Federal Tax Benefits for Higher Education
Blog Post
Sept. 1, 2014
A Background Primer
The federal government provides financial assistance for higher education in four broad categories – grants, work study, loans, and tax benefits. For the majority of the last fifty years and ever since the federal government first began providing financial assistance for higher education in the 1950s, the dominant forms of aid have been grants, work study assistance, and loans.
Since the mid-1990s, however, federal income tax benefits have increasingly become a part of the student financial aid landscape. Over the last decade, federal expenditures (foregone tax revenue) in the form of higher education tax benefits have increased 203 percent. In 2012-2013, federal education tax benefits made up eight percent of total student aid (federal, state, institutional, private) for postsecondary education. Looking only at federal student aid in 2012-2013, of the $169.7 billion in federal financial assistance, education tax credits constituted $20.2 billion (12%).
Student Aid for Higher Education in 2012 Dollars (numbers in millions) | ||||
2002-2003 | 2007-2008 | 2012-2013 | 10 Year % Change | |
Pell Grants | $14,809 | $16,142 | $32,269 | 118% |
Other Federal Grants | $5,284 | $7,189 | $14,737 | 178% |
Federal Loans | $54,670 | $75,638 | $101,469 | 86% |
Federal Work Study | $1,279 | $1,071 | $978 | -24% |
Federal Tax Benefits | $6,690 | $7,340 | $20,280 | 203% |
State Grants | $7,638 | $8,797 | $9,748 | 32% |
Institutional Grants | $22,470 | $30,930 | $44,390 | 98% |
Private and Employer Grants | $8,940 | $12,670 | $14,580 | 63% |
Data from Trends in Student Aid 2013 |
Although tax benefits are the most popular type of federal financial aid in terms of number of recipients, the average aid received by recipient is the lowest of all types of federal aid. Outside of veterans who received the most aid on average under the Post-9/11 GI Bill, students on average receive almost five times as much aid in Direct Unsubsidized Loans and almost three times as much in Pell Grants than they do through federal education tax benefits.
Types of Federal Higher Education Benefits
Generally speaking, the Internal Revenue Code (IRC) provides four categories of tax benefits – credits, deductions, exemptions, and exclusions. These benefits may either reduce an individual’s tax liability (i.e., the amount of taxes an individual owes) or reduce the amount of an individual’s income that is subject to taxation.
- Tax Credit: Tax credits reduce the amount of tax a tax filer owes on a dollar-for-dollar basis. A tax credit may be either nonrefundable or refundable. A nonrefundable credit can only reduce a tax filer’s tax bill to $0 and cannot produce a tax refund where one did not already exist. A refundable tax credit, on the other hand, can exceed taxes owed and can result in a tax refund.
- Tax Deduction: Tax deductions reduce the amount of a tax filer’s income that is subject to taxation. The eligible tax deduction amount is the amount of reduction to a taxpayer’s taxable income. Thus, if an individual is eligible for a $2,000 tax deduction and his or her taxable income is $50,000 prior to taking the deduction, the individual’s taxable income after taking the deduction would be $48,000.
- Tax Exemption: Tax exemptions work in the same way as do tax deductions in reducing a taxpayer’s taxable income. The most common tax exemptions are the personal and dependent exemptions. Tax filers may claim a personal exemption for themselves and any dependents they support. The personal exemption for tax year 2014 is $3,950.
- Tax Exclusion: The Internal Revenue Code contains a number of provisions that explicitly exclude certain types of income or amounts of income from taxation.Over the years, Congress has enacted a number of tax benefits specifically to assist individuals and families in paying for college. These higher education tax benefits come in all types – credits, deductions, exemptions, and exclusions – and may broadly be divided into four categories: tax benefits for tuition and related expenses, employment-related higher education tax benefits, tax benefits for student loans, and tax benefits for education savings.
Many of these higher education tax benefits have been part of the Internal Revenue Code for many decades and some date back to the 1950s. Yet, prior to enactment of the Taxpayer Relief Act of 1997 (P.L. 105-34), tax benefits for higher education remained a relatively small part of the federal financial aid picture. In the years before the Taxpayer Relief Act of 1997, Congress enacted the following tax benefits for higher education –
- Personal Exemption for Dependents Ages 19-23
- Qualified Scholarship Exclusion
- Gift Tax Exclusion for Education
- Employer-Provided Educational Assistance
- Employer-Provided Qualified Tuition Reduction
- Business Deduction for Education-Related Expenses
- Student Loan Interest Deduction
- Exclusion of Qualifying Cancelled Student Loans
- 529 Plans
- Exclusion of Interest on Education Savings BondsWhen President Clinton announced his Administration’s proposal for providing middle class families with tax credits to pay for college in 1996, the idea of using the Internal Revenue Code as a piece of the student financial aid puzzle firmly took hold. As the cost of tuition has soared over the last two decades, many middle class families began to feel themselves being priced out of higher education. As these families did not qualify for traditional need-based federal financial assistance such as Pell Grants and subsidized federal student loans, various tax credits and deductions for providing federal financial assistance were created through the tax code.
Signed into law in 1997, the Taxpayer Relief Act of 1997 (P.L. 105-34) created four additional higher education tax benefits and reinstated the student loan interest deduction which had been eliminated from the tax code as part of the Tax Reform Act of 1986 (P.L. 99-514). The new tax benefits created by the 1997 Taxpayer Relief Act were:
- Hope Scholarship Credit
- Lifetime Learning Credit
- Student Loan Interest Deduction
- Coverdell Education Savings Accounts
- Cancellations of the Penalty for Early Withdrawals from Individual Retirement Accounts (IRAs) In 2001, as part of the Economic Growth and Tax Relief Act of 2001 (P.L. 107-16), Congress added two new tax benefits – the tuition and fees deduction and tax-free distributions from 529 college savings plans. Then, as part of the American Recovery and Reinvestment Act of 2009 (P.L. 111-5), Congress temporarily replaced the Hope Scholarship Credit with the more generous American Opportunity Tax Credit. In 2012, lawmakers extended that change through tax year 2017 under the American Taxpayer Relief Act. Most of these tax benefits have provisions that disallow tax filers from using the same qualified educational expense for claiming more than one tax benefit. Because many tax filers may meet the qualifications for more than one tax benefit, tax filers must examine each benefit separately to determine which offers the greatest financial benefit. Current Considerations and Issues Since enactment of the Taxpayer Relief Act of 1997 (P.L. 107-16), and the introduction of higher education tax credits, the popularity of using the Internal Revenue Code as a means of offering students and families, especially middle class families, financial aid to pay for college has grown. While popular, however, a number of reports have indicated that the sheer number of benefits and complex eligibility rules often make it difficult for families to understand the tax benefits for which they may be eligible and to choose the tax benefit that is most financially beneficial to them. A 2012 report issued by the Government Accountability Office (GAO) found that in tax year 2009 almost 14 percent of filers failed to claim a higher education credit or deduction for which they were eligible.[1] That same GAO report lays out a number of possible reasons for families either failing to claim a benefit for which they are eligible or for making a suboptimal choice (i.e., choosing a less financially beneficial benefit) in their choice of education tax benefits. These include tax filers being unaware of or misunderstanding their eligibility, being confused by the sheer number of provisions, similarity in provisions making it difficult to determine which one may be best, and differences in key definitions such as the multiple definitions for qualified education expenses. Additional considerations with the education tax benefits relate to the cost and the target audience. Growth in the uptake of these tax credits and deductions was relatively flat for the first part of the decade; however, their popularity and uptake have more than doubled in the past five years. This uptick was caused almost exclusively by the introduction of the more generous American Opportunity Tax Credit in 2008. In 2011, 14.1 million tax filers benefited from an education tax credit and 1.2 million tax filers benefited from an education tax deduction for a total of $20.3 billion in tax savings.
At a time of budget constraints, some have questioned whether spending on tax benefits might better be directed towards traditional financial aid programs – Pell, loans, work study, etc., especially those traditional programs that are more targeted to lower-income families and students. In 2011, 51 percent of higher education tax credits went to families with adjusted gross incomes above $50,000, and 89 percent of the tuition and fees deduction went to families with an adjusted gross income above $50,000. Additionally, for both the credits and the deduction, the average tax savings per recipient is greater for both middle and upper-income families.
A final set of considerations related to higher education tax benefits concerns their effectiveness in meeting public policy goals. A recent GAO report in response to Congressional inquiries on the effectiveness of both Title IV and federal higher education tax benefits found that research into the effects of this wide array of programs on college attendance, choice, cost, persistence, and completion is scant and questions of effectiveness remain largely unstudied.[2] As Congress takes up comprehensive tax reform and the reauthorization of the Higher Education Act for consideration, questions related to the purposes, target populations, and effectiveness of all forms of federal financial assistance for higher education – education tax benefits and traditional Title IV aid – may be in order.
Following is more detailed information on each of the federal higher education tax benefits.
Details of Federal Higher Education Tax Benefits
American Opportunity Tax Credit and Hope Scholarship Credit (IRC Sec. 25A) Both the American Opportunity Tax Credit (AOTC) and the Hope Scholarship Credit are exclusively for undergraduate education. The AOTC has temporarily replaced the Hope Credit, and barring further Congressional action, the AOTC is set to expire at the end of tax year 2017. After such time, the Hope Credit is scheduled to come back into effect.
As mentioned earlier, the AOTC is a more generous version of the original Hope Scholarship Credit. In addition to the AOTC providing a higher maximum benefit than Hope, the AOTC covers four years of college as opposed to two, has higher income phaseout limits, and has a broader definition of qualified education expenses. The AOTC is also a partially refundable credit. Thus, under Hope which is non-refundable, if a tax filer has $0 tax liability, the tax filer receives no financial benefit through Hope. Under AOTC which is partially refundable, however, a tax filer with $0 tax liability may still receive a financial benefit of up to $1,000.
Details of the features of the American Opportunity Tax Credit as it currently exists and of the features of the Hope Scholarship Credit in its last operational tax year 2008 follow.
American Opportunity Tax Credit | Hope Scholarship Credit | |
Type of Tax Benefit | Partially-refundable tax credit for qualified education expenses. 40% of the credit is refundable up to $1,000. | Non-refundable tax credit for qualified education expenses. |
Amount of Benefit | Maximum $2,500 credit per eligible student. The amount of the credit is the sum of 100% of the first $2,000 of qualified education expenses, and 25% of the next $2,000 of qualified education expenses. | Maximum $1,800 credit per eligible student. The amount of the credit is the sum of 100% of the first $1,200 of qualified education expenses, and 50% of the next $1,200 of qualified education expenses. |
Qualifying Income Limits | $90,000 modified adjusted gross income if single with a phaseout of maximum benefit for those with incomes between $80,000 and $90,000. $180,000 modified adjusted gross income if married filing jointly with a phaseout of maximum benefit for couples with incomes between $160,000 and $180,000. | $58,000 modified adjusted gross income if single with a phaseout of maximum benefit for those with incomes between $48,000 and $58,000. $116,000 modified adjusted gross income if married filing jointly with a phaseout of maximum benefit for couples with incomes between $96,000 and $116,000. |
Qualified Education Expenses | Tuition, fees required for enrollment or attendance at an eligible educational institution, and course-related expenses for books supplies, and equipment. Qualified education expenses do not include room and board, medical expenses, insurance, transportation, or similar personal, living, or family expenses. | Tuition and fees required for enrollment or attendance at an eligible educational institution. Qualified education expenses do not include room and board, medical expenses, insurance, transportation, or similar personal, living, or family expenses. |
Qualifying Education Level | First 4 years of undergraduate education. | First 2 years of undergraduate education. |
Eligible Student | Student enrolled at least half-time in a program leading to a degree, credential, or other recognized educational credential at an eligible education institution who is either the tax filer, tax filer’s spouse, or dependent for whom tax filer claims an exemption. To be eligible, a student must also not have been convicted of a felony for possessing or distributing a controlled substance. | Student enrolled at least half-time in a program leading to a degree, credential, or other recognized educational credential at an eligible education institution who is either the tax filer, tax filer’s spouse, or dependent for whom tax filer claims an exemption. To be eligible, a student must also not have been convicted of a felony for possessing or distributing a controlled substance. |
Number of Years of Availability | Available only for the 4 tax years per eligible student, including any years the Hope credit was claimed. | Available only for the first 2 years of undergraduate education. |
Eligible Educational Institution | Any educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. | Any educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. |
Lifetime Learning Credit | |
Type of Tax Benefit | Non-refundable tax credit for qualified education expenses. |
Amount of Benefit | Maximum $2,000 credit per tax return. The amount of the credit is 20% of the first $10,000 of qualified education expenses. |
Qualifying Income Limits | $62,000 modified adjusted gross income if single with a phase-out of maximum benefit for those with incomes between $52,000 and $62,000. $124,000 modified adjusted gross income if married filing jointly with a phase-out of maximum benefit for couples with incomes between $104,000 and $124,000. |
Qualified Education Expenses | Tuition and fees required for enrollment or attendance at an eligible educational institution. Student-activity fees and expenses for books, supplies, and equipment qualify only if a student must pay such fees and expenses to the institution as a condition of enrollment or attendance. Qualified education expenses do not include room and board, medical expenses, insurance, transportation, or similar personal, living, or family expenses. |
Qualifying Education Level | Undergraduate and Graduate. |
Eligible Student | Student enrolled in one or more courses at an eligible education institution who is either the tax filer, tax filer’s spouse, or dependent for whom tax filer claims an exemption. |
Number of Years of Availability | Available for an unlimited number of tax years. |
Eligible Educational Institution | Any educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. |
In addition to being a deduction rather than a credit, the next most distinguishing factor for the deduction over the Hope and Lifetime credits (but not the America Opportunity Tax Credit) is its higher income limits. While Hope phased out at $58,000 (single) / $116,000 (joint) and Lifetime phases out at $60,000 (single) / $120,000 (joint), the income limits for the Tuition and Fees Deduction were $80,000 for single filers and $160,000 for joint filers. However, the America Opportunity Tax Credits now has the higher income limits of the tax benefits for tuition.
In recent years, the number of tax filers claiming the Tuition and Fees Deduction has dropped off considerably falling from 2.9 million in 2008 to 1.2 million in 2011. This is due in large part to creation of the American Opportunity Tax Credit which is partially refundable and which has even higher income limit phase outs -- $90,000 (single) / $180,000 (joint) than the Tuition and Fees Deduction.
Tuition and Fees Deduction | |
Type of Tax Benefit | Tax deduction of qualified education expenses. |
Amount of Benefit | Maximum annual benefit of $4,000. |
Qualifying Income Limits | If single, head of household:
|
Qualified Education Expenses | Tuition and fees required for enrollment or attendance at an eligible educational institution. Student-activity fees and expenses for books, supplies, and equipment qualify only if a student must pay such fees and expenses to the institution as a condition of enrollment or attendance. Qualified education expenses do not include room and board, medical expenses, insurance, transportation, or similar personal, living, or family expenses. |
Qualifying Education Level | Undergraduate and Graduate. |
Number of Years of Availability | Available for an unlimited number of tax years. |
Eligible Student | Student enrolled in one or more courses at an eligible education institution who is either the tax filer, tax filer’s spouse, or dependent for whom tax filer claims an exemption. |
Eligible Educational Institution | Any educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. |
Personal Exemption for Dependents Ages 19-23 (IRC Sec. 151 & 152) While typically a parent cannot claim a child over the age of 18 as a dependent for federal income tax purposes, if a child is ages 19-23 and is enrolled full time for at least five months of the year at a school with a regular teaching staff, course of study, and a regularly enrolled student body, a parent may claim a personal exemption for the child. For tax year 2013, a parent may receive a tax benefit of $3,900 for each qualifying dependent. For tax year 2010-2012, there were no income limits for claiming a personal exemption. However, for tax year 2013 and beyond, a personal exemption phaseout (PEP) applies. The phaseout levels for single tax filers is $250,000 - $372,500 and for married tax filers filing jointly the phaseout levels are $300,000 - $422,500.
Gift Tax Exclusions for Higher Education Expenses (IRC Sec. 2503(b) and 2503(e)) Under current federal tax law, two gift tax exclusions exist that may be used to cover higher education expenses. First, under IRC Sec. 2503(b), a donor may give any individual up to $14,000 a year (tax year 2013 limit) without incurring the federal gift tax. Second, in addition to the general annual gift tax exclusion, a donor may make a direct payment for tuition (no limit) to an institution of higher education on behalf of an individual without incurring the federal gift tax (IRC Sec. 2503(e)). This second gift tax exclusion is for tuition only and does not include payments for books, supplies, or room and board. There are no income restrictions on these gift tax exclusions.
Student Loan Interest Deduction (IRC Sec. 221)
The ability to take a federal deduction for interest paid on student loan debt is one of the oldest federal higher education tax benefits and one that has been allowed and disallowed at various points in time. Prior to 1986, student loan interest like other types of personal debt (e.g., mortgage, credit card, auto) was deductible under the federal tax code. The 1986 comprehensive tax reform law (P.L. 99-514) disallowed deductions for all forms of personal debt interest, including student loan interest, with the exception of mortgage interest.
The ability to deduct student loan interest remained out of the tax code for the next ten years until passage of the Taxpayer Relief Act of 1997 (P.L. 105-34). With the passage of the Taxpayer Relief Act of 1997, the deduction was restored; however, students were only able to take the deduction for the first five years of repayment. This five-year rule was later temporarily lifted by the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16) and then permanently lifted by the American Taxpayer Relief Act of 2012 (P.L. 112-240). Today, if student borrowers meet the other eligibility requirements, they may take the deduction for as many years as they pay interest on their student loans. In tax year 2011, 8.2 million tax filers deducted $8 billion in student loan interest.
Student Loan Interest Deduction | |
Type of Tax Benefit | Tax deduction of interest paid on a qualifying student loan. |
Amount of Benefit | Maximum annual benefit of $2,500. |
Qualifying Income Limits | $75,000 modified adjusted gross income if single with a phase-out of maximum benefit for those with incomes between $60,000 and $75,000. $155,000 modified adjusted gross income if married filing jointly with a phase-out of maximum benefit for couples with incomes between $125,000 and $155,000. |
Qualified Student Loan | A loan (federal or private) taken out solely to pay qualified education expenses. A taxpayer cannot deduct interest on a loan received from a related person (e.g., spouse, sibling, parents, grandparents, lineal descendants) and certain employer plans. |
Qualified Education Expenses | Total costs of attending an eligible educational institution including tuition and fees; room and board; books, supplies, and equipment; other necessary expenses (e.g., transportation). |
Qualifying Education Level | Undergraduate and Graduate. |
Eligible Student | Student who enrolled at least half-time in a program leading to a degree, certificate, or other recognized educational credential. |
Eligible Educational Institution | Any educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. |
Student Loan Cancellations | |
Type of Tax Benefit | Exclusion of student loan cancellations from gross income. |
Qualifying Income Limits | None. |
Qualifying Student Loan | For the cancellation of a student loan to qualify for tax-free treatment, the loan must have been made by a qualified lender to assist a student in attending an eligible educational institution and contain a provision allowing all or part of the student loan debt be cancelled if the student work:
|
Qualifying Education Level | Undergraduate and Graduate. |
Eligible Educational Institution | An eligible educational institution is one that maintains a regular faculty and curriculum and one that normally has a regularly enrolled student body. |
Qualified Lender | Qualified lenders include the following:
The United States, or an instrumentality of. An eligible educational institution, if the loan is made as part of an agreement with an entity described above under which the funds to make the loan were provided to the educational institution; or under a program of the educational institution designed to encourage students to serve in occupations with unmet needs (e.g., medicine, nursing, teaching, law) or in areas with unmet needs. |
The National Health Service Corps Loan Repayment Program.
Over the years, Congress has also added education-related provisions to the tax code to assist employers in attracting and retaining talented employees and to assist employees in continuing their education and obtaining new knowledge and skills. Three of these employment-related provisions are the Employer-Provided Educational Assistance provision, the Employer-Provided Qualified Tuition Plan, and the Business Deduction for Education-Related Expenses.
Employer-Provided Educational Assistance (IRC Sec. 127) Under section 127 of the Internal Revenue Code, up to $5,250 received in employer-provided educational assistance may be excluded from an employee’s gross income. This educational benefit may be used at either the undergraduate or graduate level and may be used for payments for tuition, fees, books, supplies, and equipment. Unlike the business deduction for education-related expenses discussed later, with few exceptions education courses covered by section 127 may be either job-related or non-job-related.
This exclusion for employer-provided educational assistance has its origins in the Revenue Act of 1978 (P.L. 95-600). Congress extended this educational benefit many times over the last thirty years and most recently made the benefit permanent in 2013 as part of the American Taxpayer Relief Act of 2012 (P.L. 112-240).
Employer-Provided Educational Assistance | |
Type of Tax Benefit | Exclusion of employer-provided educational assistance from taxable income. |
Amount of Benefit | Maximum of $5,250 exclusion. |
Qualifying Income Limits | None. |
Qualified Education Expenses | Tuition, fees and similar expenses, books, supplies, and equipment. Education expenses do not include meals, lodging, or transportation; tools or supplies (other than textbooks) that students can keep after completing the course of instruction; courses involving sports, games, or hobbies unless they have a reasonable relationship to the employer’s business or are required as part of a degree program. |
Qualifying Education Level | Undergraduate and Graduate. |
Number of Years of Availability | Available for an unlimited number of tax years. |
Eligible Employer-Provided Educational Assistance Program | To qualify, the employer must have a written plan for its educational assistance program that provides the assistance exclusively to employees (i.e., not to employee spouses or dependents) and the plan must not favor highly compensated employees. |
Employer-Provided Qualified Tuition Reduction (IRC Sec. 117) To attract and retain college faculty and other college employees, a number of institutions of higher education provide their employees and their employees’ spouses and dependents with a benefit to study tuition free or at a reduced rate of tuition. Additionally, to attract high-quality graduate students, institutions will often waive or reduce tuition if a graduate student teaches or conducts research for the institution. Section 117 of the IRC provides for tax-free treatment of such qualified tuition reductions. As indicated below, different rules apply at the graduate level and at education below the graduate level.
Employer-Provided Qualified Tuition Reduction | |
Type of Tax Benefit | Exclusion of employer-provided qualified tuition reduction from gross income. |
Amount of Benefit | Unlimited. |
Qualifying Income Limits | None. |
Qualifying Education Level | Undergraduate and Graduate. |
Number of Years of Availability | Available for an unlimited number of tax years. |
Eligible Educational Institution | To qualify, tuition reduction must be received by and used at an eligible educational institution which is one that maintains a regular faculty and curriculum and one that normally has a regularly enrolled student body. |
Eligible Recipient | To qualify for tax-free treatment the tax filer’s relationship to the eligible educational institution must meet the criteria below:
Criteria for Education Below the Graduate Level (primary, elementary, secondary, undergraduate):
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Business Deduction for Work-Related Education | |
Type of Tax Benefit | Tax deduction of work-related education expenses. |
Qualifying Income Limits | None. |
Qualifying Work-Related Education | To deduct the costs of qualifying work-related education as business expenses, the education must meet one of two tests:
The education is required by tax filer’s employer or the law in order to keep present salary, status, or job. |
Deductible Expenses | Deductible education expenses include tuition, books, supplies, lab fees, and similar items; certain transportation and travel costs; other education expenses. |
Qualifying Education Level | Undergraduate and Graduate. |
As the cost of college continued to escalate in the 1980s and 1990s, Congress turned to the tax code to create tax-preferred benefits for college savings. Over the years, Congress authorized two additional tax benefits for education savings – a tax exclusion for interest earned on education savings accounts (529 Plans) and the waiving of the penalty on early withdrawals from Individual Retirement Accounts used to pay for qualified education expenses.
529 Plans (IRC Sec. 529) 529 plans named after the section of Internal Revenue Code that stipulates their tax treatment were created by the states as state-sponsored investment vehicles to encourage families to save for college. The specific federal tax benefit of 529 plans to families is that the distributions are tax-free if used to pay for qualified higher education expenses.
The first such plan was created by the state of Michigan in 1986. Initial confusion regarding the tax treatment of these plans led Congress to enact legislation to clarify their tax treatment. Congress first recognized 529 plans in the Small Business Job Protection Act of 1996 (P.L. 104-188) and made subsequent changes to them in 1997 under the Taxpayer Relief Act (P.L. 105-34). It should be noted that with respect to federal income taxes, these plans allowed for tax-free growth of investments, but distributions were fully taxable. In 2001, as part of a broader set of tax reforms, Congress made distributions tax-free and that rule was made permanent in 2006.
Two types of 529 plans exist – prepaid tuition plans and college savings plans. While prepaid tuition and college savings plans have distinct differences, the federal tax treatment and benefit of these two types of plans are identical – under both types of 529s distributions and withdrawals are tax-free if the funds are used to pay for qualified higher education expenses.
Under a prepaid 529 plan, a contributor (e.g., parent, grandparent, family friend) purchases a percentage of future tuition costs at current prices. The initial idea of the prepaid tuition plans was to provide families with a hedge against tuition inflation. Although prepaid tuition plans were the first type of 529 plan, the number of such plans has dropped considerably as skyrocketing tuition costs have ballooned future obligations. As such, 529 college savings plans are now the most popular of the two types. There are currently 19 prepaid 529 plans and 90 529 college savings plans across the nation. Under a 529 college savings plan, contributors invest in a portfolio of mutual funds, stocks, bonds, and other investments with the final value of the 529 account determined by the performance of the plan’s investments. Many states offer a variety of 529 college savings plans some of which provide more aggressive investment opportunities as the beneficiary is younger and more conservative investments as the beneficiary approaches the age of enrolling in college.
Over the last decade the total assets in state-sponsored 529 plans has grown considerably, growing from $58 billion in 2003 to $205 billion in 2013.
Additionally, in 2013, there were approximately 11.4 million 529 accounts with an average account value of $17,997. While the number of accounts and their assets have grown over time, still a very small number of American households have an account. According to the Federal Reserve’s Survey of Consumer Finance, less than three percent of families save for college in a 529 or Coverdell account (discussed below). Further, those families with college savings plans are generally wealthier, having about three times the median income as families without a college savings account.
529 Qualified Tuition Programs | |
Type of Tax Benefit | Earnings on savings not taxed. |
Annual and Lifetime Contribution Limits | No annual contribution limits. All plan sponsors must, however establish an overall lifetime limit on contributions to an account to an amount “necessary to provide for the qualified higher education expenses of the beneficiary.” |
Qualifying Income Limits | None. |
Qualified Education Expenses | Tuition and fees required for enrollment and attendance; course-related books, supplies, and equipment; room and board for students enrolled at least half-time; expenses for special needs services. |
Qualifying Education Level | Undergraduate and Graduate. |
Eligible Educational Institution | Any educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. |
Coverdell Savings Accounts were first created as part of the Taxpayer Relief Act of 1997 (P.L. 105-34) and were initially called Education IRAs. Most recently, the $2,000 annual contribution limit was made permanent as part of the American Taxpayer Relief Act of 2012 (P.L. 112-240). Barring such a change, the annual limit would have dropped to $500 in 2013.
Coverdell Education Savings Accounts | |
Type of Tax Benefit | Earnings on savings not taxed. |
Annual Contribution Limits | $2,000 annual contribution from all contributors per beneficiary. |
Qualifying Income Limits for Contributors | $110,000 modified adjusted gross income if single with a phase-out of maximum benefit for those with incomes between $95,000 and $110,000. $220,000 modified adjusted gross income if married filing jointly with a phase-out of maximum benefit for couples with incomes between $190,000 and $220,000. |
Qualified Beneficiary | Contributions may be made to any beneficiary ages 18 or younger. Contributions may be made to beneficiaries older than age 18 who are special needs. |
Qualified Education Expenses | Qualified Elementary and Secondary Expenses related to enrollment at an eligible elementary or secondary school:
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Qualifying Education Level | K-12, undergraduate, and graduate. |
Eligible Educational Institution | Eligible elementary or secondary school is any public, private, or religious school that provides elementary or secondary education as determined under state law. Eligible postsecondary institution is any educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. |
Early Withdrawals from Individual Retirement Accounts (IRC Sec. 72(t)) Under normal circumstances, if an individual takes a distribution from an IRA—Traditional or Roth--before the age of 59 ½, the individual must pay a 10 percent penalty for the early distribution in additional to any regular income tax that is due. However, if the distribution is used to pay for qualified higher education expenses for the taxpayer, spouse, or dependents at any educational institution eligible to participate in a student aid program administered by the U.S. Department of Education, the 10 percent penalty is waived. Qualified education expenses are tuition, fees, books, supplies, and equipment required for attendance. If the student is enrolled on at least a half-time basis, room and board may be considered a qualified education expense. [1] U.S. Government Accountability Office (2012). Improved Tax Information Could Help Families Pay for College (GAO-12-560).[2] U.S. Government Accountability Office (2012). Improved Tax Information Could Help Families Pay for College (GAO-12-560).[3] National Association of Independent Colleges and Universities & Society for Human Resource Management (2010). Who Benefits from Section 127: A Study of Employee Education Assistance Provided under Section 127 of the Internal Revenue Code.