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More than 12 tax provisions benefit individuals and families to help offset the high cost of higher education in the United States. These provisions are often overlapping in their coverage, but each has its own set of rules and requirements.
The provisions include incentives to save for education by allowing earnings from investments in savings bonds, college savings plans, and Coverdell savings accounts to escape income tax when funds are used for qualified education expenses.
The American opportunity credit and lifetime learning credit are available for taxpayers who pay qualifying education expenses. A portion of the American opportunity credit is refundable, but the entire lifetime learning credit is nonrefundable.
The deduction for student loan interest is an above-the-line deduction for student loan interest paid in a tax year. Up to $2,500 of interest can be deducted per year, but the deduction is phased out for taxpayers with modified adjusted gross income over certain threshold amounts.
The current education tax incentives have come under criticism for their complexity and their perceived lack of value for the taxpayers who are in the most need of assistance with their expenses for education.
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
A Coverdell account may be established to save for the qualified education expenses of a named beneficiary. Many banks, brokerage firms, and mutual fund companies offer these accounts.
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-favoredway 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 INCENTIVES FOR HIGHER EDUCATION