Higher Education Tax Benefits: Brief Overview and Budgetary Effects
Released: 2018-08-27T00:00:00

Introduction

Since 1997, education tax benefits have become an increasingly important component of federal higher education policy. For the 2017 tax year, 14 tax benefits are available for college students and their parents to help pay for higher education (see Table 1 ). In 2018, this number falls to 11, as the personal exemption for dependents (including college-age dependents) and deduction for work-related business education expenses are temporarily suspended (through the end of 2025), and the tuition and fees deduction will have expired.

The available tax benefits are a mixture of credits, deductions, exclusions, and other incentives. The benefits can be placed into one of three general categories: incentives for current year expenses, preferential tax treatment of student loans, and incentives for saving for college. The Joint Committee on Taxation (JCT) estimates the cost to the federal government of education tax benefits—the revenue foregone from offering these benefits—to be $168.5 billion over the 2016-2020 window. These estimates do not include the indirect effect of the recent tax law changes made by P.L. 115-97 (see text box).

This report provides a brief overview of the higher education tax benefits that are currently available to students and their families. The report contrasts higher education tax benefits with traditional student aid; presents a brief history of higher education tax policy over the past 60 years, including recent legislative proposals to modify these tax incentives; summarizes key features of the available tax benefits; and provides JCT estimates of revenue losses resulting from individual tax provisions. The summary is contained in Table 1 and provides information on various aspects of each tax benefit including the type of benefit (credit, deduction, etc.), the annual dollar amount of the benefit, what expenses qualify for the benefit, what level of education the benefit can be claimed for, income levels at which the benefit phases out, and, if the provision is temporary, when it expires. Table 2 contains estimates of the annual forgone federal revenue attributable to each provision.

Tax Benefits Versus Traditional Student Aid

The federal government provides individuals with financial assistance for higher education expenses in two ways: tax benefits and traditional student aid (loans, grants, and work-study assistance). To qualify for traditional financial aid, students generally first submit a free application for federal student aid (FAFSA) to the Department of Education. Financial aid officers at the student's college or university use the asset and income information provided by the Department of Education to determine the student's federal financial aid award. This financial aid is then used to pay for higher education expenses at the time they are due.

A summary of available traditional financial aid is beyond the scope of this report. For more information, please see CRS Report RL31618, Campus-Based Student Financial Aid Programs Under the Higher Education Act ; CRS Report R40122, Federal Student Loans Made Under the Federal Family Education Loan Program and the William D. Ford Federal Direct Loan Program: Terms and Conditions for Borrowers , by [author name scrubbed]; and CRS Report R42446, Federal Pell Grant Program of the Higher Education Act: How the Program Works and Recent Legislative Changes , by [author name scrubbed].

In contrast, most tax-based higher education assistance becomes available after higher education expenses have been incurred—sometimes several months afterward. Aside from tax-preferred college savings accounts, taxpayers must wait until they file their federal income tax returns to claim any federal higher education tax benefits. Another difference between the two forms of educational assistance is that traditional financial aid is often directed toward students with financial need, while tax benefits are generally available to eligible taxpayers regardless of need.

Brief Historical Perspective of Tax Benefits

Tax benefits for higher education were first introduced nearly 60 years ago. While most of these benefits were originally structured as deductions and exclusions, which reduce taxable income, they now include tax credits, which directly reduce tax liability.

Between 1954 and 1996, eight tax benefits for education were enacted:

1. an exclusion for scholarships, fellowships, and tuition reductions; 2. a parental exemption for students ages 19 to 23 who were enrolled in college; 3. a business expense deduction for work-related education; 4. an exclusion for employer-provided education assistance; 5. an exclusion for the interest earned on educational savings bonds; 6. an exclusion of qualifying cancelled student loans from taxable income; 7. an unlimited gift tax exclusion for amounts paid by a donor directly to an educational institution for tuition payments on behalf of the donee; and 8. an exclusion of the earnings from qualified tuition programs (QTPs), also known as Section 529 Plans.

The deduction for student loan interest, which had existed since 1954, was eliminated with the passage of the Tax Reform Act of 1986 (TRA86, P.L. 99-514 ). TRA86 disallowed all forms of personal interest deductions other than for mortgage interest.

The Taxpayer Relief Act of 1997 ( P.L. 105-34 ) enacted five new education tax benefits:

1. the Hope Tax Credit; 2. the Lifetime Learning Credit; 3. a reinstatement of the above-the-line deduction for student loan interest; 4. an exclusion for earnings accruing to education individual retirement accounts (later renamed Coverdell education savings accounts); and 5. a cancellation of the penalty for early withdrawals from individual retirement accounts (IRAs).

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA; P.L. 107-16 ) temporarily modified several education tax benefits, including the exclusion of scholarships, grants, and tuition reductions associated with certain scholarships; the student loan interest deduction; and Coverdells. These modifications were scheduled to expire at the end of 2010. In addition, the law extended the exclusion for employer-provided educational assistance through the end of 2010. EGTRRA also enacted a new temporary above-the-line deduction for higher education expenses (often referred to as the "tuition and fees" deduction). The tuition and fees deduction was scheduled to expire at the end of 2005. (Several laws subsequently extended the deduction through the end of 2017.)

The American Recovery and Reinvestment Act of 2009 (ARRA; P.L. 111-5 ) modified a variety of parameters of the Hope Credit, increasing the amount of the credit and expanding eligibility for the credit. Collectively, these modifications resulted in the Hope Credit being referred to as the American Opportunity Tax Credit (AOTC). The AOTC as enacted under ARRA was scheduled to be in effect only for 2009 and 2010.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ( P.L. 111-312 ) extended the AOTC for two years (2011 and 2012). In addition, modifications to education tax benefits originally made by EGTRRA were also extended through the end of 2012 by this law, including modifications to the exclusion of scholarships, grants, and tuition reductions concerning specific scholarships; the student loan interest deduction; and Coverdells. The law also extended the exclusion for employer-provided educational assistance for 2011 and 2012. Finally, P.L. 111-312 extended the tuition and fees deduction for 2010 and 2011.

The American Taxpayer Relief Act of 2012 ( P.L. 112-240 ; ATRA) made the exclusion for employer-provided educational assistance permanent. The law also made several EGTRRA modifications to education tax benefits permanent, which are outlined in the shaded text box. Finally ATRA extended the AOTC for five more years, through the end of 2017, and extended the tuition and fees deduction for 2012 and 2013.

The Tax Increase Prevention Act of 2014 ( P.L. 113-295 ) extended the tuition and fees deduction through the end of 2014.

The Protecting Americans from Tax Hikes (PATH) Act (Division Q of P.L. 114-113 ) extended the tuition and fees deduction for 2015 and 2016. In addition, the PATH Act made the AOTC permanent, effectively eliminating the Hope credit.

P.L. 115-97 changed four education tax benefits: 529 plans, the tax treatment of discharged student loan indebtedness, personal exemptions for college age-dependents, and the business deduction for work-related education expenses. With respect to 529 plans, it permanently allowed up to $10,000 to be withdrawn tax-free per beneficiary per year and be used for tuition expenses at public, private, and parochial schools. With respect to the exclusion of certain discharged student loan debt, the law temporarily expanded the categories of nontaxable discharged student loan debt to include student loan debt that is discharged on account of the death or permanent disability of the student. This change is in effect from 2018 through the end of 2025. The law also temporarily suspended personal exemptions and the itemized deductions for work-related education expenses. Hence, from 2018 to 2025 taxpayers cannot claim a personal exemption for their college-age dependents or this itemized deduction. All else being equal, this will increase the taxpayer's taxable income. However, the ultimate impact on the tax bill will depend on each taxpayer's particular circumstances.

The Bipartisan Budget Act of 2018 (BBA; P.L. 115-123 ) extended the tuition and fees deduction retroactively for 2017.

Summary and Cost of Current Benefits

Table 1 summarizes the higher education tax benefits currently available to individuals. The benefits can be divided into three groups: incentives for current year higher education expenses, incentives that provide preferential tax treatment of student loan expenses, and incentives for saving for college. Generally, a taxpayer cannot claim more than one tax benefit for the same education expense.

The benefits available are structured as a tax credit, deduction, exemption, or exclusion. While these terms are sometimes used interchangeably, they are different. It is important to understand the distinctions among the types of incentives:

Tax credits reduce the amount an individual owes in taxes directly, on a dollar-for-dollar basis. Credits are available to all qualified taxpayers, whether they itemize deductions or not. Credits can be nonrefundable or refundable. Nonrefundable credits cannot exceed taxes owed, and therefore can only reduce an individual's tax liability to zero. Refundable credits can exceed taxes owed, meaning a taxpayer with no tax liability may receive all or part of the credit amount as a refund check. Education tax credits include the Lifetime Learning Credit , which is nonrefundable , and the American Opportunity Tax Credit , which is refundable , although the maximum amount that can be received as a refund is limited to 40% of the total credit .Tax deductions reduce the amount of a taxpayer's income that is subject to taxation by the amount of the deduction. As a result, deductions reduce a taxpayer's tax liability, but only in proportion to the taxpayer's highest marginal tax bracket. Hence, deductions are generally less valuable than a given dollar amount in tax credits. Generally, the amount that may be deducted is equal to a portion of some expense incurred. Deductions can either be "above-the-line" or "itemized." Above-the-line deductions are typically more advantageous than itemized deductions and may be claimed by most taxpayers. Itemized deductions may only be claimed by those taxpayers who itemize all their deductions on their tax returns. The alternative to itemizing is claiming the standard deduction. Education tax deductions include the business deduction for work- related expenses (an itemized deduction), the deduction for tuition and fees, and the student loan interest deduction (both above-the-line deductions).Tax exemptions reduce the amount of a taxpayer's income which is subject to taxation, by a fixed dollar amount per exemption claimed. Generally, every taxpayer is allowed to claim one exemption for themselves, one exemption for a spouse, and one for each dependent. Exemptions function similarly to deductions in that they reduce the income that is subject to taxation, but they are based on a fixed amount per person instead of actual expenses. An exemption's value to a taxpayer is also similar to the value of a deduction in terms of being proportional to a taxpayer's highest marginal tax bracket. Parents of students between the ages of 19 and 23 are eligible for a personal tax exemption for their children. Under P.L. 115-97 , the personal exemption, including for students ages to 19 to 23, is suspended from 2018 through 2025.Tax exclusions are amounts of income that are not included as income for tax purposes because the tax code explicitly excludes—or exempts—them from taxation. Education tax exclusions include the exclusion of certain scholarships, grants, and tuition reductions, the exclusion of employer - provided educational assistance, the exclusion of qualifying cancelled student loans, and the exclusion of direct transfers to educational institutions.

As Table 1 shows, there are a number of limitations to the available tax benefits. Some benefits are subject to an annual limit, or "cap." For example, the maximum annual American Opportunity Tax Credit that may be claimed is $2,500. A number of the tax benefits may be limited by the type of "qualifying" expenses they are used to offset. For some tax benefits, only tuition and required fees qualify. Generally fees that must be paid to the educational institution as a condition of enrollment or attendance are considered "required fees." Other tax benefits can be used to offset course-related books, supplies, and materials. And still other benefits may be used to cover travel and other expenses.

A number of higher education tax benefits also have income limitations. When an income limitation does exist, it is in the form of an income phaseout range. Taxpayers with incomes below the start of the phaseout range are eligible to claim the maximum tax benefit amount. The amount of the credit that can be claimed is then reduced for individuals with incomes within the phaseout range, and is zero for those with incomes above the phaseout range. In addition, the expiration date for the provision, if temporary, is provided.

Table 2 presents the JCT cost estimates for each available tax benefit. The JCT advises that these estimates cannot be simply summed to estimate the aggregate revenue loss from multiple tax provisions. This is because of interaction effects. When the revenue loss associated with a specific tax provision is estimated, the estimate is made assuming that there are no changes in other provisions or in taxpayer behavior. When individual tax expenditures are summed, the interaction effects may lead to different revenue loss estimates. Consequently, aggregate tax expenditure estimates, derived from summing the estimated revenue effects of individual tax expenditure provisions, are unlikely to reflect the actual change in federal receipts associated with removing various tax provisions.