and officials at the majority of state plans we interviewed told us they have taken steps to reduce fees – for example, by renegotiating program manager contracts, using competitive bidding for program management, or consolidating functions in-house rather than using a program manager. As we have previously reported, fees are one of many factors participants should consider when investing because even a small fee increase can significantly decrease savings over time.

State plans offer a variety of investment options to 529 college savings plan participants. Plans in the states we reviewed, for example, include up to 17 different investment options, including age-based, static, and customized portfolios, to cater to participants’ various levels of risk tolerance and investment sophistication. Age-based options were generally the most popular and, according to state officials we interviewed, may appeal to investors who might have more limited investment experience or a lower risk tolerance. One state plan we reviewed also offers a customized option for participants who seek more control over their investments, which allows them to designate their own allocations in funds such as stocks and bonds. For more risk-averse participants, some states also offer a FDIC-insured investment option or one that in some other way guarantees the investment’s principal. To help investors determine which plan best meets their needs, officials we interviewed in two states said their states provide risk assessment information through customer call centers. One state developed a risk tolerance questionnaire to explain investment scenarios, while the other had a representative ask informal questions to help potential investors assess their own risk level.

Families can also choose to invest in prepaid plans, which were offered in three of the five states we reviewed. These plans also vary in fees, payment options, and cost. Two plans, for example, charged an annual administrative fee of just under 0.50 percent and the third charged no annual fee. In terms of payment options and costs, two states we interviewed offered prepaid plans by academic periods or units that can be used to pay for future tuition costs with the option of paying in lump sum or through a monthly payment program. According to state officials, the cost of these prepaid plans is generally determined by forecasting future tuition and fees at different types of schools (4-year, community college, etc.), given a number of actuarial assumptions on tuition inflation and anticipated investment return. One state, for example, offered a contract to cover four years of college costs for a child currently under age five at a lump sum of $56,600 and another state offered a similar contract for just under $66,500. A third state we reviewed does not offer units or contracts, but allows participants to contribute any amount to the plan. When the participant withdraws the funds for qualified educational expenses, they will receive the amount they contributed adjusted by a tuition inflation value.

Participation is Affected by Ability to Save and Other Factors, but Some States Have Adopted Strategies to Address Barriers

Families encounter a number of barriers as they consider saving for college: they may struggle with making saving a priority, and for those who do plan to save, many do not know 529 plans exist as a savings option. Additionally, once families decide to invest in a 529 plan they may have trouble understanding how it works and the variation across plans may affect their ability to select one that best meets their needs (see fig. 5).

Families may encounter a variety of barriers saving for college, such as insufficient income, underestimating the cost of college, and misconceptions about financial aid availability, but selected states are taking steps to help address these barriers. A 2010 national survey published by Sallie Mae found that while nearly nine out of ten parents expected their child would attend some form of higher education, only three out of five parents of college-bound children have saved or invested for their oldest child’s education.

First, many families may not save because they lack adequate income or have competing financial priorities. The same Sallie Mae survey reported that 68 percent of those who are not saving cited a lack of money as a major reason.this as a challenge: for example, one state official said that the economic downturn has affected some families who are reluctant to make deposits or participate in a 529 plan because they may need to choose between paying their mortgage and saving for college. In terms of competing priorities, two industry representatives we interviewed stressed that retirement should be a higher priority than saving for college. Officials from one state added when a family’s budget shrinks or the economy is uncertain, families reduce college rather than retirement savings. Furthermore, a few industry representatives said families should consider using other tax-deferred savings vehicles where funds could be used for multiple purposes, such as retirement and education. The states we selected to review have adopted strategies to expand participation among lower income families who may have limited resources to allocate towards savings, including offering matching programs, low minimum initial contributions, and less risky investment options.

For example, in 2011 a family of 4 earning less than $44,700 would qualify, according to plan documentation. dollar for dollar, up to $400 annually per beneficiary for up to 4 years. In addition to increasing participation, officials from one state plan noted that the matching program can also help minimize student loans and reduce the amount students will have to work while in school. An ongoing experiment conducted by the Center for Social Development also found a positive impact on the number of 529 plan accounts for families who were automatically enrolled in a state-owned 529 account with a matching program in one state. In addition to participating in the automatically opened account, families in the treatment group were offered an additional $100 to open a private account. These families opened private 529 accounts at a higher rate (17 percent of families with a match compared to 2 percent of those in the control group without the incentives), and deposited more into those accounts. While matching programs may have positive results, two states we reviewed reported challenges with funding and awareness. One state’s program had not been authorized since 2008 and officials in another state said their enrollment remained low despite being open to all participants because the state’s 529 marketing budget was eliminated.

Low or No Minimum Initial Contributions: Low or no minimum initial contributions and fee waivers may also help increase participation among low-income families, according to state officials and others we interviewed. Nationally, minimum initial contributions range from $10 to $5,000, according to our analysis of CSPN data; however, the majority of states require an initial contribution of $25 or less. Two states allow participants to open an account with any amount. Officials in one state reported that keeping the initial deposit amounts low can also help facilitate one of their main goals: to help spur the mental commitment and habit to save.

Less Risky Investment Options: Officials from many states we reviewed said they offer investment options that pose less risk to the investor, which can appeal to low- to moderate-income families. One state, for example, partnered with two local banks to provide a FDIC-insured option to target families who might otherwise save in the bank’s savings account. According to an official from the plan’s banking partner, clients with more assets often use financial planners and are aware of 529 plans, while the FDIC-insured option was designed for those without financial planners and who use the bank’s more traditional products.

According to state officials, most of the states we reviewed are not tracking participant’s demographic information such as income, however, making the success of these efforts for low-income families difficult to assess.

Second, in addition to insufficient income, some families may not save because they procrastinate or underestimate the true cost of college, according to officials from most of the states we reviewed. Some parents may not budget money to save for college due to a lack of understanding about what college really costs or they become overwhelmed and do nothing, officials at one state 529 plan said. To address these challenges, selected state 529 plans have adopted financial literacy programs and marketing strategies emphasizing the importance of saving even a small amount early and often. To target families with younger children, two states provide materials to parents of newborns through the hospital or direct mail and two states work with elementary schools to distribute materials on the states’ 529 plans. Some states also establish contribution deadlines linked to certain benefits, such as discounted enrollment, or provide incentives to families who contribute during certain times of the year. To prevent families from feeling overwhelmed about college costs, one state has focused its marketing on saving a small amount each month, $25, to help reduce the student’s future debt, instead of focusing on the total cost of college.

Sallie Mae, August 2010. impact of a difficult economic climate, constraints on endowments, and tighter budgets. In response, many of the states we reviewed have attempted to address misconceptions about the financial aid process. For example, one state lists common myths about 529 plans on its website, explaining that approximately 60 percent of federal financial aid comes in the form of loans, a debt the family must repay. The site encourages families to save even in small amounts to offset the amount of debt the family will incur.

For those who are saving for college, awareness that 529 plans exist as a savings option is a challenge to participation, according to officials in most of the states we reviewed. In addition, among parents who are saving for college, one study found that almost half are unfamiliar with 529 plans. An additional 4 percent volunteered that they had never heard of the plan or did not know what it was. financial planners, according to many state officials we interviewed; therefore, awareness may be a particular challenge for low-income families who generally do not have access to such resources. Further, some state officials and industry representatives we interviewed encountered families with misperceptions about how 529 plans work, such as not understanding they can invest in plans outside their home state or use savings at any college or university. For example, officials from two states reported families mistakenly believe prepaid plans can only be used at an in-state institution.

Sallie Mae, August 2010. marketing and communication difficult, according to officials we interviewed in two states. Marketing officials from one state told us consumers requested more information on 529 plans, but it was difficult to communicate information about the complex plans in a simple, consumer- friendly way. Officials in another state noted that plan complexity and a lack of clear information can discourage families from researching and enrolling in a plan.

Many state officials and some academic experts and industry representatives reported that simplifying the information available to consumers might keep families from feeling overwhelmed. Because MSRB rules do not apply to state issuers when they market their direct- sold 529 plans, CSPN developed a set of disclosure principles to help states provide consistent information. The voluntary principles contain recommendations to help consumers understand plans and compare various features, such as fees, tax issues, and risk. While disclosures have been helpful, according to one expert who consults with a number of states, there is room for improvement: disclosures could be more rigorous in ensuring that consumers are informed of less-costly options within a state if they exist and should cover information on prepaid plans, which is currently not standardized. When comparing direct-sold disclosure documents across states we reviewed, we found that the five states generally adhered to the CSPN disclosure principles and contained consistent information a consumer could compare. Three states, however, were missing some information that could be helpful to consumers, such as information on the risk of state tax law changes and a statement that 529 plans should only be used to save for qualified higher education expenses.

The structure of federal and state tax benefits, a primary incentive for some 529 plan investors, can also affect participation as they may not be as helpful to low-income families, according to some academic experts, industry representatives, and state officials we interviewed. Low-income families with low or no tax liability see less benefit from federal tax benefits and may see no benefit from nonrefundable state tax credits provided to 529 plan investors. According to a 2009 Treasury report, families saving in 529 plans may need to carefully consider whether their child will go to college because the penalty incurred if the funds are not used for qualified education expenses may outweigh the tax benefits for low-income families. In addition, Treasury noted most states do not extend tax benefits to residents investing in out-of-state plans, limiting competition. As a result, families have a strong incentive to choose their home state plan even if other plans offer preferable investment choices. In 2009, Treasury recommended states eliminate this “home-state bias” to provide more investment options to consumers, more intense competition between plans, and potentially lower fees. According to an annual report from one state that extends its tax benefits to residents who invest in other states’ plans, doing so, when other states do not, puts the home state plan at a competitive disadvantage. State officials explained that this policy results in other plans marketing their products in the state. Residents, therefore, may be unaware of their home state plan’s benefits, according to the report.

Finally, the fact that account holders may change their investment option only one time per year may affect participation in 529 plans, according to state officials and some industry representatives we interviewed. Officials from one financial services company advocated removing any limits on changing investment choices beyond those imposed by the financial services company sponsoring the fund, as is the case with 401(k) plans and individual retirement accounts. Another industry representative observed some 529 plan participants changing their account beneficiary solely because it would allow them to change their investment options. However, the representative cautioned that participants should not change their investment options too frequently; many experts advocate that investors are best served by sticking with a long-term investment plan.

Savings in 529 Plans Affect Financial Aid the Same as Other Assets

Savings in 529 Plans Are Treated Similarly to Other Assets That Are Included When Calculating the Expected Family Contribution

The extent to which savings in 529 plans, or other investments, affect how much a family is expected to contribute to the cost of college—the federal expected family contribution (EFC)—generally depends on the family’s amount of assets. Education incorporates the amount of specific types of assets into various calculations to determine the EFC. However, in two calculations, families who meet certain criteria are either not expected to contribute to the cost of college (automatic zero EFC) or they qualify for a simplified calculation. In both cases, assets, including savings in 529 plans, are not included in the calculation of the EFC. According to the 2007-2008 NPSAS, about a quarter of families who filed FAFSAs met these criteria.

In other calculations, assets, including savings in 529 plans, may affect the EFC to different extents depending on whether students are dependent on their parents or are independent with dependents of their own. For dependent students, between 2.64 percent and 5.64 percent of parental assets may be included in the EFC as described below:

First, the parents report the net worth (current value minus debt) of their investments (see fig. 6 #1),contribution from assets is calculated, an amount known as the “education savings and asset protection allowance” is subtracted but before the total (see fig. 6, #2). This allowance is designed to help protect a portion of the parents’ assets.

Second, 12 percent of any parental asset amount that exceeds the education savings and asset protection allowance is used to determine the contribution from assets that will be considered in the final EFC calculation (see fig. 6 #3).

Third, this contribution from assets is added to the parents’ available income to determine their adjusted available income (see fig. 6, #4).

Fourth, a marginal rate, from 22 percent up to a maximum of 47 percent, is applied to the sum of the parents’ available income and contributions from assets (known collectively as the adjusted available income) to determine their EFC (see fig. 6, #5). As a result, the amount of net parental assets, including savings in 529 plans, that can be included in the EFC ranges from 2.64 percent to 5.64 percent.

Many States and Selected Institutions Also Treat 529 Plan Savings As Assets

States

Most state financial aid offices also consider savings in 529 plans as assets. According to the 2009-2010 National Association of State Student Grant and Aid Programs survey, 35 states reported that they used the federal methodology for determining the EFC for state aid. However, some states that reported using federal methodology for their primary student needs analysis also indicated they provide special treatment for state 529 college savings or prepaid plans when determining student eligibility for aid. Specifically, seven states that used federal methodology to award their state aid excluded the state’s 529 college savings plan and three excluded the state’s prepaid plan from their calculation for state aid.

Of the officials in the six state financial aid offices we interviewed, none said they considered assets to a greater extent than the FAFSA and a few said their state took specific steps to exempt savings in these plans from consideration. Specifically, officials in two states said there is language in their 529 plan authorizing legislation that exempts plan savings when determining a student’s eligibility for state financial aid. Officials in another state said their state issued a regulation stating that savings in a 529 plan would not affect state grant eligibility for residents attending nonprofit higher education institutions. An official in a fourth state said the legislature changed its higher education authorization language so that students would still be eligible to receive a state scholarship even if they enrolled in the state’s prepaid plan.

Institutional financial aid practices vary with regard to assets, but those with more aid to award may gather additional information about a family’s financial status, according to some representatives of national financial aid organizations and institutional officials we interviewed.schools require students to provide information in addition to the FAFSA, such as filling out the College Board’s PROFILE form or submitting tax returns. One official said the PROFILE provides more detailed information on a family’s assets, such as home equity and retirement account balances, which helps the university prioritize the students with the most need.

Institutional officials we interviewed said their schools considered savings in 529 plans as assets, even if they used different methodologies to calculate their financial aid or included the assets at different percentages. Officials at two institutions said they did not consider savings in 529 plans beyond how they are already reported by the family on the FAFSA. An official at a third institution said the school does not collect any additional information on savings in 529 plans beyond what is requested on the FAFSA even though the school requires families to fill out the PROFILE form and uses an institutional methodology to award its financial aid. The remaining institutional officials said they collect additional family financial information when calculating student aid, but consider savings in 529 plans similarly to the family’s other assets. Specifically, one institutional official said her school uses the PROFILE form to gather more detailed information about a family’s financial situation. Even so, 529 plan savings do not affect a student’s need any differently than other assets, she said, which are assessed by the institution at about five percent of their value. Additionally, she said 529 plan assets are considered parental assets even if they are reported as student assets because the school assesses parental assets at a lower percentage. An official at another institution said her school assesses assets at around 20 percent of their value when calculating the EFC for institutional aid.

Officials’ opinions varied on whether savings in 529 plans should affect financial aid, but many said families’ concerns that these savings will have an adverse effect are common. One state financial aid official said it would be helpful if 529 plan savings were excluded entirely from the calculation because including them can be a deterrent to saving. She said her office often encounters families who feel penalized for saving because they believe the students without savings receive financial aid. Likewise, a 529 plan official said regardless of whether the student’s financial aid will be reduced by savings in a 529 plan, there is the perception that it will. In contrast, one institutional financial aid official said savings in 529 plans should not be treated any differently than other assets because the need analysis is meant to determine the family’s fair share of college expenses and excluding 529 plans would be counter to this aim. One researcher we interviewed found that the issue may be most important for those families who are on the margin of receiving federal financial aid. Regardless of the perceived effect 529 plan savings may have on financial aid, some of the officials we interviewed said they encourage families to save for college because much of the aid they may be offered could be in the form of loans, so saving will generally be in the student’s long-term financial interest.

Concluding Observations

As currently designed, 529 college savings plans benefit a small percentage of U.S. families. In general these families tend to be wealthier than others. It is not clear whether the $1.6 billion in federal tax expenditures that these plans represent strategically targets limited federal resources. Although 529 plans do help some families save for college, families with less income and who are uncertain about whether their children will attend college may have less incentive to invest resources in 529 plans than in other forms of savings. In addition, the tax benefits attractive to a higher-income family do not offer as much benefit to a family with lower tax liability.

Questions about who benefits from this tax expenditure occur in an environment of long-term fiscal challenges and difficult choices about how the federal government allocates limited resources. Reviewing 529 plans in conjunction with the other billions of dollars in federal educational assistance provided through tax expenditures, credits, and deductions could help Congress determine whether this program is meeting its goals. Similar to GAO’s prior work on higher-education related tax expenditures, our analysis of 529 college savings plans was not able to address all questions that could inform future policy choices regarding 529 plans. For example, what is the purpose of the federal tax benefits provided through 529 plans? Are the goals and objectives clearly defined and measurable? Who is the target population for 529 plans and does the current structure provide appropriate incentives for that population? How do the 529 plan federal tax benefits interact with other programs, such as federal financial aid and other higher education tax benefits and savings vehicles?

Consideration of these questions could facilitate continued congressional oversight of this tax expenditure.

Agency Comments

We provided a draft of this report to Education, Treasury, and IRS for comment. The agencies provided technical comments that were incorporated, as appropriate.

We are sending copies of this report to the Secretary of Education, Secretary of the Treasury, Commissioner of Internal Revenue, relevant congressional committees, and other interested parties. In addition, the report will be available at no charge on the GAO Web site at http://www.gao.gov. If you or your staff have any questions about this report, please contact me at sagerm@gao.gov or 202-512-6806. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made key contributions to this report are listed in appendix III.

Appendix I: Objectives, Scope, and Methodology

Our review examined: (1) the percentage and characteristics of families enrolling in 529 plans, (2) the plan features and other factors that affect participation in 529 plans, and (3) the extent to which savings in 529 plans affect financial aid awards. To answer these research objectives, we analyzed government data; interviewed state 529 plan officials from select states as well as industry representatives and academic experts; reviewed plan documents and analyzed industry data; conducted a literature review; interviewed federal, state, and institutional financial aid officials; and reviewed Department of Education (Education) and Internal Revenue Service (IRS) documents as well as relevant federal laws, regulations and guidance.

We assessed the reliability of the data we used by reviewing documentation, interviewing knowledgeable officials, and conducting electronic testing on relevant data fields. We found the data we reviewed reliable for the purposes of our analyses. We conducted this performance audit from November 2011 to December 2012 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Analysis of Government Data

To determine the percentage and characteristics of families enrolling in 529 plans, we reviewed data from the 2010 Survey of Consumer Finances (SCF); the 2007-2008 National Postsecondary Student Aid Study (NPSAS); and 2007-2010 Statistics of Income (SOI) federal tax data. The 2010 SCF, 2007-2008 NPSAS, and 2010 SOI were the most recent data available at the time of our engagement, so to ensure consistency in reporting we adjusted all dollar amounts from previous years’ data to 2010 dollars.

Each of these three data sources (SCF, NPSAS, and SOI) are based on probability samples and estimates are formed using the appropriate estimation weights provided with each survey’s data. Because each of these samples follows a probability procedure based on random selections, they represent only one of a large number of samples that could have been drawn. Since each sample could have provided different estimates, we express our confidence in the precision of our particular sample’s results as a 95 percent confidence interval (e.g., plus or minus 2.5 percentage points). This is the interval that would contain the actual population value for 95 percent of the samples we could have drawn. Unless otherwise noted, all percentage estimates based on the SCF, NPSAS, and SOI have 95 percent confidence intervals that are within 5 percentage points of the estimate itself, and all numerical estimates other than percentages have 95 percent confidence intervals that are within 5 percent of the estimate itself.

For our analysis of the percentage and characteristics of families who held 529 plans, we relied primarily on restricted data from the 2010 SCF. SCF is a triennial survey sponsored by the Board of Governors of the Federal Reserve System (Federal Reserve) to provide detailed information on the finances of U.S. households. The SCF sample of 6,492 households represented approximately 118 million households in 2010. It collects detailed financial characteristics on an economically dominant single individual or couple (married or living as partners) in a household, which we refer to as a family for the purposes of this report. For our analysis, we aggregated financial information so that, unless otherwise noted, all SCF estimates are for the family rather than the individual survey respondent. We did not restrict our analysis to families with children, in part, because 529 plans can be used for nearly anyone, including one’s child, grandchild, niece, nephew, and oneself. However, about 88 percent of families with 529 plans or Coverdell Education Savings Accounts (Coverdells), a similar education savings vehicle, had children 25 years of age or younger living with them. Our estimates for 529 plans included Coverdells because Federal Reserve officials said respondents did not always distinguish between the two account types; therefore, we did not separate these responses because of data reliability concerns. However, the officials indicated that a larger share of the SCF respondents reported having 529 plans than Coverdells. Further, using SOI data, we estimate that in 2010 approximately 85 percent of tax filers who took a distribution from either a 529 plan or a Coverdell reported distributions from a 529 plan while 14 percent reported distributions from a Coverdell and 1 percent reported distributions from both. We wrote an analysis program that the Federal Reserve ran using their restricted SCF dataset to separate information on Medical Savings Accounts and Health Savings Accounts, which had been included in the 2010 public dataset with 529 plans and Coverdells. Federal Reserve officials modified some resulting information to protect the privacy of survey respondents, for example by rounding dollar amounts.

Using SCF, we generated estimates on the percentage and characteristics of families enrolled in 529 plans or Coverdells and of families not enrolled in these plans. We examined family characteristics such as wealth (financial assets), income, education, and race or ethnicity. To calculate financial assets, we used the methodology the Federal Reserve uses to produce variables for its published Bulletin articles. This methodology included assets held in checking, savings, and brokerage accounts, certificates of deposit, mutual funds, stocks, bonds, life insurance, retirement accounts, and other vehicles such as 529 plans. Assets held in retirement accounts included those in defined contribution plans (e.g. a 401(k), individual retirement account, or thrift savings plan) as well as in traditional pensions or defined benefit plans. To calculate income, we used the family’s self-reported total income. To report the family’s highest educational attainment, we reviewed the education of each respondent and his or her partner or spouse and included whichever was higher. We reported information on the respondent’s race or ethnicity, which does not necessarily indicate the race or ethnicity of other family members.

We used 2007-2008 NPSAS data to develop a similar demographic profile for college students and generate other estimates on college costs and financial aid amounts. NPSAS is a comprehensive study by Education that examines how students and their families pay for higher education. It includes nationally representative samples of 113,535 undergraduates, 12,585 graduate students, and 1,581 first-professional students enrolled any time between July 1, 2007 and June 30, 2008. The NPSAS data are based on administrative records and student interviews, and NPSAS includes survey results from both students who received financial aid and those who did not. While we used NPSAS to develop a demographic profile for college students similar to the one we developed for the general population using SCF, families with 529 plans are not directly comparable to families of college students. For example, while our estimates using SCF are for all families (including families with children in college, with children not in college, and with no children), our estimates for families using NPSAS are exclusively for families with a current college student. In NPSAS, families include the student and the student’s parents (if the student is dependent) or the student’s spouse and dependents (if the student is independent). Further, the population of NPSAS students’ families is not the same as the population of families with a child in college because a family may have more than one student in college in a given year. Consequently students’ family characteristics derived from NPSAS are not directly comparable to family characteristics based on the SCF, though for the purposes of our report we use similar terminology to describe them. Similar to our analysis of SCF, we generated estimates of the characteristics of college students’ families— education, and race or ethnicity. To report income, we including income,calculated the total income of (1) the student’s parents (if the student was dependent) and (2) the student and the student’s spouse (if the student was independent). To report the family’s highest educational attainment, we reviewed the education of each student’s mother and father and included whichever was higher. We also reported information on the student’s race or ethnicity, which does not necessarily indicate the race or ethnicity of other family members. We also developed separate estimates for students who are considered either dependent on their parents or independent for financial aid purposes.

We also used NPSAS to generate other estimates related to the cost of college and amount of financial aid awards. First, we estimated the median annual cost of attendance at 4-year public and private non-profit institutions. This included tuition and fees, room and board, transportation, and personal expenses, though the estimate is valid only for students who attended one institution. Second, we estimated the percentage of students who received grants and loans, as well as the median amount of these grants and loans and the percent and amount of college expenses remaining. Third, we generated estimates for the proportion of students who filled out the Free Application for Federal Student Aid (FAFSA) and, for those who did fill out the FAFSA, the proportion who met certain criteria to have assets excluded from the federal expected family contribution (EFC) and the proportion whose assets affected the EFC. Finally, we calculated the percentage of students who received state and institutional financial aid.

We also analyzed 2007-2010 taxpayer data from SOI to determine the extent to which taxpayers used distributions from 529 plans for qualified education expenses and how the tax savings from these plans were distributed across income levels. The SOI individual tax return file is a stratified probability sample of income returns filed with the IRS. The SOI sample of 308,583 returns represented approximately 143 million tax returns filed for 2010. We combined data from the SOI individual tax file with information from the Form 1099-Q. A 529 plan must file a Form 1099-Q with the IRS and the account owner or beneficiary each time a taxpayer receives a distribution from a 529 plan account. This form includes information on the amount of the distribution and the earnings (or loss) on the distribution. When taxpayers receive a Form 1099-Q, they must determine if the distribution was used for qualified education expenses. If the distribution, or any portion of it, was nonqualified, the earnings portion is subject to taxes and, in some cases, a penalty. The taxpayer determines the amount of taxes and penalty owed on the nonqualified distribution by completing Form 5329, which is contained in the individual tax return file. By combining information from the 1099-Q with information in the individual tax return file, we identified the percentage of taxpayers who reported nonqualified distributions that were subject to a penalty. We also used SOI data to estimate the tax savings by using the National Bureau of Economic Research’s (NBER) TAXSIM Model, a microsimulation model of U.S. federal and state income tax systems. TAXSIM calculates estimated liabilities under U.S. federal and state income tax laws from actual tax returns that have been prepared for public use by the Statistics of Income Division of the IRS. Our analysis of the tax savings from 529 plans excludes returns with a filing status of married filing separately.

Interviews with State 529 Plan Representatives, Academic Experts, and Industry Representatives

To provide information on the factors that affect participation we interviewed officials from the following five state 529 plans and their industry partners: Louisiana, Michigan, Pennsylvania, Utah, and Virginia. We used College Savings Plan Network (CSPN) data to select states that represented a variety of plan types (direct-sold, advisor-sold, and pre- paid), offered a number of features (i.e., various state tax benefits, state matching program), and were geographically diverse. We also used suggestions provided by academic experts and industry representatives to inform our selection as well as to provide information on 529 plan participation. We interviewed academic researchers (including the Center for Social Development), industry regulators (the Financial Industry Regulatory Authority and the Municipal Securities Rulemaking Board), financial services companies (American Funds and UPromise), financial experts (such as Financial Research Corporation and Morningstar), College Savings Plan Network, Savingforcollege.com, and consumer interest groups (Investment Company Institute and the American Association of Individual Investors).

Analysis of Plan and Industry Data and Documentation

We analyzed CSPN data on state 529 plans to provide a national overview of plan features, such as fees and state tax benefits. Biennially, states submit plan data to CSPN through an online system to be posted on the CSPN website. CSPN provided us with data on each state as of July 2012. We analyzed the data for every state for both direct-sold and advisor-sold plans on the following features: whether the state offers a matching grant program, whether the state offers tax deductions for contributions and the amount, whether the state offers tax credits for contributions and the amount, types of investment options offered, total contribution limits, and required initial contribution amounts. We also analyzed the following fee categories: program manager fee, state fee, annual account maintenance fee, miscellaneous fee, annual distribution fee, estimated underlying fund expenses, total annual asset-based fees, maximum deferred sales charge, and minimum initial sales charge.

Further, we compared CSPN disclosure principles with direct-sold plan disclosure documentation for the five states we interviewed. We reviewed the extent to which the selected states incorporated elements of the CSPN disclosure principles and whether plan documentation was easily comparable across states. Specifically, we compared whether the state documents contained eleven elements outlined in the principles, including: a summary of key features, an assessment of the individual summary features, a statement of any guarantee by the state issuer or the state, information on state tax treatment and other benefits, information that the state offers more than one plan, fee descriptions, and investment risks, among others. These elements were chosen based on discussions with states and experts who identified plan fees, tax benefits, and investment options as some of the most important features consumers consider when choosing whether or not to participate in a 529 plan. In addition to recording whether states have disclosed the information listed above, we assessed whether any information was missing, where the information was located in the document, and any other observations about the ability to find and understand plan information.

Literature Review

We reviewed studies conducted by academics, researchers, industry representatives, and federal agencies on why families choose to participate in 529 plans and what features might serve as barriers or incentives. We identified literature published since 2006, when Congress passed the Pension Protection Act of 2006, Pub. L. No. 109-250, which made permanent the tax-exemption on 529 plan distributions used for qualified education expenses. Our review included scholarly/peer reviewed material, government reports, hearings and transcripts, trade/industry articles, association/nonprofit/think tank publications, and working papers. We searched information sources such as EconLit, ProQuest, ERIC, PolicyFile, WorldCat, ECO, PapersFirst, ArticleFirst, and Academic OneFile. These online sources are nationally recognized databases that index and abstract research literature. We selected search terms to capture literature that specifically addressed 529 plans, college savings plans, qualified state tuition programs, and prepaid tuition. Of the 32 studies we identified, 12 studies met the following criteria: 1) included information on plan features in specific states, 2) addressed the consequences for consumers of choosing one type of 529 plan over another, 3) identified barriers or incentives for consumers to choose 529 plans, 4) included data collected by states on plan participation, and/or, 5) included information on plan disclosures to consumers. All studies cited in the report were reviewed by at least two GAO analysts. Studies that included statistical methods were reviewed by a GAO statistician and social science analyst. All studies were reviewed for methodological soundness and to ensure that any limitations associated with study methodologies were conveyed to readers in our report text, footnotes, or this appendix.

Financial Aid Analysis

To understand the extent to which savings in 529 plans affect federal financial aid awards, we interviewed Education officials in the Office of Postsecondary Education. We also reviewed relevant statutory provisions, the FAFSA, the Federal Student Aid Handbook, and other Education documents related to calculating the EFC.

To understand the extent to which savings in 529 plans are considered in state financial aid calculations, we interviewed officials from state financial aid offices in six states. To select the state financial aid offices, we used information from a 2009-2010 survey by the National Association of State Student Grant and Aid Programs to identify states that indicated they used a financial aid formula other than the federal methodology in their primary needs analysis and/or provided special treatment for state 529 plans. For report consistency, we selected the same states selected for 529 plan site visit locations to the extent possible (i.e., where the data supported the selection based on the criteria). We interviewed representatives in the following state financial aid offices: Louisiana Office of Student Financial Assistance, Michigan Office of Scholarships and Grants, New York Higher Education Services Corporation, Pennsylvania Higher Education Assistance Agency, Utah Higher Education Assistance Authority, and State Council of Higher Education for Virginia.

We also selected six institutions from the states whose financial aid offices were selected for interviews. To obtain a national perspective on institutional financial aid and determine the best method for selecting the individual institutions, we interviewed representatives at several financial aid organizations including the Association of Private Sector Colleges and Universities, the College Board, the National Association of Student Financial Aid Administrators, the National Association of Independent Colleges and Universities, and the American Association of Community Colleges. In these interviews, some officials said that schools with larger endowments were likely to require families to provide additional information, such as that required on the College Board’s PROFILE application, to award their institutional financial aid. We matched the 2012-2013 College Board’s list of institutions that use the PROFILE application with Education’s 2009-2010 Integrated Postsecondary Education Data System to calculate endowment amounts per student at public and private non-profit four-year institutions. We also reviewed the list of schools that participate in the Private 529 Consortium and selected at least one school that was also part of this group. One state did not have an institution that used the PROFILE application so we reviewed websites of postsecondary schools in that state to identify a school that collected data in addition to the FAFSA. We interviewed representatives at the following institutions: Xavier University of Louisiana, University of Michigan, St. Lawrence University, Swarthmore College, University of Utah, and University of Richmond.

Appendix II: Free Application for Federal Student Aid, 2012-2013

Appendix III: GAO Contacts and Staff Acknowledgments

GAO Contacts

Michelle Sager, Acting Director, Education, Workforce, and Income Security Issues, 202-512-6806 or sagerm@gao.gov.

Staff Acknowledgments

In addition to the contact named above, Gretta Goodwin (Assistant Director), Amy Anderson, Rachel Beers, and Laura Henry contributed to all aspects of this report. Also making key contributions were Carl Barden, James Bennett, Nora Boretti, Jessica Botsford, Jason Bromberg, Alicia Cackley, Melinda Cordero, Patrick Dudley, Shannon Finnegan, Kim Frankena, Mark Glickman, David Lewis, Ashley McCall, John Mingus, Mark Ramage, MaryLynn Sergent, George Scott, Walter Vance, Kathleen van Gelder, and Michelle Loutoo Wilson.