Congress has often attempted to assist Americans in paying for higher education by using the individual income tax laws. Between 1954 and 1996, eight education-related tax benefits were added to the Internal Revenue Code. The Taxpayer Relief Act of 1997, P.L. 105-34, introduced five new education tax benefits. Recently, the American opportunity tax credit greatly expanded the prior Hope scholarship credit. Today, at least 12 income tax provisions are designed to provide tax benefits for the pursuit of education.1
The education-related income tax provisions can be divided into three general categories:
- Tax incentives to save for education;
- Tax relief when paying current-year education expenses; and
- Tax assistance with student loans.
Some of these tax provisions allow deductions for a portion or all of education expenditures. Some exclude otherwise taxable income from inclusion in the calculation of taxable income. Still others furnish tax credits that can provide a direct reduction of tax for each dollar of qualified expenditures.
It has been estimated that in 2017 the forgone tax revenue from these provisions may have exceeded $30 billion,2 yet there is reason to believe that many of them will be ineffective in accomplishing their objectives.
This article examines the requirements and limitations that taxpayers face when they seek to obtain the tax benefits of some of the most significant education-related income tax provisions.3 It then looks at the American Bar Association's and the AICPA's suggestions for simplification as well as the recommendations of National Taxpayer Advocate Nina Olson.Tax incentives to save for education
Congress has enacted provisions to give parents, students, and other taxpayers a tax incentive to save for education costs. The Code provisions discussed here are:
- Sec. 135: Income from U.S. savings bonds used to pay higher education tuition and fees;
- Sec. 530: Coverdell education savings accounts; and
- Sec. 529: Qualified tuition programs.
Each program is designed to encourage saving for education by excluding the earnings on those savings from tax.
Education savings bond interest exclusion
Potential income tax benefit: Interest earned on U.S. savings bonds generally is taxable. Most taxpayers report the accumulated interest as income when the savings bonds are redeemed. This provision encourages taxpayers to purchase savings bonds for higher education costs by permitting the interest earned on qualifying savings bonds (up to the amount of "qualifying educational expenses") to be excluded from taxable income. The benefit to the taxpayer is equal to the amount of income tax that would otherwise have been imposed on the savings bond interest.4
- Only certain savings bonds qualify.5
- The owner of the bond must be 24 years old or older before the bonds are issued. As a result, bonds gifted to a person before he or she is age 24 (e.g., at birth) do not qualify.
- Interest from other investments, including interest on other U.S. government obligations (e.g., Treasury notes, bills, and long-term bonds), does not qualify for exclusion under this provision even if the funds are used solely for education expenses.
- The exclusion can be claimed only if the proceeds are used to pay qualified expenses for the taxpayer, the taxpayer's spouse, or a dependent.
- Qualifying educational expenses include tuition and required fees at eligible educational institutions but do not include expenses for room (e.g., dormitory charges) or meals. Books are not considered a qualifying expense unless a student may not attend or enroll in a course without purchasing them.
- Qualifying educational expenses must equal or exceed redemption proceeds, not just the interest earned on the redeemed bonds. If qualifying educational expenses are less than the bond proceeds, only a portion of the interest on the redeemed bonds will be tax free.6
Income limits: The exclusion of savings bond interest is phased out after a taxpayer's "modified adjusted gross income" (MAGI) exceeds a threshold amount, which is adjusted each year for inflation.7 In 2018, a taxpayer who has MAGI in excess of $79,700 ($119,550 if filing a joint return) will lose a portion or all of this benefit.8
Coverdell education savings account
Potential income tax benefit:The earnings on amounts deposited in a Coverdell account are excluded from taxable income until the funds in the account are distributed. If distributions from a Coverdell account are equal to or less than qualified education expenses,9 earnings will be permanently excluded from tax.
- When the account is established, the beneficiary must be 18 or younger or be a special-needs beneficiary. The beneficiary does not need to be the taxpayer's dependent.
- Total contributions for any year cannot exceed $2,000 and (except for a special-needs beneficiary) cannot be made after the beneficiary attains age 18. The maximum lifetime contribution limit thus ordinarily would be $36,000.10
- Qualified higher education expenses are defined differently from qualifying expenses for education savings bonds. The costs of room and board, for instance, may be a qualified expense provided the student is enrolled at least "half-time."11
- When determining qualified expenses, education expenses are reduced by any tax-free educational assistance received and by expenses used in determining the American opportunity or lifetime learning credits.
- If a beneficiary receives distributions from both a Coverdell account and a qualified tuition program in the same year and the total distributions from both are more than the beneficiary's adjusted qualified higher education expenses, those expenses must be allocated between the two distributions to determine how much of each distribution is taxable.
- Any unused balance in a Coverdell account usually must be distributed when the beneficiary reaches age 30 even if this results in a taxable distribution.
- An additional tax of 10% is imposed on any taxable distribution.
- The maximum amount that a taxpayer is allowed to contribute in a year ($2,000) is phased out if MAGI exceeds a threshold amount. The definition of MAGI is different from the definition for purposes of the education savings bond interest exclusion.12
- The phaseout threshold for making contributions is $95,000 ($190,000 for joint return filers) and is not adjusted for inflation.
- If excess contributions are made, a 6% excise tax is imposed on the excess contribution every year that those excess funds remain in the account.
In view of the many limitations on the above two programs, it is fortunate that Congress has provided another tax-favored way to save for college — college savings plans — established under Sec. 529.13
College savings plans
College savings plan accounts may be established to save for the qualified higher education expenses of a designated beneficiary. Only states and eligible education institutions may offer these plans.
Potential income tax benefit: Like Coverdell accounts, amounts invested in a college saving plan account grow tax free until distributed. If distributions from an account are equal to or less than qualified education expenses, there is also no income tax on the distributions. While there is no federal tax deduction for contributions, many states allow deductions from state income tax.
- Unlike Coverdell accounts, there is no annual limit on contributions. State and private plans do limit total contributions to each beneficiary's account. It is often possible to fully fund a beneficiary's higher education expenses using these plans, because the total contribution limit for many plans exceeds $300,000.14
- After 2017, college saving plans can be used to a limited extent for elementary and secondary school expenses as well as higher education.15 Qualified higher education expenses are defined similarly for college savings plans and Coverdell accounts.
- If a taxpayer receives a taxable distribution (i.e., one that is not used for qualified expenses), the Code generally imposes an additional tax of 10% on the amount included in income. Unlike Coverdell accounts, the balance in the account need not be distributed by a set age.
Income limits: None.
Compared to other programs designed to provide incentives to save for education expenses, college savings plans are flexible and simple. Perhaps it is no surprise that many Americans are now using these plans to save for higher education.Tax relief when paying current-year education expenses
Congress has also enacted provisions that provide tax relief when paying current-year education expenses. Two important Code provisions are:
- Sec. 25A(i): American opportunity tax credit; and
- Sec. 25A(c):Lifetime learning credit.
American opportunity tax credit
Potential income tax benefit: An annual tax credit of up to $2,500 per student. Forty percent of the American opportunity tax credit is "refundable," meaning a taxpayer who has no U.S. tax liability may receive up to a $1,000 refund (40% of $2,500) when filing a return.
- The amount of the credit is 100% of the first $2,000 of qualified expenses and 25% of the next $2,000. Thus, a taxpayer must have $4,000 of qualified expenses during a year to obtain the full $2,500 credit.
- Books are considered qualifying expenses, but housing and meals are not.
- The student must be pursuing a degree or other recognized academic credential and must have been enrolled at least half-time for at least one academic period (e.g., one semester) that begins during the calendar year.
- The credit is available only for the first four years of higher education (generally freshman through senior years).
- The credit is denied when certain other educational incentives are used. For example, a taxpayer cannot claim this credit for any student for whom a lifetime learning credit is claimed in the same year.
- A student cannot claim the credit if another person has claimed the student as a dependent.
- The student cannot have had a felony conviction for possessing or distributing a controlled substance. Conviction for any other felony (e.g., fraud, kidnapping, arson) does not result in denial of the credit.
Income limits: The credit is phased out if MAGI16 exceeds a threshold amount, which is not adjusted for inflation. The phaseout threshold is $80,000 ($160,000 if filing a joint return).
Lifetime learning credit
The lifetime learning credit is another credit available to assist with the costs of higher education. Since it typically provides less of a tax benefit, it is generally claimed only when the American opportunity tax credit is not available.
Potential income tax benefit: The provision provides for an annual tax credit of up to $2,000 per taxpayer.
- The credit is 20% of the first $10,000 of qualified expenses. Thus, a taxpayer must have $10,000 of qualified expenses during a year to obtain the full $2,000 credit.
- As with the American opportunity tax credit, the lifetime learning credit cannot be claimed when certain other educational incentives are claimed.
- Unlike the American opportunity credit:
• None of the credit is refundable. The lifetime learning credit only provides a tax savings to the extent the taxpayer has a tax obligation equal to or greater than the credit.
• Costs for books, supplies, and equipment are not qualified expenses unless they must be paid to the educational organization.
• There is no degree or workload requirement, and the credit is not limited to four years of study. Thus, the credit can be claimed for continuing education expenses.
• Having a felony conviction for possessing or distributing a controlled substance (or any felony conviction) will not cause the student to lose the credit.
Income limits: The credit phases out if MAGI exceeds a threshold amount. However, the threshold for the phaseout is significantly less than that under the American opportunity tax credit. In 2018, a taxpayer who had MAGI in excess of $57,000 ($114,000 if filing a joint return) would lose a portion or all of this credit.17Tax assistance with student loans
Congress has also enacted provisions that provide tax relief for loans used for education. Sec. 221, discussed below, is one important provision.
Student loan interest deduction
Potential income tax benefit: The payment of personal interest is not generally deductible. A taxpayer may, however, be able to claim an above-the-line deduction for up to $2,500 of interest paid each year on qualified student loans.
- The loan must have been incurred solely to pay qualified higher education expenses of the taxpayer, the taxpayer's spouse, or a dependent at the time of the loan. The definition of "dependent," however, is not the same as the definition used for determining the availability of a dependency exemption,18 which is unavailable beginning in 2018.
- The loan cannot be from a related person or made under a qualified employer plan.
- The student must have been enrolled at least half-time in a program leading to a degree, certificate, or other recognized educational credential at an eligible educational institution.
- The loan may be used for tuition, fees, books, supplies, and equipment. The cost of room and board may also qualify.
- Only interest is deductible; however, the allocation of payments between interest and principal for tax purposes may not be the same as the allocation shown on Form 1098-E, Student Loan Interest Statement, or other statement received from the lender.19
- The deduction is phased out if MAGI exceeds a threshold amount. The definition of MAGI is different from that used for the American opportunity and lifetime learning credits.20
- In 2018, the phaseout threshold for taxpayers filing joint returns is $135,000, and the deduction is totally phased out for taxpayers with MAGI of $165,000 or more. The phaseout threshold for other taxpayers is $65,000, and the deduction is totally phased out for taxpayers with MAGI of $80,000 or more.21
Albert Einstein is reported to have said, "The hardest thing in the world to understand is income taxes."22
Our current educational income tax incentives build on that legacy. Although all were designed to assist with the costs of higher education, the provisions do not even agree as to what should be considered qualifying educational costs. Some, but not all provisions, include the costs of books and supplies. Some, but not all, include the costs of housing and meals.
- Some require at least half-time student enrollment; others have no minimum requirement.
- Some have age limits; some do not.
- Some, but not all, are limited to a taxpayer, spouse, and dependents, and for those, the definition of a "dependent" varies.
- The American opportunity tax credit is partially refundable; the lifetime learning credit is not.
- Some, but not all, require that income be below a certain amount. The amount of income that defines "need" varies and can be almost as much as $220,000. Those provisions that have income requirements do not use a uniform definition of "income."
The provisions were designed to reduce income taxes for those in need to encourage the pursuit of higher education. There are significant structural reasons why the provisions may have limited effectiveness in accomplishing this goal:
Value of exclusions and deductions: When an exclusion or deduction is claimed, the tax savings are equivalent to the amount of the deduction or exclusion multiplied by the taxpayer's marginal tax rate. A taxpayer with need often has a low marginal tax rate and, thus, will receive only a negligible tax reduction. Using exclusions and deductions to provide education benefits can in fact have the undesired effect of giving the largest tax savings to those with the highest incomes.
Lack of federal income tax liability: An inherent problem in using the U.S. income tax law to assist taxpayers is that in 2016 approximately 44% of Americans had no U.S. income tax liability.23 As a result, most of the educational tax provisions are of no value to them.24Recommendations for change
The American Bar Association (ABA) and the AICPA tax sections have long noted the need to simplify the education tax provisions. Some of the previous recommendations were:25
- Eliminate or standardize income ranges for eligibility of benefits;
- Combine the education tax credits and establish a single amount of expenses eligible for the credit; and
- Consider replacing the existing incentives with a universal deduction or credit.
National Taxpayer Advocate Nina Olson, who has served in that role since 2001, recently wrote, "If I had to distill everything I've learned into one sentence, it would be this: The root of all evil is the complexity of the tax code."26 Olson has specifically noted the need to consolidate and harmonize the Code's education provisions. In the Taxpayer Advocate Service's 2016 annual report to Congress, she stated: "The point of a tax incentive, almost by definition, is to encourage certain types of economic behavior. However, taxpayers will only respond to incentives if they know they exist and understand them. Few, if any, taxpayers are aware of each of the education tax incentives and familiar enough with the particulars to make wise choices."27
The recent tax overhaul legislation, P.L. 115-97, failed to fix the current state of the educational tax provisions, although early versions of the bill had proposed to consolidate the education tax credits and make other changes. Hopefully, Congress will someday heed the calls for change and provide education tax incentives that taxpayers can understand and use.
1Crandall-Hollick, Higher Education Tax Benefits: Brief Overview and Budgetary Effects, CRS Report R41967 (March 12, 2014). In December 2014, another provision with education tax benefits, Sec. 529A qualified ABLE programs, was signed into law.
2Estimates of tax expenditures for educational incentives vary. Estimates provided by the Joint Committee on Taxation listed total tax expenditures for these provisions of $35.4 billion for 2017 (Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2016-2020 (JCX-3-17) (Jan. 30, 2017)). Estimates provided by the Office of Management and Budget (OMB) for 2017 totaled $29.7 billion (OMB, Analytical Perspectives, Budget of the United States Government: Fiscal Year 2017, Tax Expenditures, Table 14-2B (Feb 10, 2016)). The OMB report noted that totaling the individual incentives might not reflect the potential revenue effect due to possible changes in economic behavior and the fact that tax expenditures are interdependent. The Joint Committee report also noted that it used different methodologies than OMB. See Comparisons With Treasury and Tax Expenditures Calculations Generally in that report.
3Not all of the education-related tax provisions are reviewed in this article. For the fearless, citations to many provisions not discussed are listed here. Provisions that provide incentives to save include the following: Sec. 127 (educational assistance programs); Sec. 72(t)(2)(E) (distributions from individual retirement plans for higher education expenses); and Sec. 529A (qualified ABLE programs). Provisions that assist in paying for current expenses include the following: Sec. 222 (qualified tuition and related expenses); Sec. 162 (trade or business expenses) (Regs. Sec. 1.162-5); Sec. 117(a) (qualified scholarships); and Sec. 117(d) (qualified tuition reduction). A provision that may provide tax savings upon discharge of a student loan is Sec. 108(f) (student loans).
4It should be noted that the interest rate on Series EE U.S. savings bonds issued from Nov. 1, 2017, through April 30, 2018, is only 0.10% (Treasury Direct, "May 2005 and Later (EE Bond Rates and Terms)," available at www.treasurydirect.gov.
5Series EE bonds issued after 1989 and Series I bonds (Sec. 135(c)(1)).
6IRS Publication 970, Tax Benefits for Education, p. 57 (2017).
7Sec. 135(b)(2). "Modified adjusted gross income" is defined at Sec. 135(c)(4).
8Rev. Proc. 2017-58.
9Qualifying expenses may include elementary and secondary school expenses in addition to higher education expenses (Sec. 530(b)(2)).
10While helpful, this may not be sufficient, since the average posted charges for one year of tuition, fees, room, and board at a four-year private college during 2017 to 2018 was $46,950 (College Board, Trends in College Pricing 2017, Table 1, p. 9 (October 2017)).
11Sec. 530(b)(2). See Sec. 529(e)(3)(B) and Sec. 25A(b)(3)(B).
13Although not discussed here, Sec. 529 also provided for the establishment of prepaid tuition plans.
14Hurley, The Best Way to Save for College, p. 44 (Saving for College LLC 2015).
15For distributions made after Dec. 31, 2017, the definition of qualified higher education expense has been expanded to include up to $10,000 per student per year for tuition in connection with enrollment or attendance at an elementary or secondary school (Sec. 529(e)(3)(A); Sec. 529(c)(7)).
16Sec. 25A(d)(3); for purpose of this provision and the lifetime learning credit, "modified adjusted gross income" means the adjusted gross income of the taxpayer for the tax year increased by any amount excluded under Sec. 911, 931, or 933.
17Rev. Proc. 2017-58.
19IRS Publication 970, Tax Benefits for Education, p. 33 (2017).
21Rev. Proc. 2017-58.
22As reported by his tax adviser, Leo Mattersdorf, in a letter to Time magazine, Feb. 22, 1963.
23Urban-Brookings Tax Policy Center, Tax Units With Zero or Negative Income Tax Under Current Law, 2011-2026, T16-0121 (July 11, 2016).
24The American opportunity tax credit is 40% refundable; however, to claim the benefit, an individual must file a U.S. tax return.
25ABA Section of Taxation, 2001 Top Simplification Recommendations, p. 6 (February 2001).
27National Taxpayer Advocate, 2016 Annual Report to Congress, p. 322 (Jan. 11, 2017).
Peter D. Lucido is the department chair, and Kenneth A. Winkelman and James M. Fornaro are professors in the Accounting, Taxation & Business Law Department of SUNY College at Old Westbury, in Old Westbury, N.Y. For more information about this column, contact firstname.lastname@example.org.