Do Rich Coloradans Really Need a Tax Break to Pay for College?
By Carol Hedges
You’d think we could all agree that very wealthy folks don’t need big tax breaks in order to get them to spend money. But the debate over reforming Colorado’s 529 savings program—a tax incentive to encourage saving for college which should be targeted in a more equitable way—is proving otherwise. Taxes are ripe for confusion and any time changes are being considered, some taxpayers who will lose their ability to pay less in taxes will object. That’s exactly what’s happening with HB21-1311, which would, among other provisions, change the state’s tax incentive for college savings.
Colorado’s 529 tax deduction was adopted in 1981 to help low- and middle-income families save for post-high school education. It creates a tax incentive to save for qualified higher education expenses by allowing taxpayers to subtract, dollar for dollar, any contribution to a qualified 529 savings program from their state taxable income.
The state deduction advantage is not the biggest tax benefit of saving through a 529 plan. Federally, any interest or return on investment gained on 529 investments is tax-free federally (and at the state level) when it is used for allowable purposes. This means, for example, if a family saves $60,000 for a child’s education over 15 years, any interest on those investments can be used for college expenses without being reported as income. These tax advantages make 529 investments an attractive way to help incentivize saving for the constantly rising cost of higher education.
And who is using the tax advantages from Colorado’s 529 incentivized savings program? Lots of Coloradans. In 2017 (the newest Department of Revenue data available), 55,565 taxpayers claimed the deduction. However, that same data shows the program largely benefits Colorado’s richest taxpayers—people who don’t really need an incentive to save since they can often pay cash for tuition and education costs.
However, taxpayers with adjusted gross incomes of more than $500,000—the threshold for being in the top 1% of Colorado taxpayers—make up 6.2% of Colorado taxpayers claiming the 529 deduction and have an average deduction of $28,327. And despite being such a small group of people, those deductions make up 24% of the total spent on this deduction. To reiterate: The top 1 percent of Colorado taxpayers claim 24% of this tax deduction.
A tax incentive to save for college is vastly different than a tax credit to make college tax free. The 529 deduction isn’t designed to make college costs tax-free. It’s designed to encourage people to put money away for a big and important future expense. While it’s been made confusing by those wanting to protect the current deduction, the reform contained in HB21-1311 does not change the tax advantage of saving for college through a 529 for most Coloradans, only those who are wealthy enough to put away very large amounts of savings.
Colorado’s 529 deduction was authorized to help low- and middle-income families. Imposing an annual cap on the deductibility of 529 contributions of $15,000 per beneficiary—contributions won’t be capped and will still get favorable tax treatment for investment returns and interest—will enhance the ability of this credit to meet its original objective. While the cap will mean that some of the highest income investors will lose a portion of their tax deduction, few (if any) low- and middle-income families would see any change in the deductibility of their investment.
Let’s use a practical example to show just how much a middle class family would have to save to be affected by the proposed annual cap amount. A taxpayer earning Colorado’s median annual household income of $70,000 would have to save nearly 20% of their income each year. That is an unrealistic annual college saving rate.
In fact, the 2017 data shows that the average annual deduction for taxpayers earning that median income is $3,730, a fairly healthy amount but nowhere near the cap proposed in HB21-1311. It’s hard to imagine that those taxpayers have much more room in their budgets considering that, on average, those same taxpayers devote over 30% of their income to housing. The 2017 data reveals that no group of taxpayers (other than those with incomes above $500,000) come close to the proposed cap of $15,000. 32 of the 36 states that allow income tax deductions for 529 savings have a cap.
The current deduction means those with financial resources to pay cash for college expenses can do so tax-free but those who lack those cash resources are required to pay for college from taxed assets. That hardly seems fair, does it?
What makes the current rules of this deduction even more unfair is that one of the reasons college costs are growing so fast is the lack of state investments in higher education. Tuition at Colorado public universities is growing faster than all but five other states. Support for higher education ranks us second-to-last among all states.
Of course, the primary reason for lack of state support is lack of state revenue, a problem made worse by inequitable treatment of 529 deductions that allows the wealthiest to pay less. That lack of state revenue has also resulted in a bigger part of college costs being paid by students and families in Colorado. Since 2000, the portion of tuition costs paid by families has increased from 32% to 61% while the state contribution has fallen from 68% to 39%, making it harder for low- and middle-income families to afford college and other higher education opportunities for their kids.
The COVID-caused recession has laid bare the many inequities that plague our public systems. And “building back better,” a slogan that’s been embraced by our legislators this year, is a goal Coloradans across the state are embracing too. Modernizing and reforming our tax code, like adding a cap to the deductibility of 529, is the path forward to make it work for more than just a few wealthy people.
The deduction cap, as well as other tax code clean-ups in HB21-1311 and HB21-1312, are common sense, data-based reforms we need now. It’s time to change the rules so that those with the assets to pay cash for college are not relieved of their responsibility to pay state taxes at the expense of students in families who struggle to afford higher education.
