To Save or Borrow

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JASON D. DELISLE AND PRESTON COOPER

SEPTEMBER 2017

To Save or Borrow

A M E R I C A N E N T E R P R I S E I N S T I T U T E

COMPARING FEDERAL BENEFITS FOR 529

COLLEGE SAVINGS PLANS AND STUDENT

LOAN FORGIVENESS

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merican families may contribute to tax- advantaged savings accounts known as 529 plans to save for a child’s college and graduate education. These plans have come under scrutiny in recent years as favoring upper-income households, who use them at much higher rates and derive a greater benefit from the tax savings therein. However, less scrutinized is the federal government’s student loan program, which offers student borrowers loan forgiveness after 20 years of payments. Due to changes lawmakers adopted in 2010, this program also has the potential to deliver sizable benefits to upper-income families.

In this report, we compare the fiscal costs of the 529 plan and the federal student loan program for a hypothetical upper-income family. We assume our household has the choice to finance $68,000 worth of expenses for a child’s undergraduate and graduate college education through a 529 college savings plan or through the federal student loan program. We find

that when the upper-income family uses the loan program, it receives 1.5 to 2.3 times the magnitude of federal benefits versus using a 529 plan.

One of the main reasons for this difference is that the tax benefits of 529 plans are secondary and therefore practically limited; savers avoid tax only on distributed earnings, not on contributions. By contrast, the loan program offers potential forgiveness of both prin- cipal and interest, a benefit that even upper-income users can realize if they borrow to finance a graduate education. While 529 plans tend to favor more afflu- ent families, the loan program can provide even larger benefits to these households, and policymakers may wish to address the costs of both programs, not only the former. In that regard, they could cap the amount graduate students can borrow through the loan program and restrict the tax preferences of 529 plans to only undergraduate educational expenses, disallowing them for graduate and professional educations.

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COMPARING FEDERAL BENEFITS FOR 529 COLLEGE SAVINGS PLANS AND STUDENT LOAN FORGIVENESS Jason D. Delisle and Preston Cooper

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istorically, the federal government’s higher education programs have been targeted to students from low-income families. The student loan program, created in the 1960s, provided benefits to only lower-income students, as did the Pell Grant program, which Congress established in the 1970s. But this phi- losophy changed in the 1990s. Lawmakers opened the loan program to all students regardless of income and created tuition tax credits for middle-class families. In the 2000s lawmakers went further, raising the income limits for the tax credits and making 529 college savings plans tax-free for families of all incomes.

Although both political parties have historically supported allowing upper-income families to claim tax breaks for college expenses, 529 savings plans have come under increasing scrutiny in recent years because they overwhelmingly benefit high earners.¹ The most prominent attack on 529 plans occurred in 2015 when President Barack Obama called on Con- gress to eliminate this federal tax break. (The Obama administration quickly dropped the proposal after bipartisan opposition.)²

Lawmakers have also greatly expanded the benefits that upper-income families can receive through the federal student loan program in recent years, but the benefits this program now provides to upper-income households have escaped scrutiny.

In 2010, Congress and President Obama expanded benefits under the Income-Based Repayment (IBR)

program, which provides loan forgiveness after 20 years of payments. While IBR provides an important safety net for student borrowers who unexpect- edly earn lower incomes when they leave school, the 2010 expansion also has the potential to provide benefits to upper-income families.

In this report, we analyze whether a 529 plan or the IBR program provides larger benefits to upper-income families. Specifically, we examine the potential benefits a hypothetical family and student would receive by financing an undergraduate and graduate education using a 529 plan or using IBR to repay federal student loans. We find that for a typical upper-income household, the loan program and IBR provide more than twice the benefits of a 529 plan.

Importantly, this brief does not provide a distribu- tional analysis of the benefits of 529 plans and federal student loans. We are not able to assess how much total government subsidy each group of beneficiaries receives under IBR or 529 plans. As we discuss, 529 plans inevitably provide more in total government funds to upper-income families than to lower-income families. IBR, on the other hand, provides benefits to both groups and may even provide a disproportion- ate amount of government subsidies to lower-income families. However, our focus is on the magnitude of each program’s subsidy to upper-income families rather than the distribution of that subsidy among families of different income levels.

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An Overview of 529 Plans

Congress created the 529 plan as a way to encour- age families to save money for college by providing tax benefits for such savings. A parent or other individual may save money in a 529 plan on behalf of a designated beneficiary, usually a child, to pay for the beneficiary’s college education. Under a 529 plan, the account holder uses after-tax dollars to invest in various assets, typically traditional savings accounts and mutual funds that hold stocks and bonds. With- drawals (distributions) from a 529 plan can be used to pay for tuition, fees, room and board, and other education-related expenses.³

The account holder owes no federal income taxes on any accrued earnings if distributions are used to pay these expenses. The benefit the federal government provides for 529 plans is therefore equivalent to the account holder’s marginal tax rate times the value of any earnings in the plan.

Research shows that few families use 529 plans.

An analysis by the Government Accountability Office using the 2010 Survey of Consumer Finances (SCF) found that less than 3 percent of households used 529 plans, including just 7 percent of households antici- pating major educational expenses.⁴ The 2013 SCF data reveal little has changed. Roughly 3 percent of households use 529 plans, which rises to just 6 percent among households that have dependent children under 25.

Use of 529 plans skews toward upper-income households. Among the richest fourth of families with dependent children under age 25, 18 percent use 529 plans, compared with just 0.2 percent of households in the poorest fourth.⁵ This is what one would expect.

Because wealthier families have more money to save and derive a greater benefit from saving in the form of avoided tax payments, they naturally are more able and have a larger incentive to use 529 plans.

In 2016, the average annual withdrawal from 529 plans was $12,100, according to the College Savings Plans Network.⁶ These data do not show how much of those distributions are from contributions versus earnings; only the latter are tax-free. Due to these tax benefits, the Congressional Joint Committee on

Taxation (JCT) estimates that 529 plans and similar savings plans cost the federal government $1.1 billion in foregone revenue each year.⁷ In addition to the federal tax benefits, most states provide additional benefits to 529 account holders. These usually include exempting earnings from state taxes but may also include more generous benefits such as tax credits for contributions.

An Overview of Federal Student Loans and IBR

The federal government offers students direct loans to pay for tuition and living expenses at any accred- ited institution of higher education. Dependent undergraduate students may borrow up to an overall cap of $31,000. Graduate students may borrow unlimited amounts to cover tuition and living expenses.⁸ Students from families of any income level may use the loan program.

After leaving college, borrowers can use IBR to repay their loans. Under the most recent version of IBR, which Congress and the Obama administration enacted in 2010 and made available to all new borrowers as of July 2014, borrowers pay 10 percent of their discretionary income toward the loan. After a 20-year repayment period, any remaining balance is forgiven. Under current law, borrowers must pay federal income taxes on the amount forgiven, but its political unpopularity makes it uncertain that this provision will go into effect. (Before lawmakers’ changes to IBR in 2010, borrowers paid 15 percent of their discretionary income, and loan forgiveness occurred after 25 years of payments.)

IBR can provide a large benefit to borrowers at substantial cost to the government. The Department of Education projects that many borrowers who use it will not repay their loans in full and thus receive forgiveness.⁹ If the present value of the IBR payments a borrower makes before receiving forgiveness does not exceed the amount borrowed, the borrower receives a net federal subsidy under the program. The Department of Education estimates that the subsidy costs taxpayers $28 for every $100 of loans a borrower

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repays through IBR.¹⁰ In total, projected costs are

$15.2 billion annually for loans repaid in IBR.

Because payments are based on income and not debt levels in IBR, borrowers with large balances receive greater benefits, all else being equal. The vol- ume of loans in IBR or similar plans has risen 206 percent over the past three years. The average balance of borrowers using IBR is $57,009, much higher than the overall average balance.¹¹ This suggests that graduate student borrowers, who have larger balances on average, use IBR at a disproportionately high rate.

In addition to IBR, the federal government provides a secondary benefit to student borrowers.

Borrowers may deduct up to $2,500 in student loan interest from their taxable income each year if their incomes are below a certain level.¹² JCT estimates that the deduction reduces tax revenues by $2.4 billion per year. Around half of these benefits flow to households earning more than $75,000 per year.¹³

The student loan interest deduction is above the line, meaning borrowers need not itemize deduc- tions to claim it, and it also reduces their adjusted gross income (AGI) by the amount of the deduction.

Because IBR payments are based on AGI, claiming the interest deduction reduces a borrower’s loan payments in the following year by as much as $250, making the deduction a double benefit.

529 Versus IBR: Which One Provides Upper-Income Families with Larger Benefits?

Both 529 plans and the student loan program offer potential benefits to upper-income families. To gauge which is more beneficial, we consider a scenario in which an upper-income family has the choice to finance a child’s undergraduate and graduate education in one of two ways: saving in a 529 plan or using the federal loan program and IBR. We design a model to estimate how much each program costs the government in the benefits it delivers to a hypothetical upper-income family.

We define an upper-income household as one in which the student’s parents have high incomes,

even though the student is the one who pays off the loans. Our student’s parents have a combined income between $171,000 and $374,000. Were the federal loan program not available to the children of upper-income parents, we assume the parents would help pay their child’s educational expenses out of pocket. The federal loan program thus enables upper-income parents to avoid tuition expenditures, saving those families money at the government’s expense.

The student in our example spends four years at an undergraduate college and then attends graduate school for two years immediately afterward. We assume he uses $27,000 in loans or distributions from a 529 plan for his undergraduate education and $41,000 for his graduate education. In total he uses $68,000 in federally subsidized funds for his education, either through a 529 plan in one example or the student loan program in the other.¹⁴ The following section details each of those two approaches and the resulting federal benefits for the student and his parents.

Option 1: Finance with a 529 Plan. Under the first option, our student’s family sets up a 529 plan for him as soon as he is born. His parents make annual contributions of $1,568 until his 18th birthday. Contribu- tions of this level will enable them to finance exactly

$68,000 of their child’s college and graduate education. After the student turns 18, his family starts taking distributions to pay his educational expenses, which average $11,300 annually. Those annual distributions

The Department of Education estimates that the subsidy costs taxpayers $28 for every

$100 of loans a borrower

repays through IBR.

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are comparable to the $12,100 average for all 529 plans in 2016. The final distribution, when our student is 24 and in his last year of graduate school, leaves no funds remaining in the plan. Of the $68,000 in distributions, earnings constitute $39,913—or 59 percent of distributions.

In our example, funds invested in the 529 plan earn an average annual rate of return of 6.62 percent.¹⁵ When funds are distributed, the household avoids an average federal tax of 23.7 percent on the earnings.¹⁶ For our purposes, the cost to the government of a 529 plan is the portion of the distribution that is from investment earnings multiplied by this tax rate.¹⁷ Therefore, the 529 option costs the federal government $10,572 in foregone tax revenue in total. We do not consider additional benefits that states may provide to 529 plan holders, as the focus of this report is higher education programs at the federal level.

Option 2: Finance with Federal Student Loans.

The second option for our household is to forego the 529 plan entirely and finance the $68,000 in college and graduate school expenses with federal student loans. Under this scenario, the student borrows the maximum allowed for each of the four years of his undergraduate education ($27,000) and a further

$41,000 for his graduate education.¹⁸ Students who borrowed federal loans for both their undergraduate and graduate educations and completed a graduate degree in 2012 typically borrowed about $62,000 over the course of their educational careers.¹⁹ Allowing for inflation, $68,000 represents a typical borrowing amount for students such as ours who attend college between 2017 and 2023.

Our borrower does not make any payments on his loans in school and graduates after six years with a balance of $78,572 because of accrued interest. He immediately consolidates his loans and begins repaying using IBR. His annual income when he begins repaying is $46,866, which grows at a nominal rate of 5.3 percent per year. This figure represents typical earnings for young individuals with graduate degrees.²⁰ At the end of the 20-year repayment period, our borrower’s annual nominal income is $125,026. If he receives loan forgiveness at the end of his repayment period,

he will pay a federal marginal tax rate of 28 percent on the dollar value of his forgiveness, assuming Congress does not eliminate these tax consequences.²¹

During his first year of repayment, our student makes a monthly payment of $221, nearly $1,000 lower than the $1,182 monthly payment he would make under a 10-year fixed payment plan that fully repays the loan. For several years, his payments cover only interest—but not all of it—and he pays enough interest to claim the full $2,500 student loan interest deduction when he files his taxes.

We measure the cost of the loan program for the government as the amount disbursed minus the present value of payments made. We assume the borrower takes the student loan interest deduction when eligible; we incorporate as costs both the present value of the deduction itself and the reduction it causes to our borrower’s AGI in the following year.²² Administrative costs of $986 that the government incurs servicing the loans over the entire repayment term are also included.²³

If our student chooses the student loan option, the government will incur a cost of $23,773, roughly 2.3 times the cost of the 529 option. Specifically, the loan disbursement to the student exceeds the present discounted value of what he repays using IBR by

$16,121, accounting for most of the loss to the government. Another $6,667 in losses to the government results from him claiming the student loan interest deduction and the remaining $986 are due to administrative costs the government pays to operate the student loan program.

If we assume the government taxes the forgiven debt, the cost of the student loan option falls to

$16,150, or roughly 1.5 times the cost of the 529 option.

Discussion

Both the 529 plan and the federal loan program have no restrictions on participants’ income, so both have the potential to provide benefits to households near the top of the income distribution. Our analysis shows that the federal student loan program combined with IBR (and the student loan

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Table 1. Assumptions Behind Simulations of 529 Plan Versus Federal Student Loans

Option 1: Finance with 529 Plan Option 2: Finance with Federal Direct Student Loans

• $68,000 in undergraduate and graduate education costs*

• $131 monthly contributions for 18 years

• 6.6 percent annual rate of return*

• 23.7 percent marginal avoided tax rate

• Cash flows discounted to year student exits college (at a 5 percent rate)*

• $68,000 in undergraduate and graduate education costs*

• Interest rates as projected by the Congressional Budget Office over next six academic years

• Annual income starts at $46,866; grows at 5.3 percent annually*

• Administrative costs equal to 1.45 percent of loan disbursements

• 28 percent marginal tax rate on forgiven loans

• Cash flows discounted to year student exits college and enters repayment (at a 5 percent rate)*

Note: Assumptions with an asterisk (*) are adjusted in a sensitivity analysis in the appendix.

Source: Authors’ calculations.

Figure 1. Cost to Government of Two Options for Financing $68,000 in Education Expenses

529 Account Federal Student Loans Federal Student Loans (With Tax Consequences

for Loan Forgiveness)

$17,106

$9,483

$6,667

$10,572

$0

$5,000

$10,000

$15,000

$20,000

$25,000

Cost to Federal Government

Student Loan Subsidy Student Loan Interest Deduction 529 Tax Benefits

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interest deduction) delivers more benefits to typical upper-income households. This suggests that those who are concerned that these households receive overly generous government benefits for higher education may want to prioritize reforming federal student loans over 529 plans.

Why do student loans provide larger government- funded benefits to the family and student in our example? For one, the benefits that 529 plans provide, while still significant, are only a small share of the amount of funds a family invests through a 529. The federal government does not provide a tax deduction for contributions; only the investment earnings from those contributions are tax-free. Therefore, a family could possibly make cumulatively large contributions to a 529 plan and use those funds to finance educational expenses but derive tax benefits that are only a frac- tion of the value of funds in the 529 plan. The family in our example saves $28,088 with the plan and earns

another $39,913 in interest and capital gains on those funds, yet the tax benefits they earn are only about

$10,572 (in present value terms). See Figure 2 for an illustration of these numbers.

Like 529 plans, the student loan program allows students from any income background to use the program to finance undergraduate and graduate educations. And accumulating $68,000 in debt for undergraduate and graduate studies combined is typical for those students borrowing for both degrees and arguably easier for an upper-income family than accumulating the same amount in a 529 plan. Of course, if the student had to fully repay the loans, the 529 plan would deliver larger benefits.

Under IBR, however, a borrower’s payments are set at such a low share of his income relative to what would be needed to repay $68,000 plus interest over a 20-year term that he ends up having about a third of his obligation forgiven.

Figure 2. Cumulative Contributions, Earnings, and Tax Benefits of 529 Plan

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 Child’s Age

Cumulative Contributions Plus Earnings Cumulative Earnings Cumulative Tax Benefits Student

Enters College

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We illustrate this dynamic in Figure 3. The orange line shows our student’s actual payments, which average $252 (in present value terms) over the lifetime of the loan. For the government to break even on his loans, he would need to make payments of $324 (also in present value terms) for 20 years, a scenario rep- resented by the blue line. The result is a gap in total payments of $17,106. The figure incorporates the government’s administrative costs but not the student loan interest deduction.

There are, of course, other ways to compare 529 plans and student loans that could show different results. Our analysis is merely a comparison of government costs for a particular beneficiary; it does not examine which program is “better” or which offers a higher return on the government’s investment. Nor does it assess how the benefits are distributed among the population, such as what share

of funds under each program flow to upper-income households.

By that measure, 529 plans are almost certain to provide a larger share of their benefits to upper-income families because those families use them at much higher rates. By comparison, IBR provides benefits to lower- and upper-income families. Finally, with no contribution or withdrawal limits for 529 plans, the benefits to rich families (and consequent costs to the government) are theoretically unlimited.²⁴

Another consideration is that a household consid- ering whether to finance college expenses with a 529 plan must make that decision early on, to give savings time to accrue. If a household chooses to forgo a 529 plan and instead finance college with the student loan program, it gambles that Congress will not modify the student loan program before a child goes to college. The likelihood that Congress will retroactively Figure 3. Cumulative Payments on Federal Student Loan, Compared to Cumulative Payments Necessary for the Government to Break Even

Note: All cash flows are discounted at a 5 percent rate to the year our hypothetical student enters repayment.

$60,535

$77,642

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

$90,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Year of Repayment

Cumulative Payments (Actual) Cumulative Payments (Government Break Even)

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remove tax benefits for existing 529 plans is much lower. Therefore, even if a household could theoretically extract greater benefits from the student loan program than from a 529 plan, it may choose to use a 529 plan to insure against the risk of a policy change.

Our analysis does not capture other important dif- ferences between the two programs. IBR provides generous benefits to students who go on to earn low or medium incomes because it ensures that a borrower’s payments are always an affordable share of his income. Conversely, 529 plans provide relatively small benefits to these families because they are less able to save and may not even owe federal income taxes.

IBR also has a safety valve to limit benefits from flowing to high earners, unlike 529 plans. Borrowers who go on to earn high incomes early in repayment will pay more under IBR than the hypothetical borrower in our example and would likely fully repay their debts. Similarly, undergraduates are subject to a $31,000 borrowing limit, and a borrower earning a high income during repayment is likely to fully repay $31,000 in loans under IBR. In contrast, a family could use an unlimited amount of savings in a 529 plan to finance an undergraduate education and need not finance a graduate education to reap large benefits, as is the case for IBR.

On the other hand, our analysis may understate the benefits of federal student loans for upper-income families. Graduate students can borrow far more than the borrower in our example does and have a strong incentive to do so: For borrowers who can expect to receive loan forgiveness, borrowing additional sums through the loan program is essentially free. Borrow- ers who exploit this provision may vastly increase costs to the government. We explore this possibility and other alternative scenarios in a sensitivity analysis in the appendix.

We also assume that our borrower does not receive Public Service Loan Forgiveness, which offers borrowers who work in a broad set of public service occu- pations full loan forgiveness after 10 years rather than 20 if they use IBR. This forgiveness program will also increase costs for the government and potentially augment the benefits to upper-income households.

Conclusion

Our analysis reveals that for a given student from an upper-income household, financing college expenses through the federal student loan program is more costly to the government than using a 529 plan. Poli- cymakers who wish to make federal higher education programs less generous for upper-income households could concentrate their efforts on reforming the loan program. In that effort they could consider reforms such as capping the amount graduate students can borrow annually or requiring that borrowers repay their loans for longer before qualifying for loan forgiveness under IBR.

Of course, reforming student loans and 529 plans need not be mutually exclusive. Policymakers could address the excesses of 529 plans similarly by limiting tax-free distributions to expenses for undergraduate educations only, disallowing 529 plans for financing graduate educations.

About the Authors

Jason D. Delisle is a resident fellow at the American Enterprise Institute. Preston Cooper is a research analyst with the Center on Higher Education Reform at the American Enterprise Institute.

The American Enterprise Institute (AEI) is a nonpartisan, nonprofit, 501(c)(3) educational organization and does not take institutional positions on any issues. The views expressed here are those of the author(s).

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Appendix: Sensitivity Analysis

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n the following section we adjust the parameters of our example to gauge the sensitivity of our conclu- sions to alternative assumptions. In each of the following charts, we report results for our original analysis and four alternative assumptions.

Our first analysis adjusts the amount of college expenses our student must fund, whether through a 529 plan or through the federal student loan program (Figure A1). Our original example used a figure of $68,000; adjusting this figure downward makes 529 plans more costly to the government than student loans. However, the effect in the other direction is

far more extreme; using a figure of $107,000 makes student loans four times as costly as 529 plans. As we note in the discussion, unlimited loan forgiveness cre- ates an incentive for students to borrow more because marginal loans will be forgiven.

Our second analysis varies our student’s starting income after leaving college (Figure A2). This does not affect the estimated costs of 529 plans, but it has a dramatic effect on the estimated costs of federal student loans. Our original analysis used a starting income of roughly $46,866. Lower starting incomes produce higher costs and vice versa. Students with

Figure A1. Adjusting College Expenses

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$27,000 $47,000 $68,000 $87,000 $107,000

Cost to Government

College Expenses 529 Cost Student Loan Cost

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high starting incomes receive a negative subsidy when using student loans in our model because the interest rate they pay on the loan is higher than the discount rate used to value those payments, and they often do not receive loan forgiveness after 20 years.

Our third analysis adjusts the annual rate of return on contributions invested in the 529 plan; the original example used 6.6 percent. For obvious reasons, changing this assumption does not affect the estimated costs of the student loan program. As shown in Figure A3, different rates of return have only a moder- ate effect on the estimated costs of the 529 plan.

Finally, our fourth analysis varies the discount rate we apply to cash flows in both the 529 plan and student loan examples (Figure A4). Higher discount rates increase the costs of both options and vice versa.

However, the effects are much more dramatic for the federal student loan program because the cash flows

on that program are far in the future. Only under discount rates close to the risk-free rate of return (2.5 percent in September 2017) does the 529 option cost the government more than the federal student loan option does. Because the cash flows in this analysis are risky, it does not make sense to discount them using a risk-free rate.

Sensitivity analysis reveals that some plausible scenarios would result in greater government costs associated with a 529 plan than with the federal student loan program. However, equally plausible scenarios result in the costs of the loan program exceeding those of 529 plans to an even greater degree than we find in our chosen example. Therefore, while some students from upper-income families might receive larger government benefits from a 529 plan than from the federal student loan program, that does not appear to be the norm.

Figure A2. Adjusting Starting Income

($10,000)

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$23,433 $35,150 $46,866 $58,583 $70,300

Cost to Government

Starting Income 529 Cost Student Loan Cost

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Figure A3. Adjusting 529 Rate of Return

$0

$5,000

$10,000

$15,000

$20,000

$25,000

4.6% 5.6% 6.6% 7.6% 8.6%

Cost to Government

Annual Rate of Return on 529 Contributions 529 Cost Student Loan Cost

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Figure A4. Adjusting Discount Rate

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

3.0% 4.0% 5.0% 6.0% 7.0%

Cost to Government

Discount Rate

529 Cost Student Loan Cost

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Notes

1. Richard V. Reeves, “A Better Way to Cut Government Spending: End Tax Breaks on 529 College Savings Plans,” Brookings Insti- tution, June 29, 2017, https://www.brookings.edu/blog/social-mobility-memos/2017/06/29/a-better-way-to-cut-government-spending- end-tax-breaks-on-529-college-savings-plans/.

2. John D. McKinnon, “Obama Drops Plan to Raise Taxes on 529 College Savings Accounts,” Wall Street Journal, January 28, 2015, https://www.wsj.com/articles/obama-drops-plan-to-raise-taxes-on-529-accounts-1422390991.

3. Internal Revenue Service, “Qualified Tuition Program,” accessed September 5, 2017, https://www.irs.gov/publications/p970/ch08.

html.

4. Government Accountability Office, “A Small Percentage of Families Save in 529 Plans,” December 2012, http://www.gao.gov/

assets/660/650759.pdf.

5. Of families in the second income quartile, 1.7 percent use 529 plans, along with 5.3 percent in the third income quartile. See the authors’ analysis of the 2013 Survey of Consumer Finances (SCF) data via US Federal Reserve, “Survey of Consumer Finances,”

updated February 28, 2017, https://www.federalreserve.gov/econres/scfindex.htm.

6. College Savings Plan Network, “529 Plan Data,” accessed September 5, 2017, http://www.collegesavings.org/529-plan-data/.

7. Joint Committee on Taxation, “Estimates of Federal Tax Expenditures for Fiscal Years 2016–2020,” January 30, 2017, https://

www.jct.gov/publications.html?func=startdown&id=4971.

8. Graduate students may borrow $20,500 per year in traditional Stafford loans and then may use the higher-interest-rate Graduate PLUS loan program to borrow up to the cost of attendance, as defined by their university.

9. US Department of Education, “Student Loans Overview: Fiscal Year 2018 Budget Proposal,” accessed September 5, 2017, https://

www2.ed.gov/about/overview/budget/budget18/justifications/q-sloverview.pdf.

10. Office of Management and Budget, “Budget Appendix: Department of Education,” accessed September 5, 2017, https://www.

whitehouse.gov/sites/whitehouse.gov/files/omb/budget/fy2018/edu.pdf.

11. US Department of Education, Federal Student Aid, “Federal Student Loan Portfolio: Portfolio by Repayment Plan,” accessed Sep- tember 5, 2017, https://studentaid.ed.gov/sa/about/data-center/student/portfolio.

12. Internal Revenue Service, “Student Loan Interest Deduction,” accessed September 5, 2017, https://www.irs.gov/publications/

p970/ch04.html#en_US_2014_publink1000178283; and 26 USC § 221(f).

13. Joint Committee on Taxation, “Estimates of Federal Tax Expenditures for Fiscal Years 2016–2020.”

14. These figures are equivalent to the maximum amount of Stafford loans (but no PLUS loans) a student may borrow for four years of undergraduate study and two years of graduate study. Data from the 2012 National Postsecondary Student Aid Study show that 55 percent of full-time, dependent bachelor’s degree seekers who borrowed and 49 percent of full-time graduate students who borrowed exhausted their Stafford loan eligibility, so we believe these assumptions about educational costs financed with debt (or, alter- natively, with a 529 plan) are valid. Furthermore, students who completed their educations in 2012 and borrowed federal loans for both their undergraduate and graduate educations typically accumulated approximately $62,000 in debt, a figure in line with $68,000 once inflation is factored in. See National Center for Education Statistics, “2011–12 National Postsecondary Student Aid Study (NPSAS:12),”

accessed via NCES DataLab on September 5, 2017, https://nces.ed.gov/datalab/index.aspx.

15. These figures are based on SCF data on 529 plans. Among the largest 529 plans in each household, about 32 percent are invested entirely in stocks, 19 percent are entirely in bonds or other interest-bearing assets, and another 49 percent are in mixed accounts. We use the geometric average return of the S&P 500 for the past 20 years (7.61 percent) and the comparable return for 10-year US Treasury bonds (5.34 percent) to infer that the “typical” 529 plan should have a return of 6.62 percent. See Survey of Consumer Finances &

Aswath Damodoran, “Annual Returns on Stocks, T.Bonds and T.Bills: 1928–Current,” New York University, January 5, 2017, http://

pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html.

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16. According to the SCF, households with 529 plans of this size and college-age dependent children have incomes with an interquar- tile range of $171,000 to $374,000. This puts our hypothetical household in either the 28 percent or 33 percent tax bracket for ordinary income for married couples filing jointly. Capital gains tax rates are lower, between 15 percent and 18.8 percent. For simplicity, we take the weighted average of tax rates on stocks and bonds for each tax bracket and then average the two income groups to arrive at an

“avoided” marginal tax rate on distributed earnings of 23.7 percent. See US Federal Reserve, “Survey of Consumer Finances.”

17. We discount these costs to the government to the year the student exits college, at a rate of 5 percent. This adjustment is to ensure comparability with our cost estimates under the student loan option.

18. Our student borrows the maximum amount of Stafford loans for dependent students each year as an undergraduate; this amount is $5,500 for freshmen, $6,500 for sophomores, and $7,500 for juniors and seniors. Neither the student nor his parents use the PLUS loan program, which offers an unlimited line of credit but carries a higher interest rate. As a graduate student, he borrows at the Staf- ford loan limit of $20,500 for each of his two years. We assume he enters college as a freshman in the 2017–18 academic year and leaves college after his second year of graduate school, the 2022–23 academic year. The Congressional Budget Office publishes projected interest rates on student loans for the next 10 years; we use these projections in the analysis of costs. See Congressional Budget Office,

“CBO’s January 2017 Baseline Projections for the Student Loan Program,” January 25, 2017, https://www.cbo.gov/sites/default/files/

recurringdata/51310-2017-01-studentloan.pdf.

19. National Center for Education Statistics, “2011–12 National Postsecondary Student Aid Study (NPSAS:12).”

20. Median personal income for individuals age 24–26 with graduate degrees was $40,000 in 2015, according to the American Com- munity Survey (ACS). Assuming 2 percent inflation, the equivalent income for a comparable individual in 2023, when our student graduates, is $46,866. The ACS income data for older individuals with graduate degrees imply that income should grow at a rate of 5.3 percent, after accounting for expected inflation. This is close to the 5 percent rate the Department of Education uses in its official calculator. See Steven Ruggles et al., “Integrated Public Use Microdata Series: Version 6.0 [Data Set],” University of Minnesota, 2015, http://doi.org/10.18128/D010.V6.0; and US Department of Education, “Repayment Estimator,” accessed September 5, 2017, https://

studentloans.gov/myDirectLoan/repaymentEstimator.action.

21. For simplicity, we assume that our borrower remains single and has no dependents throughout the loan’s lifetime. This could bias cost estimates up or down: up, because adding dependents raises the amount of income exempt from IBR payments, and down, if our borrower’s spouse brings additional income to the household and thus increases IBR payments. Married borrowers also have the option under current law to file separate federal income taxes so that their loan payments under IBR would be based solely on their own income.

22. We discount all cash flows at a rate of 5 percent. The base year is the year our student enters repayment, or in the case of the 529 plan, the year our student graduates from college. Our chosen discount rate is slightly lower than the yield on a 20-year Treasury bond (2.51 percent at the beginning of September 2017) plus a market risk premium for unsubsidized federal Stafford loans of 2.85 percent calculated by the Congressional Budget Office. US Treasury Department, “Daily Treasury Yield Curve Rates,” accessed September 5, 2017, https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield; and Congressional Budget Office, “Fair-Value Estimates of the Costs of Federal Credit Programs in 2013,” June 28, 2012, https://www.cbo.gov/

publication/43352.

23. These administrative costs are equivalent to the loan disbursement, $68,000, multiplied by the Department of Education’s estimated administrative cost rate of 1.45 percent. We assume administrative costs to the government associated with 529 plans are negli- gible. Office of Management and Budget, “Budget for Fiscal Year 2018 Appendix: Department of Education,” accessed September 5, 2017, https://www.whitehouse.gov/sites/whitehouse.gov/files/omb/budget/fy2018/edu.pdf.

24. The 529 plan carries contribution limits but not withdrawal limits so long as withdrawals are used to pay for qualified educational expenses. If annual contributions to 529 plans in the name of a particular beneficiary exceed $14,000, the contributions may incur gift taxes.