OVERVIEW OF PRESENT LAW AND ECONOMIC ANALYSIS

RELATING TO TAX AND SAVINGS

INCENTIVES FOR EDUCATION

Scheduled for a Public Hearing

Before the

SENATE COMMITTEE ON FINANCE

on February 14, 2001

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

February 12, 2001

JCX-1-01
i

CONTENTS

Page

INTRODUCTION................................................................................................................ 1

I. OVERVIEW OF PRESENT-LAW TAX INCENTIVES FOR

EDUCATION............................................................................................................... 2

A. General Tax Treatment of Education Expenses.................................................... 2

B. Exclusion for Employer-Provided Educational Assistance .................................. 2

C. Qualified Scholarships......................................................................................... 3

D. HOPE and Lifetime Learning Credits................................................................... 3

1. HOPE Credit .................................................................................................. 3

2. Lifetime Learning credit ................................................................................. 5

E. Provisions Relating to Student Loans ................................................................... 7

1. Deduction for student loan interest ................................................................. 7

2. Exclusion of income from student loan forgiveness........................................ 7

F. Qualified State Tuition Programs ......................................................................... 8

G. Exclusion of Interest Earned on Education Savings Bonds................................... 9

H. Education IRAs..................................................................................................... 10

1. In general........................................................................................................ 10

2. Coordination with HOPE and Lifetime Learning credits................................ 11

I. Individual Retirement Arrangements ("IRAs")..................................................... 11

1. In general........................................................................................................ 11

2. Traditional IRAs............................................................................................. 12

3. Roth IRAs....................................................................................................... 13

J. Tax Benefits for Certain Types of Bonds for Educational Facilities and

Activities.............................................................................................................. 13

1. Tax-exempt bonds........................................................................................... 13

2. Qualified zone academy bonds....................................................................... 16
Page

ii

II. BACKGROUND DATA ON COLLEGE ENROLLMENT AND COSTS.............. 24

III. ECONOMIC ANALYSIS............................................................................................ 27

A. The Economics of Subsidizing Education................................................................ 27

B. Treatment of Education Expenses Under an Income Tax ......................................... 29
1

INTRODUCTION

The Senate Committee on Finance has scheduled a public hearing on February 14, 2001, 

on issues relating to tax proposals to make education more affordable, including proposals 

relating to student loan payments, employer-provided educational assistance, education IRAs, 

teachers' expenses, and school construction financing. This document,1 prepared by the staff of 

the Joint Committee on Taxation, describes present law and economic analysis relating to tax 

incentives for education.

Part I of this pamphlet is an overview of present-law tax incentives for education. Part II 

provides background information with respect to college enrollment and costs. Part III provides 

economic analysis of issues relating to tax incentives for education.

 

1

 This document may be cited as follows: Joint Committee on Taxation, Overview of 

Present Law and Economic Analysis Relating to Tax and Savings Incentives for Education (JCX1-01), February 12, 2001.
2

I. OVERVIEW OF PRESENT-LAW TAX INCENTIVES FOR EDUCATION

A. General Tax Treatment of Education Expenses

Individual taxpayers generally may not deduct their education and training expenses. 

However, a deduction for education expenses generally is allowed under Internal Revenue Code 

(“the Code”) section 162 if the education or training (1) maintains or improves a skill required in 

a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of 

the taxpayer's employer, or requirements of applicable law or regulations, imposed as a condition 

of continued employment (Treas. Reg. sec. 1.162-5). Education expenses are not deductible if 

they relate to certain minimum educational requirements or to education or training that enables 

a taxpayer to begin working in a new trade or business. In the case of an employee, education 

expenses (if not reimbursed by the employer) may be claimed as an itemized deduction only if 

such expenses meet the above described criteria for deductibility under section 162 and only to 

the extent that the expenses, along with other miscellaneous deductions, exceed 2 percent of the 

taxpayer's adjusted gross income (“AGI”). A taxpayer's total itemized deductions, including 

miscellaneous deductions in excess of 2 percent of AGI, may be further limited by the overall 

limit on itemized deductions (the so-call "Pease provision").

B. Exclusion for Employer-Provided Educational Assistance

A special rule allows an employee to exclude from gross income for income tax purposes 

and from wages for employment tax purposes up to $5,250 annually paid by his or her employer 

for educational assistance (secs. 127 and 3121(a)(18)). This exclusion does not apply to 

graduate-level courses.2 In order for the exclusion to apply, certain requirements must be 

satisfied. The educational assistance must be provided pursuant to a separate written plan of the 

employer. The employer’s educational assistance program must not discriminate in favor of 

highly compensated employees. In addition, no more than 5-percent of the amounts paid or 

incurred by the employer during the year for educational assistance under a qualified educational 

assistance program can be provided for the class of individuals consisting of more than 5-percent 

owners of the employer and the spouses or dependents of such more than 5-percent owners. This 

special exclusion for employer-provided educational assistance expires with respect to courses 

beginning after December 31, 2001.3

For purposes of the exclusion, educational assistance means the payment by an employer 

of expenses incurred by or on behalf of the employee for education of the employee including, 

but not limited to, tuition, fees, and similar payments, books, supplies, and equipment. 

 

2

 The exclusion was made inapplicable to graduate-level courses by the Technical and 

Miscellaneous Revenue Act of 1988. The exclusion was reinstated with respect to graduate-level 

courses by the Omnibus Budget Reconciliation Act of 1990, effective for taxable years 

beginning after December 31, 1990. The exclusion was again made inapplicable to graduatelevel courses by the Small Business Job Protection Act of 1997, effective for courses beginning 

after June 30, 1996.

3

 The section 127 exclusion was originally enacted on a temporary basis by the Revenue 

Act of 1978 (through 1983). Since then, it has been extended 9 times, each time on a temporary 

basis.
3

Educational assistance also includes the provision by the employer of courses of instruction for 

the employee (including books, supplies, and equipment). Educational assistance does not 

include (1) tools or supplies that may be retained by the employee after completion of a course, 

(2) meals, lodging, or transportation, and (3) any education involving sports, games, or hobbies.

In the absence of the exclusion under section 127, employer-provided educational 

assistance is excludable from gross income and wages as a working condition fringe benefit (sec. 

132(d)) only if the education expenses would have been deductible by the employee (if paid by 

the employee) under section 162. In determining the amount deductible for this purpose, the 2-

percent floor on miscellaneous itemized deductions is disregarded.

C. Qualified Scholarships

Present law provides an exclusion from gross income for amounts received as a qualified 

scholarship by an individual who is a candidate for a degree and used for tuition and fees 

required for the enrollment or attendance (or for fees, books, supplies, and equipment required 

for courses of instruction) at a primary, secondary, or post-secondary educational institution (sec. 

117). This tax-free treatment does not extend to scholarship amounts covering regular living 

expenses, such as room and board. In addition to the exclusion for qualified scholarships, 

present law provides an exclusion from gross income for qualified tuition reductions for certain 

education provided to employees of certain educational organizations (and their spouses and 

dependents) (sec. 117(d)).

The exclusion for qualified scholarships and qualified tuition reductions does not apply to 

any amount received by a student that represents payment for teaching, research, or other 

services by the student required as a condition for receiving the scholarship or tuition reduction.

D. HOPE and Lifetime Learning Credits

1. HOPE credit

Individual taxpayers are allowed to claim a nonrefundable credit, the “HOPE” credit, 

against Federal income taxes of up to $1,500 per student per year for qualified tuition and related 

expenses paid for the first two years of the student's post secondary education in a degree or 

certificate program. The HOPE credit rate is 100 percent on the first $1,000 of qualified tuition 

and related expenses, and 50 percent on the next $1,000 of qualified tuition and related 

expenses.4

The qualified tuition and related expenses must be incurred on behalf of the taxpayer, the 

taxpayer's spouse, or a dependent of the taxpayer. The HOPE credit is available with respect to 

an individual student for two taxable years, provided that the student has not completed the first 

 

4

 Thus, an eligible student who incurs $1,000 of qualified tuition and related expenses is 

eligible (subject to the AGI phaseout) for a $1,000 HOPE credit. If an eligible student incurs 

$2,000 of qualified tuition and related expenses, then he or she is eligible for a $1,500 HOPE 

credit.
4

two years of post-secondary education before the beginning of the second taxable year.5 The 

HOPE credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with 

modified AGI between $40,000 and $50,000 ($80,000 and $100,000 for married taxpayers filing 

a joint return). For taxable years beginning after 2001, the $1,500 maximum HOPE credit 

amount and the AGI phase-out ranges are indexed for inflation. 

The HOPE credit is available in the taxable year the expenses are paid, subject to the 

requirement that the education is furnished to the student during that year or during the first three 

months of the next year. Qualified tuition and related expenses paid with the proceeds of a loan 

generally are eligible for the HOPE credit. The repayment of a loan itself is not a qualified 

tuition or related expense.

A taxpayer may claim the HOPE credit with respect to an eligible student who is not the 

taxpayer or the taxpayer's spouse (e.g., in cases in which the student is the taxpayer's child) only 

if the taxpayer claims the student as a dependent for the taxable year for which the credit is 

claimed. If a student is claimed as a dependent, the student is not entitled to claim a HOPE credit 

for that taxable year on the student's own tax return. If a parent (or other taxpayer) claims a 

student as a dependent, any qualified tuition and related expenses paid by the student are treated 

as paid by the parent (or other taxpayer) for purposes of determining the amount of qualified 

tuition and related expenses paid by such parent (or other taxpayer) under the provision. In 

addition, for each taxable year, a taxpayer may elect either the HOPE credit or the “Lifetime 

Learning” credit (described below) with respect to an eligible student.6

The HOPE credit is available for “qualified tuition and related expenses,” which include 

tuition and fees required to be paid to an eligible educational institution as a condition of 

enrollment or attendance of an eligible student at the institution. Charges and fees associated 

with meals, lodging, insurance, transportation, and similar personal, living, or family expenses 

are not eligible for the credit. The expenses of education involving sports, games, or hobbies are 

not qualified tuition and related expenses unless this education is part of the student's degree 

program.

Qualified tuition and related expenses generally include only out-of-pocket expenses. 

Qualified tuition and related expenses do not include expenses covered by employer-provided 

educational assistance and scholarships that are not required to be included in the gross income 

of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and related 

expenses are reduced by any scholarship or fellowship grants excludable from gross income

under section 117 and any other tax-free educational benefits received by the student (or the 

taxpayer claiming the credit) during the taxable year. The HOPE credit is not allowed with 

respect to any education expense for which a deduction is claimed under section 162 or any other 

section of the Code.

 

5

 The HOPE credit generally may not be claimed against a taxpayer’s alternative 

minimum tax liability. However, the credit may be claimed against a taxpayer's alternative 

minimum tax liability for taxable years beginning in 2000 or 2001.

6

 The coordination between the HOPE credit, Lifetime Learning Credit, and education 

IRA provisions is discussed at I.H.2. below.
5

An eligible student for purposes of the HOPE credit is an individual who is enrolled in a 

degree, certificate, or other program (including a program of study abroad approved for credit by 

the institution at which such student is enrolled) leading to a recognized educational credential at 

an eligible educational institution. The student must pursue a course of study on at least a halftime basis. A student is considered to pursue a course of study on at least a half-time basis if the 

student carries at least one half the normal full-time work load for the course of study the student 

is pursuing for at least one academic period that begins during the taxable year. To be eligible 

for the HOPE credit, a student must not have been convicted of a Federal or State felony 

consisting of the possession or distribution of a controlled substance.

Eligible educational institutions generally are accredited post-secondary educational 

institutions offering credit toward a bachelor's degree, an associate's degree, or another 

recognized post-secondary credential. Certain proprietary institutions and post-secondary 

vocational institutions also are eligible educational institutions. In order to qualify as an eligible 

educational institution, an institution must be eligible to participate in Department of Education 

student aid programs.

2. Lifetime Learning credit

Individual taxpayers are allowed to claim a nonrefundable credit, the Lifetime Learning 

credit, against Federal income taxes equal to 20 percent of qualified tuition and related expenses 

incurred during the taxable year on behalf of the taxpayer, the taxpayer's spouse, or any 

dependents. For expenses paid prior to January 1, 2003, up to $5,000 of qualified tuition and 

related expenses per taxpayer return are eligible for the Lifetime Learning credit (i.e., the 

maximum credit per taxpayer return is $1,000). For expenses paid after December 31, 2002, up 

to $10,000 of qualified tuition and related expenses per taxpayer return will be eligible for the 

Lifetime Learning credit (i.e., the maximum credit per taxpayer return will be $2,000).7

In contrast to the HOPE credit, a taxpayer may claim the Lifetime Learning credit for an 

unlimited number of taxable years. Also in contrast to the HOPE credit, the maximum amount of 

the Lifetime Learning credit that may be claimed on a taxpayer's return will not vary based on 

the number of students in the taxpayer's family -- that is, the HOPE credit is computed on a per 

student basis, while the Lifetime Learning credit is computed on a family-wide basis. The 

Lifetime Learning credit amount that a taxpayer may otherwise claim is phased out ratably for 

taxpayers with modified AGI between $40,000 and $50,000 ($80,000 and $100,000 for married 

taxpayers filing a joint return).

The Lifetime Learning credit is available in the taxable year the expenses are paid, 

subject to the requirement that the education is furnished to the student during that year or during 

the first three months of the next year. Qualified tuition and related expenses paid with the 

proceeds of a loan generally are eligible for the Lifetime Learning credit. As with the HOPE 

credit, repayment of a loan is not a qualified tuition expense.

 

7

 The Lifetime learning credit generally may not be claimed against a taxpayer's 

alternative minimum tax liability. However, the credit may be claimed against such liability for 

taxable years beginning in 2000 or 2001.
6

As with the HOPE credit, a taxpayer may claim the Lifetime Learning credit with respect 

to a student who is not the taxpayer or the taxpayer's spouse (e.g., in cases in which the student is 

the taxpayer's child) only if the taxpayer claims the student as a dependent for the taxable year 

for which the credit is claimed. If a student is claimed as a dependent by the parent or other 

taxpayer, the student may not claim the Lifetime Learning credit for that taxable year on the 

student's own tax return. If a parent (or other taxpayer) claims a student as a dependent, any 

qualified tuition and related expenses paid by the student are treated as paid by the parent (or 

other taxpayer) for purposes of the provision.

A taxpayer may claim the Lifetime Learning credit for a taxable year with respect to one 

or more students, even though the taxpayer also claims a HOPE credit for that same taxable year 

with respect to other students. If, for a taxable year, a taxpayer claims a HOPE credit with 

respect to a student, then the Lifetime Learning credit is not available with respect to that same 

student for that year (although the Lifetime Learning credit may be available with respect to that 

same student for other taxable years).8

The Lifetime Learning credit is available for “qualified tuition and related expenses,”

which include tuition and fees required to be paid to an eligible educational institution as a 

condition of enrollment or attendance of a student at the institution. Charges and fees associated 

with meals, lodging, insurance, transportation, and similar personal, living or family expenses 

are not eligible for the credit. The expenses of education involving sports, games, or hobbies are 

not qualified tuition expenses unless this education is part of the student's degree program.

In contrast to the HOPE credit, qualified tuition and related expenses for purposes of the 

Lifetime Learning credit include tuition and fees incurred with respect to undergraduate or 

graduate-level (and professional degree) courses.9

As with the HOPE credit, qualified tuition and fees generally include only out-of-pocket 

expenses. Qualified tuition and fees do not include expenses covered by employer-provided 

educational assistance and scholarships that is not required to be included in the gross income of 

either the student or the taxpayer claiming the credit. Thus, total qualified tuition and fees are 

reduced by any scholarship or fellowship grants excludable from gross income under section 117 

and any other tax-free educational benefits received by the student during the taxable year (such 

as employer-provided educational assistance excludable under section 127). The Lifetime 

Learning credit is not allowed with respect to any education expense for which a deduction is 

claimed under section 162 or any other section of the Code.

In addition to allowing a credit for the tuition and related expenses of a student who 

attends classes on at least a half-time basis as part of a degree or certificate program, the Lifetime 

Learning credit also is available with respect to any course of instruction at an eligible 

educational institution (whether enrolled in by the student on a full-time, half-time, or less than 

 

8

 The coordination between the HOPE credit, Lifetime Learning Credit, and education 

IRA provisions is discussed at I.H.2. below.

9

 The HOPE credit is available only with respect to the first two years of a student’s 

undergraduate education.
7

half-time basis) to acquire or improve job skills of the student.10 Undergraduate and graduate 

students are eligible for the Lifetime Learning credit. Moreover, in contrast to the HOPE credit, 

the eligibility of a student for the Lifetime Learning credit does not depend on whether or not the 

student has been convicted of a Federal or State felony consisting of the possession or 

distribution of a controlled substance.

E. Provisions Relating to Student Loans

1. Deduction for student loan interest

Certain individuals who have paid interest on qualified education loans may claim an 

above-the-line deduction for such interest expenses, subject to a maximum annual deduction 

limit (sec. 221). The deduction is allowed only with respect to interest paid on a qualified 

education loan during the first 60 months in which interest payments are required. Required 

payments of interest generally do not include voluntary payments, such as interest payments 

made during a period of loan forbearance. Months during which interest payments are not 

required because the qualified education loan is in deferral or forbearance do not count against 

the 60-month period. No deduction is allowed to an individual if that individual is claimed as a 

dependent on another taxpayer's return for the taxable year.

A qualified education loan generally is defined as any indebtedness incurred solely to pay 

for the costs of attendance (including room and board) of the taxpayer, the taxpayer's spouse, or 

any dependent of the taxpayer as of the time the indebtedness was incurred in attending on at 

least a half-time basis (1) post-secondary educational institutions and certain vocational schools 

defined by reference to section 481 of the Higher Education Act of 1965, or (2) institutions 

conducting internship or residency programs leading to a degree or certificate from an institution 

of higher education, a hospital, or a health care facility conducting postgraduate training.

The maximum allowable deduction per year is $2,500. The deduction is phased out 

ratably for single taxpayers with AGI of $40,000-$55,000 and $60,000-$75,000 for married 

taxpayers filing a joint return. The income phaseout ranges will be indexed for inflation after 

2002.

2. Exclusion of income from married taxpayers filing student loan forgiveness

Gross income generally includes the discharge of indebtedness of the taxpayer. Under an 

exception to this general rule, gross income does not include any amount from the forgiveness 

(in whole or in part) of certain student loans, provided that the forgiveness is contingent on the 

student's working for a certain period of time in certain professions for any of a broad class of 

employers (sec. 108(f)).

Student loans eligible for this special rule must be made to an individual to assist the 

individual in attending an educational institution that normally maintains a regular faculty and 

curriculum and normally has a regularly enrolled body of students in attendance at the place 

where its education activities are regularly carried on. Loan proceeds may be used not only for 

 

10 Eligible higher education institutions are defined in the same manner for purposes of 

both the HOPE and Lifetime Learning credits.
8

tuition and required fees, but also to cover room and board expenses. The loan must be made by 

(1) the United States (or an instrumentality or agency thereof), (2) a State (or any political 

subdivision thereof), (3) certain tax-exempt public benefit corporations that control a State, 

county, or municipal hospital and whose employees have been deemed to be public employees 

under State law, or (4) an educational organization that originally received the funds from which 

the loan was made from the United States, a State, or a tax-exempt public benefit corporation. 

In addition, an individual's gross income does not include amounts from the forgiveness 

of loans made by educational organizations (and certain tax-exempt organizations in the case of 

refinancing loans) out of private, nongovernmental funds if the proceeds of such loans are used 

to pay costs of attendance at an educational institution or to refinance any outstanding student 

loans (not just loans made by educational organizations) and the student is not employed by the 

lender organization. In the case of such loans made or refinanced by educational organizations 

(or refinancing loans made by certain tax-exempt organizations), cancellation of the student loan 

must be contingent upon the student working in an occupation or area with unmet needs and such 

work must be performed for or under the direction of a tax-exempt charitable organization or a 

governmental entity.

F. Qualified State Tuition Programs

Present law provides tax-exempt status to "qualified State tuition programs," meaning 

certain programs established and maintained by a State (or agency or instrumentality thereof) 

under which persons may (1) purchase tuition credits or certificates on behalf of a designated 

beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education 

expenses of the beneficiary, or (2) make contributions to an account that is established for the 

purpose of meeting qualified higher education expenses of the designated beneficiary of the 

account (sec. 529). The term "qualified higher education expenses" has the same meaning as 

does the term for purposes of education IRAs (as described above) and, thus, includes expenses 

for tuition, fees, books, supplies, and equipment required for the enrollment or attendance at an 

eligible educational institution,11 as well as certain room and board expenses (i.e., the minimum 

room and board allowance applicable to the student as determined by the institution in 

calculating costs of attendance for Federal financial aid programs under sec. 472 of the Higher 

Education Act of 1965) for any period during which the student is at least a half-time student. 

Present law also provides that no amount shall be included in the gross income of a 

contributor to, or beneficiary of, a qualified State tuition program with respect to any distribution 

from, or earnings under, such program, except that (1) amounts distributed or educational 

benefits provided to a beneficiary (e.g., when the beneficiary attends college) will be included in 

the beneficiary's gross income (unless excludable under another Code section) to the extent such 

amounts or the value of the educational benefits exceed contributions made on behalf of the 

beneficiary, and (2) amounts distributed to a contributor or another distributee (e.g., when a 

parent receives a refund) will be included in the contributor's/distributee’s gross income to the 

extent such amounts exceed contributions made on behalf of the beneficiary.

 

11 “Eligible educational institutions” are defined the same for purposes of education 

IRAs (described in I.H., below) and qualified State tuition programs.
9

A qualified State tuition program is required to provide that purchases or contributions 

only be made in cash. Contributors and beneficiaries are not allowed to direct the investment of 

contributions to the program (or earnings thereon). The program is required to maintain a 

separate accounting for each designated beneficiary. A specified individual must be designated 

as the beneficiary at the commencement of participation in a qualified State tuition program (i.e., 

when contributions are first made to purchase an interest in such a program), unless interests in 

such a program are purchased by a State or local government or a tax-exempt charity described 

in section 501(c)(3) as part of a scholarship program operated by such government or charity 

under which beneficiaries to be named in the future will receive such interests as scholarships. A 

transfer of credits (or other amounts) from one account benefitting one designated beneficiary to 

another account benefitting a different beneficiary will be considered a distribution (as will a 

change in the designated beneficiary of an interest in a qualified State tuition program), unless 

the beneficiaries are members of the same family. Earnings on an account may be refunded to a 

contributor or beneficiary, but the State or instrumentality must impose a more than de minimis 

monetary penalty unless the refund is (1) used for qualified higher education expenses of the 

beneficiary, (2) made on account of the death or disability of the beneficiary, or (3) made on 

account of a scholarship received by the designated beneficiary to the extent the amount 

refunded does not exceed the amount of the scholarship used for qualified higher education 

expenses.

No amount is includible in the gross income of a contributor to, or beneficiary of, a 

qualified State tuition program with respect to any contribution to or earnings on such a program 

until a distribution is made from the program, at which time the earnings portion of the 

distribution (whether made in cash or in-kind) is includible in the gross income of the distributee. 

However, to the extent that a distribution from a qualified State tuition program is used to pay for 

qualified tuition and related expenses (as defined in sec. 25A(f))(1)), the distributee (or another 

taxpayer claiming the distributee as a dependent) will be able to claim the HOPE credit or 

Lifetime Learning credit under section 25A with respect to such tuition and related expenses 

(assuming that the other requirements for claiming the HOPE credit or Lifetime Learning credit 

are satisfied and the modified AGI phaseout for those credits does not apply).

G. Exclusion of Interest Earned on Education Savings Bonds

Interest earned on a qualified U.S. Series EE savings bond issued after 1989 is excludable 

from gross income if the proceeds of the bond upon redemption do not exceed qualified higher 

education expenses paid by the taxpayer during the taxable year (sec. 135).12 "Qualified higher 

education expenses" include tuition and fees (but not room and board expenses) required for the 

enrollment or attendance of the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer at 

certain eligible higher educational institutions (defined in the manner as for the HOPE and 

Lifetime Learning credits). The amount of qualified higher education expenses taken into 

account for purposes of the exclusion provided by section 135 is reduced by the amount of such 

expenses taken into account in determining the HOPE or Lifetime Learning credits claimed by 

 

12 If the aggregate redemption amount (i.e., principal plus interest) of all Series EE bonds 

redeemed by the taxpayer during the taxable year exceeds the qualified education expenses 

incurred, then the excludable portion of interest income is based on the ratio that the education 

expenses bears to the aggregate redemption amount (sec. 135(b)).
10

any taxpayer, or an exclusion from gross income for a distribution from an education IRA, with 

respect to a particular student for the taxable year. 

The exclusion provided by section 135 is phased out for certain higher-income taxpayers, 

determined by the taxpayer's modified AGI during the year the bond is redeemed. For 2001, the 

exclusion is phased out for single taxpayers with modified AGI between $55,750 and $70,750 

($83,650 and $113,650 for married taxpayers filing a joint return). To prevent taxpayers from 

effectively avoiding the income phaseout limitation through issuance of bonds directly in the 

child's name, present law provides that the interest exclusion is available only with respect to 

U.S. Series EE savings bonds issued to taxpayers who are at least 24 years old.

H. Education IRAs

1. In general

Taxpayers may establish certain trusts or custodial accounts created exclusively for the 

purpose of paying qualified higher education expenses of a named beneficiary (“education 

IRAs”) (sec. 530). Annual contributions to education IRAs may not exceed $500 per designated 

beneficiary and may not be made after the designated beneficiary reaches age 18. The 

contribution limit is phased out for taxpayers with modified AGI between $95,000 and $110,000 

($150,000 and $160,000 for married taxpayers filing a joint return); the AGI of the contributor 

not the beneficiary controls whether a contribution is permitted by the taxpayer. No contribution 

may be made to an education IRA during any year in which any contributions are made by 

anyone to a qualified State tuition program on behalf of the same beneficiary.

Earnings on contributions to an education IRA generally are subject to tax when 

withdrawn.13 However, distributions from an education IRA are excludable from the gross 

income of the distributee (i.e., the student) to the extent that the distribution does not exceed the 

qualified higher education expenses incurred by the beneficiary during the year the distribution is 

made (provided that a HOPE credit or Lifetime Learning credit is not claimed with respect to the 

beneficiary for the same taxable year). The earnings portion of an education IRA distribution not 

used to pay qualified higher education expenses is includible in the gross income of the 

distributee and generally is subject to an additional 10-percent tax.14

Tax-free (and penalty-free) transfers or rollovers of account balances from one education 

IRA benefitting one beneficiary to another education IRA benefitting another beneficiary (as 

well as redesignations of the named beneficiary) are permitted, provided that the new beneficiary 

is a member of the family of the old beneficiary.

The term “qualified higher education expenses” includes tuition, fees, books, supplies, 

and equipment required for the enrollment or attendance of the designated beneficiary at an 

 

13 In addition, education IRAs are subject to the unrelated business income tax (“UBIT”) 

imposed by section 511.

14 This 10-percent additional tax does not apply if a distribution from an education IRA 

is made on account of the death or disability of the designated beneficiary, or if made on account 

of a scholarship received by the designated beneficiary.
11

eligible education institution, regardless of whether the beneficiary is enrolled at an eligible 

educational institution on a full-time, half-time, or less than half-time basis. Moreover, qualified 

higher education expenses include certain room and board expenses for any period during which 

the beneficiary is at least a half-time student. Qualified higher education expenses include 

expenses with respect to undergraduate or graduate-level courses. In addition, section 

530(b)(2)(B) specifically provides that qualified higher education expenses include amounts paid 

or incurred to purchase tuition credits (or to make contributions to an account) under a qualified 

State tuition program for the benefit of the beneficiary of the education IRA.

Qualified higher education expenses generally include only out-of-pocket expenses. 

Such qualified higher education expenses do not include expenses covered by employerprovided educational assistance or scholarships for the benefit of the beneficiary that are 

excludable from gross income. Thus, total qualified higher education expenses are reduced by 

scholarship or fellowship grants excludable from gross income under section 117, as well as any 

other tax-free educational benefits, such as employer-provided educational assistance, that are 

excludable from the employee’s gross income under section 127. 

2. Coordination with HOPE and Lifetime Learning credits

If an exclusion from gross income under section 530 is allowed for a particular student, 

then neither the HOPE credit nor the Lifetime Learning credit will be available in the same 

taxable year with respect to the same student. However, if a student elects to waive the 

exclusion from gross income under section 530, then either the student or a parent (if the student 

is claimed as a dependent by the parent) may claim the HOPE credit or the Lifetime Learning 

credit.

I. Individual Retirement Arrangements ("IRAs")

1. In general

In general, there are two types of IRAs under present law: traditional IRAs, to which 

both deductible and nondeductible contributions may be made, and Roth IRAs. The economic 

benefits of deductible IRA contributions and Roth IRAs are similar, 15 although the rules 

applicable to each type of IRA vary. IRAs may generally be used to save for any purpose. In 

general, withdrawals from an IRA before age 59-1/2 are subject to a 10 percent additional tax on 

early withdrawals. Certain exceptions apply to the early withdrawal tax. Thus, for example, 

withdrawals used to pay for educational expenses are not subject to the 10-percent early 

withdrawal tax.

 

15 For a detailed comparison of Roth IRAs and deductible IRAs, see Joint Committee on 

Taxation Description and Analysis of Tax Proposals Relating to Individual Savings and IRAs

(JCS-2-97), March 3, 1997.
12

2. Traditional IRAs

Deductible IRA contributions 

Under present law, an individual may make deductible contributions to an IRA up to the 

lesser of $2,000 or the individual’s compensation if the individual and the individual’s spouse 

are not active participants in an employer-sponsored retirement plan. In the case of a married 

couple, deductible IRA contributions of up to $2,000 can be made for each spouse (including, for 

example, a homemaker who does not work outside the home), if the combined compensation of 

both spouses is at least equal to the contributed amount. If the individual (or the individual’s 

spouse) is an active participant in an employer-sponsored retirement plan, the $2,000 deduction 

limit is phased out for taxpayers with AGI over certain levels for the taxable year.

The AGI phase-out limits for a single individual who is an active participant in an 

employer-sponsored retirement plan are as follows: for 2001, $33,000 to $43,000; for 2002, 

$34,000 to $44,000; for 2003, $40,000 to $50,000; for 2004, $45,000 to $55,000; and for 2005 

and thereafter, $50,000 to $60,000.

The AGI phase-out limits for a married individual filing a joint return who is an active 

participant in an employer-sponsored plan are as follows: for 2001, $53,000 to $63,000, for 

2002, $54,000 to $64,000; for 2003, $60,000 to $70,000; for 2004, $65,000 to $75,000; for 2005, 

$70,000 to $80,000; for 2006, $75,000 to $85,000; and for 2007 and thereafter, $80,000 to 

$90,000.

If the individual is not an active participant in an employer-sponsored retirement plan, but 

the individual’s spouse is, the $2,000 deduction limit is phased out for taxpayers with AGI 

between $150,000 and $160,000.

Amounts held in a deductible IRA are includible in income when withdrawn (except to 

the extent the withdrawal is a return of nondeductible contributions). Includible amounts 

withdrawn prior to attainment of age 59-1/2 are subject to an additional 10-percent early 

withdrawal tax, unless the withdrawal is due to death or disability, is made in the form of certain 

periodic payments, is used to pay medical expenses in excess of 7.5 percent of AGI, is used to 

purchase health insurance of an unemployed individual, is used for education expenses, or is 

used for first-time homebuyer expenses of up to $10,000. Education expenses that qualify for 

the exception to the early withdrawal tax are qualified higher education expenses (as defined 

under the rules relating to qualified State tuition programs) of the taxpayer, the taxpayer's 

spouse, or any child or grandchild of the taxpayer and his or her spouse, at an eligible 

educational institution. The amount of education expenses is reduced by certain scholarships and 

similar payments.

Nondeductible IRA contributions

To the extent an individual cannot or does not make deductible contributions to an IRA 

or contributions to a Roth IRA, the individual may make nondeductible contributions to an IRA. 

Distributions from an IRA attributable to nondeductible contributions are includible in income 

and subject to the 10-percent early withdrawal tax to the extent attributable to earnings.
13

3. Roth IRAs

Individuals with AGI below certain levels may make nondeductible contributions to a 

Roth IRA. The maximum annual contribution that may be made to a Roth IRA is the lesser of 

$2,000 or the individual’s compensation for the year. The contribution limit is reduced to the 

extent an individual makes contributions to any other IRA for the same taxable year. As under 

the rules relating to IRAs generally, a contribution of up to $2,000 for each spouse may be made 

to a Roth IRA provided the combined compensation of the spouses is at least equal to the 

contributed amount. The maximum annual contribution that can be made to a Roth IRA is 

phased out for single individuals with AGI between $95,000 and $110,000 and for married 

couples filing a joint return with AGI between $150,000 and $160,000.

Taxpayers with modified AGI of $100,000 or less generally may convert a traditional 

IRA to which deductible or nondeductible contributions have been made into an Roth IRA. The 

amount converted is includible in income as if a withdrawal had been made, except that the 10-

percent early withdrawal tax does not apply.16

Amounts held in a Roth IRA that are withdrawn as a qualified distribution are not 

includible in income, nor subject to the additional 10-percent tax on early withdrawals. A 

qualified distribution is a distribution that is made (1) after the 5-taxable year period beginning 

with the first taxable year for which the individual made a contribution to a Roth IRA, and (2) 

after attainment of age 59-1/2, on account of death or disability, or is made for first-time 

homebuyer expenses of up to $10,000.

Distributions from a Roth IRA that are not qualified distributions are includible in 

income to the extent attributable to earnings, and subject to the 10-percent early withdrawal tax 

(unless an exception applies). The same exceptions to the early withdrawal tax that apply to 

traditional IRAs apply to Roth IRAs. Thus, a withdrawal from a Roth IRA that is not a qualified 

distribution and that is used for educational expenses is includible in gross income to the extent

attributable to earnings, but is not subject to the 10-percent early withdrawal tax.

J. Tax Benefits for Certain Types of Bonds for Educational Facilities and Activities

1. Tax-exempt bonds

In general

Interest on debt17 incurred by States or local governments is excluded from income if the 

proceeds of the borrowing are used to carry out governmental functions of those entities or the 

debt is repaid with governmental funds (sec. 103).18 Like other activities carried out and paid 

for by State and local governments, the construction, renovation, and operation of public schools 

is an activity eligible for financing with the proceeds of tax-exempt bonds.

 

16 If the conversion occurred in 1998, the income inclusion may be spread ratably over 4 

years.

17 Hereinafter referred to as “State of local government bonds.”

18 Interest on this debt is included in calculating the “adjusted current earnings” 

preference of the corporate alternative minimum tax.
14

Interest on bonds that nominally are issued by States or local governments, but the 

proceeds of which are used (directly or indirectly) by a private person and payment of which is 

derived from funds of such a private person is taxable unless the purpose of the borrowing is 

approved specifically in the Code or in a non-Code provision of a revenue Act. These bonds are 

called “private activity bonds.” 19 The term "private person" includes the Federal Government 

and all other individuals and entities other than States or local governments. Present law 

provides two tests for determining whether a State or local government bond is in substance a 

private activity bond (sec. 141(b) and (c)).

Private business test.--Private business use and private payments result in State or local 

government bonds being private activity bonds if both parts of a two-part private business test 

are satisfied--

(1) More than 10 percent of the bond proceeds is to be used (directly or indirectly) by a 

private business (the "private business use test"); and

(2) More than 10 percent of the debt service on the bonds is secured by an interest in 

property to be used in a private business use or to be derived from payments in respect of such 

property (the "private payment test").20 

Private loan test.--The second standard for determining whether a State or local 

government bond is a private activity bond is whether an amount exceeding the lesser of (1) 5 

percent of the bond proceeds or (2) $5 million is used (directly or indirectly) to finance loans to 

private persons. Private loans include both business and other (e.g., personal) uses and payments 

by private persons; however, in the case of business uses and payments, all private loans also 

constitute private business uses and payments subject to the private business test. Present law 

provides that the substance of a transaction governs in determining whether the transaction gives 

rise to a private loan. In general, any transaction which transfers tax ownership of property to a 

private person is treated as a loan.

Activities eligible for financing with tax-exempt private activity bonds

Present law includes several exceptions permitting States or local governments to act as 

conduits providing tax-exempt financing for certain private activities. In most cases, the 

aggregate volume of these private activity tax-exempt bonds is restricted by annual aggregate 

volume limits imposed on bonds issued by issuers within each State. These annual volume limits 

are equal to $62.50 per resident of the State, or $187.5 million if greater. The volume limits are 

 

19 Interest on private activity bonds (other than qualified 501(c)(3) bonds) is a preference 

item in calculating the alternative minimum tax. 

20 The 10-percent private business use and payment threshold is reduced to 5 percent for 

private business uses that are unrelated to a governmental purpose also being financed with 

proceeds of the bond issue. For example, a privately operated cafeteria in a government office 

building financed as part of the building’s construction could represent a related private business 

use. On the other hand, a separate, private manufacturing facility financed with proceeds of the 

same bond issue would constitute an unrelated private business use of bond proceeds.
15

scheduled to increase to the greater of $75 per resident of the State or $225 million in calendar 

year 2002. After 2002, the volume limits will be indexed annually for inflation.

Qualified 501(c)(3) bonds.--Both capital expenditures and limited working capital 

expenditures of charitable organizations described in section 501(c)(3) of the Code -- including 

elementary, secondary, and post-secondary schools -- may be financed with tax-exempt bonds 

("qualified 501(c)(3) bonds"). Bonds to finance activities of these organizations are not subject 

to the annual aggregate State volume limits. 

Qualified student loan bonds.--States and local governments may issue tax-exempt 

private activity bonds to finance certain student loans. Eligible student loans include Federally 

guaranteed loans under the Higher Education Act of 1965 (“GSL loans”) and other loans 

financed as part of a program of general application approved by the State (sec. 144(b)(1)). NonGSL student loans may be financed with tax-exempt bonds only if no loan under the program 

exceeds the difference between the total cost of attendance and other forms of student assistance 

for which the borrower may be eligible.

Other tax-exempt private activity bonds.--States or local governments may issue taxexempt exempt-facility bonds to finance property for certain private businesses. Business uses 

generally eligible for this financing include transportation (airports, ports, local mass commuting, 

and high speed intercity rail facilities); privately owned and/or privately operated public works 

facilities (sewage, solid waste disposal, local district heating or cooling, and hazardous waste 

disposal facilities); privately-owned and/or operated low-income rental housing; and certain 

private facilities for the local furnishing of electricity or gas. A further provision allows taxexempt financing for "environmental enhancements of hydro-electric generating facilities." Taxexempt financing is authorized for capital expenditures for certain manufacturing facilities and 

land and equipment for first-time farmers ("qualified small-issue bonds"), certain local 

redevelopment activities ("qualified redevelopment bonds"), and eligible empowerment zone and 

enterprise community businesses.

Finally, in addition to student loans discussed above, certain non-business private 

housing may be financed with proceeds of these bonds: (1) mortgage loans for first-time home 

buyers satisfying moderate income and home purchase price requirements, and (2) mortgage 

loans generally for certain pre-1977 veterans who purchase homes in any of the five States that 

historically have authorized issuance of these bonds.21

Private activity tax-exempt bonds may not be used to finance schools for private, forprofit businesses.

Arbitrage restrictions on tax-exempt bonds

The Federal income tax does not apply to the income of States and local governments 

that is derived from the exercise of an essential governmental function. To prevent these taxexempt entities from issuing more Federally subsidized tax-exempt bonds than is necessary for 

the activity being financed or from issuing such bonds earlier than necessary, the Code includes 

 

21 The five States are Alaska, California, Oregon, Texas, and Wisconsin.
16

arbitrage restrictions limiting the ability to profit from investment of tax-exempt bond proceeds. 

In general, arbitrage profits may be earned only during specified periods (e.g., defined 

“temporary periods” before funds are needed for the purpose of the borrowing) or on specified 

types of investments (e.g., “reasonably required reserve or replacement funds”). Subject to 

limited exceptions, profits that are earned during these periods or on such investments must be 

rebated to the Federal Government.

Present law includes three exceptions to the arbitrage rebate rules applicable to 

education-related bonds. First, issuers of all types of tax-exempt bonds are not required to rebate 

arbitrage profits if all of the proceeds of the bonds are spent for the purpose of the borrowing 

within six months after issuance.22 Second, in the case of bonds to finance certain construction 

activities, including school construction and renovation, the six-month period is extended to 24 

months. Arbitrage profits earned on construction proceeds are not required to be rebated if all 

such proceeds (other than certain retainage amounts) are spent by the end of the 24-month period 

and prescribed intermediate spending percentages are satisfied.23 Third, governmental bonds 

issued by “small” governments are not subject to the rebate requirement. Small governments are 

defined as general purpose governmental units that issue no more than $5 million of tax-exempt 

governmental bonds in a calendar year. The $5 million limit is increased to $10 million if at 

least $5 million of the bonds are used to finance public schools.24

2. Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, certain States and local governments 

are given the authority to issue “qualified zone academy bonds.” Under present law, a total of 

$400 million of qualified zone academy bonds may be issued in each of 1998 through 2001. The 

$400 million aggregate bond authority is allocated each year to the States according to their 

respective populations of individuals below the poverty line. Each State, in turn, allocates the 

credit to qualified zone academies within such State. A State may carry over any unused 

allocation for up to two years (three years for authority arising before 2000). 

Certain financial institutions (i.e., banks, insurance companies, and corporations actively 

engaged in the business of lending money) that hold qualified zone academy bonds are entitled 

to a nonrefundable tax credit in an amount equal to a credit rate (set daily by the Treasury 

 

22 In the case of governmental bonds (including bonds to finance public schools), the sixmonth expenditure exception is treated as satisfied if at least 95 percent of the proceeds is spent 

within six months and the remaining five percent is spent within 12 months after the bonds are 

issued.

23 Retainage amounts are limited to no more than 5 percent of the bond proceeds, and 

these amounts must be spent for the purpose of the borrowing no later than 36 months after the 

bonds are issued. Issuers qualifying for this “construction bond” exception may elect to be 

subject to a fixed penalty payment regime in lieu of rebate if they fail to satisfy the spending 

requirements.

24 The Small Business Job Protection Act of 1996 permitted issuance of the additional $5 

million in public school bonds by small governments. Previously, small governments were 

defined as general purpose governments that issued no more than $5 million of governmental 

bonds, without regard to the purpose of the financing.
17

Department) multiplied by the face amount of the bond (sec. 1397E). A taxpayer holding a 

qualified zone academy bond on the credit allowance date (i.e., each one-year anniversary of the 

issuance of the bond) is entitled to a credit. The credit amount is includible in gross income (as 

if it were a taxable interest payment on the bond), and the credit may be claimed against regular 

income tax and alternative minimum tax liability.

 The Treasury Department sets the credit rate at a rate estimated to allow issuance of 

qualified zone academy bonds without discount and without interest cost to the issuer. The 

maximum term of the bonds also is determined by the Treasury Department, so that the present 

value of the obligation to repay the bond is 50 percent of the face value of the bond. Present 

value is determined using as a discount rate the average annual interest rate of tax-exempt 

obligations with a term of 10 years or more issued during the month.

“Qualified zone academy bonds” are defined as bonds issued by a State or local 

government, provided that: (1) at least 95 percent of the proceeds is used for the purpose of 

renovating, providing equipment to, developing course materials for use at, or training teachers 

and other school personnel in a “qualified zone academy” and (2) private entities have promised 

to contribute to the qualified zone academy certain equipment, technical assistance or training, 

employee services, or other property or services with a value equal to at least 10 percent of the 

bond proceeds.

A school is a “qualified zone academy” if (1) the school is a public school that provides 

education and training below the college level, (2) the school operates a special academic 

program in cooperation with businesses to enhance the academic curriculum and increase 

graduation and employment rates, and (3) either (a) the school is located in a designated 

empowerment zones or a designated enterprise community, or (b) it is reasonably expected that 

at least 35 percent of the students at the school will be eligible for free or reduced-cost lunches 

under the school lunch program established under the National School Lunch Act.
18

Table 1.BComparison of Certain Education Tax Incentives

Available to Individuals Under Present Law

Provision Tax Benefit Dollar Limits on 

Amount Eligible 

for Tax Benefit

Eligible 

Contributors (for 

savings incentives)/ 

Eligible Claimants 

(for deductions, 

credits, and 

exclusions)

Eligible 

Beneficiaries

Qualified 

Education 

Expenses

Coordination 

with Other

Education 

Provisions

1. Education IRA 

(sec. 530)

Earnings are not 

subject to tax until 

distributed. 

Distributions are not 

subject to tax if the 

amount distributed 

does not exceed the 

qualified higher 

education expenses 

of the beneficiary 

during the year. 

Earnings portion of 

distributions in 

excess of qualified 

expenses is subject 

to an additional 10-

percent tax.

Annual 

contributions may 

not exceed $500 per 

designated 

beneficiary. No 

contributions 

permitted after 

beneficiary attains 

age 18.

Contribution limit 

phased out for 

contributors with 

modified AGI of 

$95,000 to $110,000 

($150,000 to 

$160,000 for joint 

returns).

Eligible distributee 

(i.e., student) can be 

enrolled on fulltime, half-time, or

less than half-time 

basis.

Includes tuition, 

fees, books, 

supplies, and 

equipment required 

for attendance at an 

eligible educational 

institution (defined 

in sec. 481 of the 

Higher Education 

Act of 1965). Also 

includes certain 

room and board 

expenses if student 

enrolled on at least a 

half-time basis. 

Does not include 

expenses covered by 

certain scholarships 

or other tax-free 

educational benefits. 

Includes amounts 

contributed to a 

No exclusion 

from income for a 

particular student 

if either the 

HOPE credit or 

LLC is claimed 

for the same year 

with respect to the 

same student. 

Beneficiary will 

incur a penalty 

excise tax if a 

contribution is 

made by any 

person to an 

education IRA if, 

in the same year, 

a contribution is 

made to a QSTP 

on behalf of the 

same beneficiary.
19

Provision Tax Benefit Dollar Limits on 

Amount Eligible 

for Tax Benefit

Eligible 

Contributors (for 

savings incentives)/ 

Eligible Claimants 

(for deductions, 

credits, and 

exclusions)

Eligible 

Beneficiaries

Qualified 

Education 

Expenses

Coordination 

with Other

Education 

Provisions

QSTP for the 

benefit of the 

beneficiary of the 

education IRA. 

2. Qualified State 

tuition program 

(AQSTP@) 

(sec. 529)

Earnings are not 

subject to tax until 

distributed. Earnings 

not used for 

qualified higher 

education expenses 

are subject to an 

additional penalty.

QSTP must have 

adequate safeguards 

to prevent 

contributions in 

excess of amount 

needed for the 

beneficiary=s higher 

education expenses.

No restrictions. No restrictions. Same as education 

IRA, although there 

is no restriction 

regarding expenses 

covered by tax-free 

educational 

assistance.

See education 

IRA discussion 

above. 

HOPE credit or 

LLC may be 

claimed in same 

year and with 

respect to same 

expenses for 

which a 

distribution from 

a QSTP is made. 

3. HOPE credit 

(sec. 25A)

Credit against tax 

for qualified tuition 

and related expenses 

for first two years of 

post-secondary 

education. 

Maximum credit is 

$1,500, computed 

on a per-student 

basis. Credit rate is 

100% on first 

$1,000 of qualified 

expenses and 50% 

on next $1,000 of 

expenses 

Credit amount is 

phased out for 

taxpayers with 

modified AGI 

between $40,000 

and $50,000 

($80,000 and 

$100,000 for joint 

returns). Credit may 

Eligible student 

must be enrolled on 

at least a half-time 

basis and must not 

have been convicted 

of Federal or State 

felony involving 

possession or 

distribution of a 

Same as education 

IRA, except does 

not include books, 

supplies, equipment, 

charges or fees 

associated with 

room and board, 

athletics (unless part 

of student=s degree 

HOPE credit not 

available with 

respect to a 

particular student 

if, the student 

elects an 

exclusion from 

income for a 

distribution from 
20

Provision Tax Benefit Dollar Limits on 

Amount Eligible 

for Tax Benefit

Eligible 

Contributors (for 

savings incentives)/ 

Eligible Claimants 

(for deductions, 

credits, and 

exclusions)

Eligible 

Beneficiaries

Qualified 

Education 

Expenses

Coordination 

with Other

Education 

Provisions

be claimed by 

student or by 

another taxpayer if 

the taxpayer claims 

the student as a 

dependent.

controlled 

substance.

program, and 

nonacademic fees 

(including 

insurance, 

transportation, and 

similar personal, 

living or family 

expenses). 

an education IRA 

in the same year. 

HOPE credit and 

Lifetime Learning 

credit can not be 

claimed with 

respect to the 

same student in 

the same year.

Also see QSTP 

discussion above. 

4. Lifetime 

Learning credit 

(ALLC@) 

(sec. 25A)

 Credit against tax 

for qualified tuition 

and related expenses 

for undergraduate or 

graduate (and 

professional) 

courses. Unlike 

HOPE credit, LLC 

is available for an 

unlimited number of 

years.

For expenses paid 

between July 1, 

1998 and December 

31, 2002, maximum 

credit is $1,000. For 

expenses paid after 

December 31, 2002, 

maximum credit is 

$2,000. Credit rate 

is 20% of up to 

$5,000 ($10,000 

beginning in 2003) 

of qualified 

expenses.

AGI phase-out 

ranges are same as 

HOPE credit. As 

with HOPE credit, 

LLC may be 

claimed by student 

or by another 

taxpayer if the 

taxpayer claims the 

student as a 

dependent.

No restrictions. Same as HOPE 

credit.

Same as HOPE 

credit. 
21

Provision Tax Benefit Dollar Limits on 

Amount Eligible 

for Tax Benefit

Eligible 

Contributors (for 

savings incentives)/ 

Eligible Claimants 

(for deductions, 

credits, and 

exclusions)

Eligible 

Beneficiaries

Qualified 

Education 

Expenses

Coordination 

with Other

Education 

Provisions

Unlike HOPE 

credit, LLC is 

computed on 

family-wide basis, 

rather than perstudent basis.

5. Student loan 

interest deduction 

(sec. 221)

Taxpayer may claim 

an above-the-line 

deduction for 

interest paid on 

qualified education 

loans, subject to an 

annual deduction 

limit. 

Deduction allowed 

with respect to 

interest paid on 

qualified education 

loans during the first 

60 months in which 

interest payments 

are required. 

Maximum 

deduction is $1,500 

in 1999, $2,000 in 

2000, and $2,500 in 

2001 and thereafter.

Deduction is phased 

out for taxpayers 

with modified AGI 

of $40,000 to 

$55,000 ($60,000 to 

$75,000 for joint 

returns).

No restrictions. Includes tuition, 

fees, room and 

board, and related 

expenses, reduced 

by (1) any interest 

on education 

savings bonds 

excluded from 

income, (2) any 

distribution from an 

education IRA 

excluded from 

income, and (3) any 

educational benefits 

(e.g., scholarships, 

employer-provided 

educational 

assistance) excluded 

from income. 

No restrictions.
22

Provision Tax Benefit Dollar Limits on 

Amount Eligible 

for Tax Benefit

Eligible 

Contributors (for 

savings incentives)/ 

Eligible Claimants 

(for deductions, 

credits, and 

exclusions)

Eligible 

Beneficiaries

Qualified 

Education 

Expenses

Coordination 

with Other

Education 

Provisions

6. Education 

savings bonds (sec. 

135)

Interest on certain 

savings bonds is not 

subject to tax if the 

proceeds of the 

bond upon 

redemption do not 

exceed qualified 

higher education 

expenses paid by the 

taxpayer during 

taxable year.

No limit on amount 

that may be 

excluded, but see 

income phase-out 

limitation.

For 2001, exclusion 

is phased out for 

taxpayers with 

modified AGI of 

$55,750 to $70,750 

($83,650 to 

$113,650 for joint 

returns). To prevent 

avoidance of the 

income phase-out 

limitation, bonds 

must be issued to 

taxpayer who is at 

least 24 years old.

No restrictions. Same as for HOPE 

credit and LLC, but 

without the 

restriction on 

nonacademic fees. 

For purposes of 

computing 

excludable 

amount, taxpayer 

cannot include 

expenses taken 

into account in 

determining the 

HOPE credit or 

LLC claimed by 

the taxpayer, or 

the excludable 

amount of an 

education IRA 

distribution.
24

II. BACKGROUND DATA ON COLLEGE ENROLLMENT AND COSTS

Since 1990, more than 14 million students have enrolled annually in post-secondary 

education or training programs, with approximately 78 percent enrolled in public institutions and 

22 percent in private institutions in 1997. The full-time equivalent enrollment has exceeded 10 

million in every year since 1991. Of all those enrolled in 1997, 62 percent were enrolled in fouryear institutions. From the average high school sophomore class in 1980, 66.4 percent had 

enrolled in some form of post-secondary education or training program by 1992. During this 

period, 7.9 percent had attained an associate's degree, 20 percent had attained a bachelor’s 

degree, 2.7 percent had attained a master's degree, and 1.1 percent had attained a doctorate or 

professional degree. 25

In every year since 1981, the costs of attending a two- or four-year college have risen 

faster than the rate of inflation; by contrast, in the late 1970s, college costs lagged behind 

inflation. Table 2 below details average tuition and fees by type of college in both current and 

constant (inflation adjusted) dollars since 1986. Since 1976, college tuition and fees generally 

have risen 70 percent more than the economy's overall price level. For the 1976-77 academic 

year, the total cost26 of attending a four-year private college averaged $3,977 (tuition and fees of 

$2,534) and the total cost of attending a four-year public college averaged $1,935 (tuition and 

fees of $617). For the 1986-87 academic year, the comparable total cost figure had risen to 

$10,039 (tuition of $6,658) for a four-year private college and to $4,138 (tuition of $1,414) for a 

four-year public college. By the 1999-2000 academic year, the comparable total cost figure had 

risen to $20,805 (tuition and fees of $14,690) for a four-year private college and to $8,265 

(tuition and fees of $3,351) for a four-year public college. For the 1999-2000 academic year, the 

average cost of tuition and fees at a two-year public college was $1,336.27

Over the past decade, governmental funding of higher education has declined as a share 

of total funding. Table 3 reports the revenues of all institutions of higher education by source. 

The table documents that, as a percentage of all revenues, Federal funds have remained relatively 

constant while State and local funding has declined. As a percentage of all revenues, tuition and 

fees have increased while other private funding has increased modestly. As Table 3 details, State 

and local contributions have not declined in dollar terms, though their total growth over the 

period 1986-87 to 1994-95 was only 7 percent more than would be accounted for by inflation, 

while full-time equivalent fall enrollment at public institutions increased 14.4 percent.

 

25 Department of Education. National Center for Education Statistics, Digest of 

Education Statistics 1997.

26 “Total cost” includes tuition and fees, and on-campus room and board costs.

27 Department of Education. National Center for Education Statistics, Digest of 

Education Statistics 1997.
25

Table 2.--Average Undergraduate Tuition and Fees, 1986-87 Through 1999-00

Current dollars Constant 1996 dollars

Year

Private

fouryear

Private

twoyear

Public

fouryear

Public

twoyear

Private

fouryear

Private

twoyear

Public

fouryear

Public

twoyear

1986-87

1987-88

1988-89

1989-90

1990-91

1991-92

1993-93

1993-94

1994-95

1995-96

1996-97

1997-98

1998-99

1999-00

6,658

7,116

7,722

8,396

9,083

9,759

10,294

10,952

11,481

12,243

12,881

13,344

13,911

14,690

3,684

4,161

4,817

5,196

5,570

5,754

6,059

6,370

6,914

7,094

7,236

7,464

7,852

8,107

1,414

1,537

1,646

1,780

1,888

2,117

2,349

2,537

2,681

2,848

2,987

3,110

3,229

3,351

660

706

730

756

824

936

1,025

1,125

1,192

1,239

1,276

1,314

1,323

1,336

9,940

10,225

10,618

10,984

11,339

11,760

12,043

12,468

12,726

13,189

13,522

13,744

14,063

14,456

5,499

5,979

6,625

6,798

6,954

6,934

7,089

7,251

7,664

7,643

7,596

7,688

7,938

7,978

2,110

2,209

2,264

2,328

2,357

2,551

2,748

2,888

2,971

3,068

3,136

3,203

3,264

3,298

986

1,014

1,004

989

1,029

1,228

1,199

1,280

1,322

1,335

1,340

1,353

1,337

1,315

Notes: Current dollar figures are adjusted to constant dollars by reference to the average CPI of 

the calendar years spanned by the academic year for which the tuition is reported.

Source: U.S. Department of Education, National Center for Education Statistics, Digest of 

Education Statistics 1997.
26

Table 3.--Current Funds and Revenues of All Institutions of Higher Education

by Source, Selected Years, 1986-1987 Through 1995-96

[Dollar amounts in millions]

Tuition and 

Fees

State and Local 

Sources

Federal

Sources

Other

Sources

Year Dollar Percent Dollar Percent Dollar Percent Dollar Percent Total

1986-87

1990-91

1995-96

25,706

37,434

55,260

23.6

25.0

27.9

34,109

43,412

51,301

31.3

29.0

25.9

14,239

18,236

23,939

13.0

12.2

12.1

35,091

50,684

67,473

32.2

33.8

34.1

109,145

149,766

197,973

Source: U.S. Department of Education, National Center for Education Statistics, Digest of 

Education Statistics 1997, 2000.
27

III. ECONOMIC ANALYSIS

A. The Economics of Subsidizing Education

Overview of the goals of subsidies

All levels of government make substantial direct expenditures to subsidize postsecondary education. In addition, private educational organizations channel gifts from private 

persons into subsidies for the education of other persons. By exempting such organizations from 

income tax and permitting the gifts to such organizations to be deductible, additional implicit 

subsidies under the Internal Revenue Code are created for education. Other subsidies for 

education provided by the Internal Revenue Code permit students to receive tax-free qualified 

scholarships, tax-free employer-provided educational assistance, tax-free cancellation of certain 

governmental student loans, and a deduction for student loan interest. Students and parents also 

are provided the benefits of the HOPE and Lifetime Learning credits, the deferral of tax on the 

earnings of contributions to qualified State tuition programs, and the exclusion from income of 

earnings on education IRAs and of the interest on U.S. savings bonds used to pay for postsecondary education.28 Analysts attempt to evaluate subsidies in terms of their efficiency, 

equity, and administrability. In this regard, subsidies to post-secondary education have been 

argued to improve both economic efficiency and to promote economic equity.

Efficiency as a goal of subsidies to education

Economists generally have a predilection for favoring the outcomes of the free market 

and have reasoned that taxes or subsidies in the market generally lead to inefficient outcomes. 

That is, taxes or subsidies distort choices and divert resources from their highest and best use. 

However, economists also recognize that sometimes markets do not work efficiently. Economists 

observe that the consumption or acquisition of certain goods may create spillover, or external, 

effects that benefit society at large as well as the individual consumer who purchases the good. 

An example of such a good is a vaccination. The individual who is vaccinated benefits by not 

contracting an infectious disease, but the rest of society benefits as well, because by not 

contracting the disease the vaccinated individual also slows the spread of the disease to those 

who are not vaccinated. Economists call such a spillover effect a "positive externality."29 On his 

or her own, the individual would weigh only his or her own reduced probability of contracting 

the disease against the cost of the vaccination. The individual would not account for the

additional benefit the vaccination produces for society. As a result, the individual might choose 

not to be vaccinated, even though from society's perspective, total reduction in the rate of 

infection throughout the population would be more than worth the cost of the vaccination. In this 

sense, the private market might produce too few of the vaccinations. The private market 

 

28 Certain income limits restrict some benefits. Part I, above, describes tax benefits 

under present law that subsidize education.

29 For a more complete discussion of the notion of "positive externality," see Harvey S. 

Rosen, Public Finance (Homewood, Illinois: Irwin), 1988, pp. 142-146. Rosen discusses the 

notion of positive externality as applied to education. Rosen notes (pp. 144-145), "That college 

increases productivity may be true, but as long as the earnings of college graduates reflect their 

higher productivity, there is no externality [Rosen's emphasis]."
28

outcome is inefficiently small. Economists have suggested that the existence of positive 

externalities provides a rationale for the government to subsidize the acquisition of the good that 

produces the positive externalities. The subsidy will increase the acquisition of the good to its 

more efficient level.

While much evidence suggests that job skill acquisition and education benefit the private 

individual in terms of higher market wages, many people have long believed that education also 

produces positive externalities. Commentators argue that society functions better with an 

educated populace and that markets function better with educated consumers. They observe that 

education promotes innovation and that, because ideas and innovations are easily copied in the 

market place, the market return (wage or profit) from ideas and innovations may not reflect the 

full value to society from the idea or innovation. Just as the single individual does not appreciate 

the full benefit of a vaccination, a single individual may not be able to reap the full benefit of an 

idea or innovation. Thus, it is argued, subsidies for education are needed to improve the 

efficiency of society.

On the other hand, recognizing that a subsidy might be justified does not identify the 

magnitude of the subsidy necessary to promote efficiency nor the best method for delivery of the 

subsidy. It is possible to create inefficient outcomes by over-subsidizing a good that produces 

positive externalities. Given that the United States already provides substantial subsidies to postsecondary education, it is not possible to say whether such subsidies would increase or decrease 

economic efficiency without some empirical analysis of the social benefits that would arise from 

creating new subsidies.

Some observers note that, aside from potential spillover effects that education might 

create, the market for financing education may be inefficient. They observe that, while investors 

in housing or other tangible assets have property that can be pledged to secure financing to 

procure the asset, an individual cannot generally pledge his or her future earnings as security for 

a loan to obtain education or training designed to increase the individual's future earning 

potential. This inability to provide security for education loans constrains borrowing as an 

alternative to finance education for some taxpayers. Taxpayers who cannot borrow to finance 

education or training may forgo the education or training even though it would produce a high 

return for the investor. This inefficiency in the market for education finance may offer a 

justification for public subsidies. The inefficiency in the market for financing is likely most acute 

among lower-income taxpayers who generally do not have other assets that could be pledged as 

security for an education loan. This suggests that this potential source of market inefficiency also 

relates to the considerations of equity as a rationale for subsidies of education (discussed below).

Equity as a goal of subsidies to education

As noted above, there is evidence indicating that education and training are rewarded in 

the market place. Recognizing this market outcome, some argue that it is appropriate to subsidize 

education to ensure that educational opportunities are widely available, including to those less 

well off in society. Commentators argue that education can play an important role in reducing 

poverty and income inequality. They observe that even if there were no positive externalities 

from education, promoting economic equity within a market economy provides a basis for 
29

subsidizing education.30 If equity is the goal of expanded subsidies to education, the cost of the 

subsidies should be weighed in terms of the private benefits received by the target groups, rather 

than the social benefits that might be generated by any possible spillovers.

B. Treatment of Education Expenses Under an Income Tax

Educational expenditures

Students and their families incur direct educational expenses when they pay tuition and 

fees. Federal, State, and local governments and private persons make expenditures on behalf of 

students by funding State and local and private educational institutions.31 Such expenditures by 

governments or private persons are equivalent to the government or private person transferring 

funds to the student which the student subsequently pays over to the educational institution. 

Lastly, students incur implicit expenditures for education by choosing schooling over the 

alternative of taking a job and earning a wage. The time spent in school means forgone income. 

Alternatively viewed, it is as if the student worked, was paid, and used the wages to purchase 

education. Analysts have concluded that the largest cost of obtaining an education come from 

forgone wages.32

Post-secondary education helps individuals develop general analytic and reasoning skills 

(e.g., problem solving) and often job specific skills (e.g., nursing training) that enhance the 

student's ability to earn a future income. In this way, expenditures on education are like an 

investment in a capital good: an outlay is made in the present for a machine that will produce 

income over a number of years in the future. It is because of this similarity that economists often 

refer to expenditures on education as investment in "human capital." However, some part of 

expenditures on post-secondary education are not as obviously investments in human capital but 

are more like consumption. For example, the chemical engineering student who takes an elective 

course in the history of music probably would not find her future earning potential increased by 

that particular elective. It is difficult to determine what portion of post-secondary education 

represents consumption for any given student and what portion represents investment in human 

capital.

The distinction between education as investment and education as consumption is not 

important to the efficiency/externality rationale for providing a subsidy to education, as 

externalities can arise from either consumption or investment. However, the distinction between 

education as investment and education as consumption is important to the equity rationale for 

 

30 For a cautionary note on the importance of the subsidy given, see Dennis Zimmerman, 

"Expenditure-Tax Incidence Studies, Public Higher Education, and Equity, "National Tax 

Journal, 26, March 1973. Zimmerman finds that the subsidy structure can just as easily promote 

a less equal distribution of lifetime income.

31 Table 3 in Part II reports that Federal, State and local, and private expenditures 

accounted for 72.1 percent of post-secondary educational revenues for the 1995-96 academic 

year. Tuition accounted for 27.9 percent.

32 See Michael J. Boskin, "Notes on the Tax Treatment of Human Capital," in 

Department of the Treasury, Conference on Tax Research, 1975 (Washington, D.C.: Department 

of the Treasury), 1977, pp. 185-195.
30

providing a subsidy to education, as the equity rationale generally is based upon education as an 

investment in future earning potential. The distinction between education as investment and 

education as consumption also is important for analysis of the income tax treatment of 

expenditures on education--that is, should education expenses be deductible to properly measure 

a taxpayer's net income?

Educational expenses under a theoretical income tax

Under a theoretical income tax, any expenditures undertaken in the present for returns 

that are expected in the future should be capitalized and recovered as the future returns are 

earned. Consumption expenditures are neither deductible nor amortizable under a theoretical 

income tax. Thus, certain expenditures on education should be capitalized by the taxpayer and 

recovered against future earnings. As discussed above, the relevant expenditures to be capitalized 

would only be those that represent investments in human capital,33 not those related to 

consumption. Of course, making such decisions would be quite difficult in practice. For 

example, the would-be chemical engineer of the example above may not know whether her 

future employment will be in the chemical industry or perhaps as a chanteuse, making it difficult 

to know how to account for the costs of the chemical engineering courses and the music course. 

Many educational expenses are paid by a parent on behalf of a student. In such case, the 

theoretical income tax would permit amortization only by the student.

Educational expenses under the present-law income tax

As discussed above, there are three types of expenditures made by students on their 

education: (1) payment via implicit or explicit transfers received from governments or private 

persons; (2) forgone wages; and (3) direct payment of tuition and other educational expenses by 

the student.

By not including the transfers from governments or private persons in the income of the 

student, present law offers the equivalent of expensing of those expenditures undertaken on 

behalf of the student by governments and private persons.34 This treatment (the equivalent of 

expensing) also is provided for direct transfers to students in the form of qualified scholarships 

or employer-provided educational assistance, which are excludable from income. Similarly, 

because forgone wages are never earned, the implicit expenditure incurred by students forgoing 

present earnings also receives expensing under the present-law income tax.

The present-law treatment of direct payment of tuition and other educational expenses by 

the student is subject to various tax treatments. With certain exceptions, the present-law income 

tax treats direct payments of tuition and other educational expenses as consumption, neither 

 

33 For a discussion of government policy towards human capital investment, see C. 

Eugene Steuerle, "How Should Government Allocate Subsidies for Human Capital?" American 

Economic Review, 86, May 1996, pp. 353-357.

34 Of course, the actual government expenditures themselves represent a wealth transfer 

to the student. It is only the income tax treatment of such expenditures (that is, not counting 

them as income to the student) that is the equivalent of expensing.
31

deductible nor amortizable.35 An important exception to this treatment is expenses that qualify 

for the HOPE credit or the Lifetime Learning credit. The HOPE credit provides income tax 

treatment that is the equivalent of an investment tax credit for educational expenditures that 

qualify for the credit. For the first $1,000 of qualified expenditures, a taxpayer receives a $1,000 

credit, which is the equivalent of a 100-percent investment tax credit. Such 100-percent 

investment tax credit is more generous tax treatment than is expensing. A 100-percent 

investment tax credit is, from the taxpayer's perspective, preferred to expensing because it 

permits a deduction from taxes owed, rather than a deduction from taxable income itself. Thus, a 

100-percent credit allows a dollar-for-dollar credit against taxes owed, whereas the value of a 

deduction from taxable income depends on the taxpayer's marginal tax rate.36 For the next 

$1,000 of expenditures, the taxpayer receives the equivalent of a 50-percent investment tax 

credit. The Lifetime Learning credit is the equivalent of a 20-percent investment tax credit on 

qualified expenditures.

The theoretical income tax would have all expenditures toward investment in human 

capital capitalized and recovered against the student's future earnings. By permitting the 

equivalent of expensing for the indirect expenditures related to a student's education (and direct 

expenditures made in the form of qualified scholarships or employer-provided education 

assistance), the present-law income tax subsidizes investment in human capital relative to 

investment in physical capital.37 For direct expenditures by the student that qualify for the 

HOPE credit, the treatment of the first $2,000 on qualified educational expenses in the first two 

years of post-secondary education provides greater subsidy than that provided for investment in 

physical capital.38 Though certain educational expenses are thus afforded income tax treatment 

 

35 Exceptions include the direct payment of education expenses with earnings from 

education IRAs or interest earned on U.S. savings bonds by low- and middle-income taxpayers. 

Such payments are permitted an exclusion from income tax. By not counting such interest or 

earnings in income, such amounts (the earnings components, but not the principal) are afforded 

treatment equivalent to expensing. Other tax benefits for direct expenditures on education 

expenses, such as the deductibility of certain interest expense or withdrawals from IRAs without 

imposition of the early withdrawal tax provide only minor benefits in comparison to expensing 

or amortization treatment of the full amount of education expenses.

36 Specifically, the cost to the taxpayer of a dollar of expenditure on education that is 

permitted to be deducted is (1-t) times the amount of the expenditure, where t is the taxpayer=s 

marginal tax rate. For a taxpayer in the 28-percent tax bracket, a thousand dollar expenditure on 

education that is permitted to be deducted is only $720 (the tax benefit of the deduction is thus 

$280). If the taxpayer is allowed a credit for the thousand dollar expenditure, there is no cost to 

the taxpayer of the thousand dollar expenditure (that is, the tax benefit is the full $1,000). In 

general, a taxpayer will prefer expensing treatment if his or her marginal tax rate exceeds the 

percentage value of the credit.

37 Expensing is more generous cost recovery than is capitalization and amortization. 

Under simplifying assumptions, the expensing of investment is economically equivalent to the 

nontaxation of the returns to that investment. Amortization attempts to measure, and tax 

annually, the return to the investment.

38 Additionally, the Lifetime Learning credit provides a subsidy whose value in relation 

to expensing will vary depending on the marginal tax rate of the taxpayer. A taxpayer in a 

marginal rate bracket in excess of the value of the credit (20 percent under present law) would 
32

that is as favorable or more favorable than expensing, the present-law income tax generally 

permits no recovery of the direct tuition or other educational costs paid by the student that do not 

qualify for the HOPE or Lifetime Learning credits.39 On balance, the variety and complexity of 

educational benefits afforded through the tax code, when coupled with expenditures that do not 

receive favorable tax treatment, make it difficult to determine the extent to which educational 

expenditures are subsidized by the tax code, relative to investments in physical capital.

 

prefer expensing of such expenditures, whereas a taxpayer with a marginal rate bracket less than 

the value of the credit would prefer the present credit to expensing.

39 As noted previously, exceptions include the direct payment of education expenses with 

earnings from education IRAs or interest earned on U.S. savings bonds by low- and middleincome taxpayers. Again, it is only the earnings from such accounts, not the principal, that is 

afforded the favorable tax treatment.