Statement of Edward O'Conner 
First Vice President, Retirement and Education Savings
Merrill Lynch & Co., Inc., on behalf of Savings Coalition of America

Testimony Before the House Committee on Ways and Means

Hearing on President's Tax Relief Proposals that Affect Individuals

Thank you, Mr. Chairman, for giving us the opportunity to express our strong support for the proposals to promote education savings that are contained in the President's budget. I am Ed O'Connor, First Vice President, Retirement and Education Savings at Merrill Lynch & Co., Inc. In that capacity, I see day in and day out the challenges people face in trying to save for their children's education and their own retirement. The President's proposals and other similar pro-savings proposals of Members of this Committee will go a long way in helping Americans meet those critical savings challenges.

I am here today on behalf of the Savings Coalition of America. The Savings Coalition was established in 1991 to support incentives to increase personal savings in the United States. Its main objective is to win passage of expanded Individual Retirement Account (IRA) legislation for all Americans. There are approximately 75 member organizations of the Savings Coalition representing a wide variety of private interests including banking, securities, financial services, consumer groups, engineering, home-building, realtors, intangible assets, trust companies, health care industry, insurance, education and business groups.

At the outset, I would like to commend the President for his tax relief proposals, and, in particular, his proposals to provide American families with expanded tax incentives to save for education expenses. With taxes consuming an ever-larger amount of Americans' income, we salute the President's efforts to reduce the individual tax burden. One positive way to reduce the tax burden on Americans, while also to fulfilling other important national objectives, is to alleviate the anti-savings bias in the federal tax code. By providing families with enhanced savings incentives, not only will the individual tax burden be reduced, but important future education and retirement needs will be financed. As a bonus, we will generate the increased national savings that is critical to fueling continued economic growth in the future.

In recent years, this Committee has been pivotal in providing American families with exciting new tools for retirement and education savings. Mr. Chairman, your leadership on savings issues, particularly with respect to expanded IRAs, is well-known. Similarly, the bipartisan efforts of Representatives Portman and Cardin and many other Members of this Committee with respect to retirement savings are well documented. With the strong leadership of this Committee, I believe that we have a historic opportunity to reduce Americans' taxes, increase savings, and solidify the education and retirement future of millions of Americans.

In my testimony today, I will focus on the critically important task of helping American families prepare for the costs of higher education. Before reaching those issues, the Savings Coalition of America, on behalf of millions of American savers, would like to encourage this Committee to continue its efforts to enact bipartisan retirement savings legislation introduced last week by Representatives Portman and Cardin, along with more than 250 of their House colleagues. Enhanced retirement savings opportunities must be a critical national priority. Changes should include (1) increasing the IRA contribution limit to $5,000, (2) increasing allowable contributions to salary reduction plans (such as 401(k) plans, 403(b) arrangements, 457 plans and SIMPLEs), (3) allowing meaningful catch-up contributions to IRAs and salary reduction plans for those approaching retirement, and (4) enhanced portability of retirement assets between plans. Efforts in that area would complement the increased education savings opportunities that I will address in my testimony today.

Background

Families confronting college education costs for one child face a formidable challenge. For families with two, three or more children, college education costs can be overwhelming. In the past few years, Congress has created two new savings tools to help American families prepare for education expenses - the Education IRA and section 529 qualified state tuition plans (QSTPs). While both the Education IRA and QSTPs have helped American families meet their education savings challenges, they have the potential to do much more. Indeed, based on our experience on the front lines of college financing, we believe that enactment of a few relatively modest changes described below could improve Education IRAs and QSTPs substantially.

The high cost of getting a college degree is well documented. Since the early 1980s, the cost of college has increased at a significantly faster pace than inflation. Today, most families fund college education through a combination of pay-as-you-go financing (e.g., part time jobs for the student) and pay-after-you-go student loans. Over the last two decades, as college tuition and other education costs have continued to rise, direct financial aid has diminished. As a result, it has become more and more difficult for families to cover college expenses as they are incurred. That, in turn, has meant that student and parent loans have been used to finance an increasing share of higher education costs. For many, the price of a college education now involves having to deal with an overwhelming repayment burden for many years after graduation. When the interest costs on these loans are factored into the cost of education, the burden imposed on American families becomes even greater.

The difficulties in financing higher education are also getting worse because the level of education and specialization required to compete is rapidly increasing. In the 1970s, a college degree replaced a high school diploma as a prerequisite for many jobs. Today, four years of college is often not enough training. Instead, it has become increasingly common that graduate studies are necessary to stay current with either the technology or techniques in a given career. This necessary post-graduate study further increases the total costs of higher education.

Federal government programs and policies have historically been designed to help people deal with the burdens of college through assistance with these pay-as-you-go and pay-after-you-go methods of financing. Over the years, Federal assistance has taken many forms, including grants and other financial aid, tax credits, subsidized higher education loans, and tax advantages for student loans (such as the ability to deduct student loan interest). Until the last few years, those who have wanted to save for college in advance have received little incentive from the federal government.

Having said that, Mr. Chairman, I also want to stress that we do not believe that student loans (and other federal programs) to help pay for college education are bad. Just the opposite, student loans have helped many millions of Americans attend college. However, by focusing efforts primarily on assisting with pay-as-you-go financing and subsidized loans, the federal government has sent a strong signal that advance funding of college was not very important. To the contrary though, most families with children will need a wide range of resources - substantial education savings, federal grants and loans, student jobs, etc. - to meet their higher education needs.

With this backdrop, it becomes clear that the best way to finance college education with the least disruption for families, and the smallest financial burden after college graduation, is to save as much as possible for college in advance. By saving before a child reaches college age, families can help ensure that adequate funds will be there to allow their children to attend college. Moreover, by beginning an education savings strategy for a child at an early age, the family further reduces its overall burden through the so-called "miracle of compounding."

Education IRAs and QSTPs are excellent tools for increasing education savings for the entire family. One aspect of the Education IRA and QSTP savings programs that is often overlooked is that they are savings vehicles for the extended family. We have found that contributions do not only come from parents. They come from grandparents, aunts, uncles, and others who want to contribute to a loved one's future education. Often the grandparent may be uncomfortable giving money directly to the grandchildren (or the grandchildren's parents), perhaps because they are concerned that the funds may be expended for another purpose before matriculation. Yet those same grandparents are comfortable setting up an Education IRA or QSTP for each of their grandchildren. In providing a mechanism that allows these extended-family members to contribute to a child's higher education costs, these education savings vehicles have opened up new avenues for college savings.

Despite those and other advantages, there is still a need to improve education savings programs. Many commentators have rightly criticized the anti-savings bias in the tax code, and a logical step in alleviating that bias is through enhanced incentives for education savings - where there is a real chance that each dollar of new savings will also mean a dollar less of debt incurred through student and private loans.

Improving the Education IRA

When first created in 1997, the Education IRA held out hope as a potentially critical new education savings vehicle for American families. By giving a tax advantage for college savings, the Federal government sent out a highly visible signal to American families that saving in advance for a child's higher education costs must be a high priority.

In spite of this great potential, the Education IRA has had only a limited impact. While helping some families meet a portion of higher education costs, the Education IRA has not reached its full potential for a number of reasons - particularly the unrealistically low $500 annual contribution limit. Indeed, we frequently hear feedback from parents, grandparents, and other customers that the account is simply inadequate to meet more than a small fraction of the education savings need. In addition, the Education IRA rules need to be simplified. Complex restrictions on eligibility and "fine print" on the availability of favorable tax treatment confuse people and scare them away from contributing, further discouraging use.

Increasing the $500 Contribution Limit. The current $500 maximum contribution to an Education IRA is woefully inadequate. For a child born today, if the maximum $500 contribution were made to the child's Education IRA in each year, that child would only have about $17,000 by the time he or she reached college age in 2019 ⁽¹⁾-- an amount that could be little more than is needed to fund one semester's tuition, room and board at an in-state public institution.

The $500 contribution limit also creates many other problems that severely limit the effectiveness of the Education IRA. First, during the early years of an Education IRA, the account balance is so small that the broadly available savings vehicles, whether bank or brokerage accounts, mutual funds, or annuities, have administrative costs that could exceed any earnings. For example, if a financial institution charges only $20 annually to administer an Education IRA, the assets in the account would have to earn more than 4 percent just to break even during the first year the account is in existence. In addition, many products require an initial investment greater than $500. People understand this, and many are reluctant to begin savings through a vehicle that could lose them money during the early years.

Equally important, the small account size that flows from the current $500 contribution limit has meant that many financial institutions do not even offer Education IRAs to their customers. For those institutions that have incurred the expense of offering Education IRAs, advertising has been minimal. If we are to get American families focused on the importance of saving for college early, we need to make them more aware of the scope of the financial crunch that comes when children begin college. Advertising of Education IRAs would be an effective instrument for educating the American people about the importance of college saving. Significant advertising is unlikely to occur as long as the maximum annual Education IRA contribution is $500.

For these reasons, we believe that the annual Education IRA contribution limit should be increased substantially and we commend the President for his proposal to provide up to $2,000 per year in contributions. At that level, significant advertising could be expected and many of the small account problems would be eliminated for most contributors. Equally important, if the savings begins early enough in the child's life, this higher contribution limit could go a long way toward financing the total cost of a college education.

Allowing Catch-Up Contributions. The members of this Committee may also wish to consider those who are already approaching college age. For a family with a child aged fourteen, even $2,000 per year would only fund a portion of the cost of attending college. In the retirement area, bipartisan proposals have included "catch-up" contributions that would allow those approaching retirement (i.e., age 50 and older) to make increased contributions to their IRAs and employment-based retirement plans. A similar catch-up concept would make a great deal of sense for children over a specified age (e.g., age 13 or older).

Extending the Deadline for Contributions. Further confusion is caused by the rules governing timing of contributions to Education IRAs. Today, an Education IRA contribution for a year must be made by December 31^st of that year. This is different from the rule that applies to all other IRAs. For all other IRAs, contributions can be made at any time through the due date of the individual's tax return. People understand the IRA rule and do not understand why the Education IRA rule should be different. Having the same deadline for all IRA contributions (including traditional IRAs, Roth IRAs and Education IRAs) would reduce confusion.

Perhaps more important, the IRA approach to the timing of contributions has proven very successful in increasing IRA contributions. A substantial portion of total IRA contributions occur after the close of the year. We have found that one of the main reasons is that many individuals do not focus on the need to contribute until they focus on the amount of tax they are paying. For others, a tax refund may provide an ideal resource for saving. If that refund is not saved right away, however, it often will not remain unspent for long. For these reasons we strongly encourage the Committee to modify rules on timing of Education IRA contributions to track the rules currently applicable to all other IRAs.

Improving Distribution Rules. Another element of unnecessary complexity in the current Education IRA results from uncertainty regarding the tax treatment of distributions. Under the rules currently in effect, amounts distributed from Education IRAs are excludable from gross income to the extent that the amounts do not exceed qualified higher education expenses during the year of the distribution. That is a fair and easy rule to understand - if you use the money for college costs, you do not pay tax.

The problems with the current distribution rules arise in the interaction of the Education IRA tax treatment and the HOPE and Lifetime Learning credits. Today, if the HOPE or Lifetime Learning credit is claimed with respect to a beneficiary for the year in which the Education IRA withdrawal is made, then the Education IRA loses its tax-advantaged treatment. This is true even if the family is entitled to a HOPE credit or Lifetime Learning credit with respect to some college expenses and the student is making the Education IRA withdrawal to pay other expenses.

Although some type of rule to prevent "double dipping" - claiming the HOPE or Lifetime Learning credit for the same expenses that are paid out of the Education IRA - makes sense, the current rule is a clear case of overkill. For the Education IRA to be successful, individuals making contributions need to know with considerable certainty that they will get the tax benefit if they use the account to cover college costs. As a result, we recommend that the current rule denying all tax advantages to Education IRA withdrawals in any year in which HOPE or Lifetime Learning credits are claimed should be replaced with a narrower rule targeted to combat double dipping.

Expanding Eligibility. Today, eligibility to contribute to an Education IRA is limited depending on the contributor's modified adjusted gross income. Our experience with traditional IRAs, Roth IRAs and Education IRAs shows that limiting access based on income ends up reducing savings at all income levels. Right about the time someone starts getting interested in setting up a new IRA or Education IRA, they hear a disclaimer that only certain individuals are eligible and that they should immediately check with their tax advisor to see if they qualify. That scares people, especially middle income families who do not have a tax advisor. They automatically assume that they are one of the ones that are excluded. Or they decide not to start the pattern saving because they assume they will not be eligible next year and that it is just not worth the trouble.

The experience with the income limits that were placed on traditional IRAs in 1986 is illustrative of this point. Although the intention may have been to take the IRA away from more affluent households, the end result of the 1986 Act income limits was to drive over seven million Americans with income below $50,000 out of IRAs. In fact, IRA contributions dropped by more than 40 percent for those who continued to be eligible for deductible IRAs in the year after the income limits were imposed. Before the changes that went into effect in 1998, IRA participation among those with income under $50,000 had dropped by over 65 percent.

The lesson of the IRA experience is clear. Income limits confuse potential contributors and, in the end, also drive away people who are eligible to contribute. All Americans should have access to savings vehicles for their children's education. For these reasons, we strongly encourage elimination of complex Education IRA income eligibility rules.

Permitting Rollovers to Roth IRAs. A similar, problem arises with the severe restriction on Education IRA withdrawals if the individual does not withdraw funds to go to college. Today, an individual must withdraw all Education IRA balances within 30 days after attaining the age of 30 and the earnings portion of such distribution is fully taxable and subject to a 10 percent penalty tax because the amount was not used for education.

To understand the uncertainty that this age 30 rule creates, you can put yourself into the shoes of a grandparent wanting to contribute to an Education IRA of a young grandchild. That grandparent may hope (or even expect) that the grandchild will go to college, but they have no way of being absolutely certain. In many cases, that uncertainty can be enough to cause the grandparent not to make the Education IRA contribution. If on the other hand, the grandparent knew that if the child did not use the funds for college they could be transferred to a Roth IRA as the start of a retirement nest egg, the chances are increased that the grandparent would make the contribution.

In fact, the large lifetime earnings differential between those who have a college degree and their peers who are high school graduates is well documented. A leg up on retirement savings for those who are more likely to work all their lives at lower wage rates would be an important and equitable step in closing that gap. Of course, the vast majority of the children will end up using the money for college as originally intended, but the added flexibility will provide the needed comfort to the individual making the contribution in the first place.

Qualified State Tuition Programs (QSTPs)

Section 529 of the Internal Revenue Code provides federal tax rules for state-run QSTPs. Merrill Lynch assists states by acting as program manager for QSTPs. In that capacity, Merrill Lynch and other Savings Coalition members provide management, investment, administrative and advisory services to the programs.

QSTPs operate differently than Education IRAs, and have their own federal tax rules. QSTP are sponsored by a State, and can operate either as a "pre-paid" tuition plan or an education savings account - (many states sponsor both). In most instances, states have contracted with a financial institution like Merrill Lynch to administer its QSTP. QSTPs are relatively new arrangements that are evolving as the different states continue to improve their programs to better meet the higher education savings needs of American families. For those who have become acquainted with the unique advantages of QSTPs, however, these state-run programs have become a powerful tool for higher education savings. Still, certain improvements could greatly enhance the effectiveness of QSTPs in helping children attend college. These include the following:

Improving the Tax Treatment of Distributions. Today, for federal tax purposes, QSTP distributions for higher education expenses are generally taxable to the student to the extent they exceed contributions. We urge enactment of proposals that would allow QSTP distributions (or education benefits) to receive tax treatment similar to that currently afforded Education IRAs (i.e., distributions for higher education expenses generally would not be taxable). To the extent that American families are saving for higher education expenses and receiving distributions from QSTPs solely to meet those expenses, the federal government should exempt such amounts from federal taxation. By doing this, American families would not have to save additional amounts to pay taxes on QSTP distributions, and they would be provided an additional tax incentive to save for their children's higher education costs. Consequently, we support the President's budget proposal to provide a full tax exemption to all QSTPs.

Confirming That Periodic Rebalancing of Investments is Allowed. Section 529(b)(5) provides that a QSTP contributor or beneficiary may not directly or indirectly direct the investment of contributions to the QSTP. In other areas of the tax law where there are prohibitions on investor control by account or fund owners, those requirements have been interpreted to mean that the owner cannot select the individual, underlying investments of the account or fund (e.g., the owner would not be permitted to direct the purchase of stock in a particular company or companies).

With respect to QSTPs, however, the Internal Revenue Service (Service) has issued proposed regulations that imply that QSTP owners would generally be prohibited from changing their broad investment criteria after the initial selection. The narrow interpretation of the law contained in the regulations is inconsistent with the underlying purpose of the legislation and is not supported by the statutory language or its legislative history.

With the kind of volatility we have seen in investment markets recently, it is understandable why many individuals would be reluctant to make an irrevocable investment decision for a period of perhaps twenty years with regard to a matter as important as a child's education. Yet, that would be the end result if the Service were to finalize the position taken in the proposed section 529 regulations.

While there are other issues that remain to be resolved in connection with the regulatory process, we urge the members of this Committee to clarify (either formally or informally) that the section 529(b)(5) prohibition on investment direction in the statute was not intended to preclude reasonable periodic rebalancing of broad investment choices within a QSTP. There seems to be no policy rationale for the view that an investment decision once made could never be changed.

Expanding the Definition of Qualified Higher Education Expenses. Section 529 currently limits the maximum amount of qualified higher education expenses for room and board to the minimum amount charged by an institution to any student, without regard to whether or not the student has reasonable living expenses that are higher than the minimum. This limitation can be particularly unfair to students living off-campus. Thus, the definition of qualified higher education expenses should be amended to permit reasonable room and board expenses.

Allowing Rollovers. Today, QSTP amounts cannot be rolled over to a first cousin of the designated beneficiary. Because the federal government should encourage higher education savings by extended family members, the rules should allow rollovers to first cousins. Under this more logical rule, a grandparent could contribute to a QSTP for one grandchild, but if it became prudent to transfer those amounts to the QSTP of another grandchild who is a first cousin of the original designated beneficiary, the grandparent would have the flexibility to do so. Similarly, when there is no change in the designated beneficiary, rollover from one QSTP to another should be allowed. We urge this Committee to provide that a transfer of credits (or other amounts) from one qualified tuition program for the benefit of a designated beneficiary to another qualified tuition program for the benefit of the same beneficiary would not be considered a distribution, without any restrictions being placed on such transfers.

Conclusion

Thank you for giving me the opportunity to present this statement on the critically important issue of education savings. We need to give American families the best tools we can to help them prepare for their children's future education costs. While the Education IRA and QSTPs are a good start, modest improvements in these programs could help them reach their full potential - and unlock the key to the higher education dreams of millions of American families and their children.

In the end, each American must accept significant responsibility for saving for their future needs. But the government must help by reducing the tax burden on those who save and by making the savings choices simple and understandable. With that end in mind, our national savings strategy must include an effective set of incentives that will expand personal savings, especially for education and retirement. Improving existing savings vehicles like the Education IRA, QSTPs, IRAs, and employment-based plans should be the backbone of that effort. We need to give American families the best tools we can to help them prepare for the future.

1. Assumes seven percent annual rate of return on investment in the Education IRA.