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CRS Reviews Higher Education Tax Credits and Deductions

MAY 6, 2005

RL31129

DATED MAY 6, 2005
DOCUMENT ATTRIBUTES
  • Authors
    Stoll, Adam
    Levine, Linda
  • Institutional Authors
    Congressional Research Service
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2005-11635
  • Tax Analysts Electronic Citation
    2005 TNT 102-46
Citations: RL31129

 

CRS Report for Congress

 

Received through the CRS Web

 

Order Code RL31129

 

 

Updated May 6, 2005

 

 

Adam Stoll

 

Specialist in Social Legislation

 

Domestic Social Policy Division

 

Linda Levine

 

Specialist in Labor Economics

 

Domestic Social Policy Division

 

Higher Education Tax Credits and Deduction:

 

 

An Overview of the Benefits and Their

 

Relationship to Traditional Student Aid

 

 

Summary

 

 

The Taxpayer Relief Act of 1997 established two permanent federal income tax credits, effective since tax year 1998, for qualified postsecondary education expenses -- the Hope Scholarship credit and the Lifetime Learning credit. The Economic Growth and Tax Relief Reconciliation Act of 2001 authorized an income tax deduction for high education expenses, effective in 2002 and through 2005.

The Hope credit was introduced to help ensure that students have access to the first two years of undergraduate education. The Lifetime Learning credit and tuition and fees deduction provide support for students in any year of undergraduate and graduate study; they are unique in that they are available to individuals taking occasional courses. Only one of the three tax benefits may be taken in the same tax year for the same eligible student's qualified expenses.

Key features of the education credits and deduction dictate who the provisions benefit and the value of assistance they confer. Among these are the nonrefundable nature of the credits (i.e., persons must have income tax liabilities, which must exceed the maximum amount of the credits to claim their full value), the deduction's availability whether or not taxpayers take itemized deductions, and the statutory limits on benefit amounts and on taxpayers' income. Accordingly, middle- and upper middle-income individuals are the targeted beneficiaries of these tax incentives.

All three benefits apply to the tuition and fees required for enrollment that are not offset by grant aid (e.g., qualified scholarships) and other tax benefits (e.g., Coverdell Education Savings Accounts and Section 529 Plans). The Hope credit has had a maximum value of $1,500 per student since its inception; the Lifetime Learning credit, $2,000 per return since 2003. The value of the credits is gradually reduced within the same income ranges. The value of the deduction depends on taxpayers' marginal tax rates, and it is available to persons higher up the income scale than typically served by the credits. The deduction covers qualified expenses of up to $4,000 per return in 2005, although a smaller deduction of up to $2,000 is available to somewhat higher-income taxpayers.

With the introduction of these tax benefits, individuals can now receive substantial amounts of federal financial assistance for postsecondary education from two parallel systems -- the federal income tax system and the traditional student aid delivery system, which provides aid such as grants, loans, and work opportunities. The traditional system helps students meet current expenses; the tax system requires families to make outlays that are reimbursed through tax reductions determined near the end of or after an academic year. Tax benefits may offer streamlined delivery of aid, while most other aid is delivered through relatively cumbersome and laborintensive processes. Some criticize the complexity of the tax process, however; and the availability of the tax benefits adds another system that students and families must navigate and learn to coordinate with any traditional aid received. This report will be updated as warranted.

                            Contents

 

 

 Introduction

 

 Form -- An Overview of the Benefits

 

 Hope Scholarship Credit

 

 Lifetime Learning Credit

 

 Higher Education Deduction

 

 Function -- Intended Beneficiaries and Benefit Size

 

 Overview

 

 Intended Role for Each Benefit

 

 Relative Worth of Each Benefit to Taxpayers

 

 Factors That Determine Benefit Size and Eligibility

 

 Relationship to the Traditional Student Aid Delivery System

 

 Timing of Awards

 

 Disbursement of Aid

 

 Overall Complexity of College Financing

 

 Direct Effect of Tax Benefits on Traditional Student Aid

 

 

 List of Tables

 

 

 Table 1. Major Features of the Higher Education Tax Credits and Deduction

 

 Table 2. Preliminary 2003 IRS Data for the Hope and Lifetime Learning

 

          Credits and the Higher Education Deduction

 

 Table 3. Examples of Tax Savings from the Higher Education Tax

 

          Credits and Deduction

 

Higher Education Tax Credits and

 

Deduction: An Overview of the Benefits and

 

Their Relationship to Traditional Student Aid

 

 

Introduction

The Taxpayer Relief Act of 1997 (TRA, P.L. 105-34) established two permanent federal income tax credits for qualified postsecondary education expenses: the Hope Scholarship credit and the Lifetime Learning credit. They became available to taxpayers filing returns for 1998 and thereafter. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, P.L. 107-16) established a new tax deduction for higher education expenses beginning in 2002 and expiring at the outset of 2006.

The value of these benefits in forgone federal revenue places them among the largest sources of federal support to meet the costs of postsecondary education. Preliminary data from the Internal Revenue Service (IRS) for 2003 show that 7.4 million returns claimed $5.9 billion in education tax credits and 3.6 million returns claimed $6.7 billion through the higher education deduction.1

At present there are two parallel systems through which the federal government provides assistance for postsecondary education attendance, namely, the traditional student aid delivery system and the federal income tax system. The expiration of the funding authority for Higher Education Act (HEA) programs will give policymakers an opportunity to consider amendment and extension of major federal aid programs under HEA Title IV that use the traditional delivery system; among these programs are the Pell Grant program (an estimated $12.8 billion in grant aid for FY2005) and the Federal Family Education Loan and Direct Loan programs (an estimated $56.9 billion in new loan volume for FY2005).2

This report is intended to provide information about the direct assistance for education expenses provided through the federal income tax system, thereby placing congressional consideration of the HEA student aid programs in a broader context. Although data on the actual use and impact of the three tax benefits are limited, key aspects of their form and function dictate, to a large degree, who these tax provisions assist and by how much. These key features of the benefits are explored in this report. Further, it examines the relationship of the traditional student aid delivery system with the tax system as a conduit for postsecondary education assistance, identifying specific issues that may be important for congressional consideration during HEA reauthorization.

An important distinction underlies this report -- the tax system as a mechanism for providing benefits for postsecondary education expenses differs in significant ways from the traditional student aid delivery system. Tax incentives flow through a system that is dependent upon individuals' tax status and the level of qualified higher education expenses incurred. Tax benefits typically are not realized until after, sometimes well after, education spending has occurred. Benefit calculations are independent of any direct measurement of the ability to pay for postsecondary education. Further, the tax incentives are not subject to annual appropriations. In contrast, federal assistance provided through the traditional delivery system consists of grant, loan, and work aid. Much of this aid is awarded directly to students, while some is controlled and disbursed by financial aid officers at postsecondary institutions. A substantial portion of this assistance is awarded on the basis of students' financial need.3 Finally, a significant portion of this assistance is subject to annual appropriations.

Form -- An Overview of the Benefits

Hope Scholarship Credit. The Hope Scholarship credit is a nonrefundable credit against federal income tax liability for qualified higher education expenses.4 Initially, the credit for each eligible student was 100% of the first $1,000 of qualified expenses and 50% of the second $1,000 of such expenses, for a maximum benefit of $1,500. Although the $1,000 figures became indexed to inflation after 2001, the formula specified in the TRA for this purpose has resulted in the Hope credit's maximum value remaining at $1,500 through tax year 2005.

Taxpayers can claim the credit for qualified higher education expenses of each eligible student for whom they claim tax exemptions, including themselves, their spouse, and dependent children.5 Eligible students must have been enrolled on at least a half-time basis for at least one academic period during the tax year in a higher education program leading to a degree, certificate, or credential. They cannot have finished the first two years of undergraduate education, and the credit can only be claimed for their first two years of study.6 Individuals with a federal or state felony conviction for drug possession or distribution are not eligible for the credit.

Qualified higher education expenses are defined as tuition and fees required for enrollment at institutions eligible to participate in U.S. Department of Education (ED) student aid programs, including accredited public, private, and proprietary postsecondary institutions. They include those fees required as a condition for enrollment that are paid to the institution. Thus, fees for course-related books, supplies, and equipment as well as activity fees are included only if they are paid to the institution. Room and board, medical expenses including student health fees, and transportation are among the costs excluded from coverage.

Qualified tuition and fees expenses must be reduced by the amount of nontaxable educational assistance (exclusive of loans and gifts) that an eligible student receives. This includes education assistance that is excluded from taxpayers' gross income (e.g., Pell Grants, scholarships, veterans' educational benefits, and employerprovided tuition reimbursements).

The amount of the Hope credit is gradually reduced for individuals whose modified adjusted gross income7 for 2005 is between $43,000 and $53,000 (for those filing joint returns, between $87,000 and $107,000). The various income thresholds became indexed to inflation after 2001, according to a formula specified in law for this purpose, which may or may not result in a yearly increase.

The Hope credit cannot be claimed for a student if the Lifetime Learning credit is claimed for the same student in the same tax year. Individuals for whom a Hope credit is claimed cannot concurrently benefit from the deduction for qualified higher education expenses taken for the same student in the same tax year. For additional information on coordination of the Hope credit with other postsecondary education tax benefits (e.g., Coverdell Education Savings Accounts and Section 529 Programs) see Table 1.

Lifetime Learning Credit. The Lifetime Learning credit also is a nonrefundable tax credit for qualified tuition and fees. For qualified expenses paid on or after January 1, 2003, the credit per tax return is a maximum of $2,000, calculated as 20% of the first $10,000 in qualified expenses. Unlike in the case of the Hope credit, the TRA did not provide for the value of the Lifetime Learning credit to be adjusted for inflation. (The legislation had set the credit for tax years 1999-2002 at 20% of the first $5,000 of qualified expenses, or $1,000 at most.)

As with the Hope credit, the Lifetime Learning credit is available to individuals who pay the qualified higher education expenses of eligible students for whom they claim exemptions on their tax returns. Qualified tuition and related expenses are calculated and treated in the same fashion as they are under the Hope credit, including the reduction for nontaxable educational assistance that the student receives. The Lifetime Learning and Hope credits share the same income-eligibility levels and income-phaseout ranges. (See Table 1 for a side-by-side comparison of the major provisions of the three tax benefits discussed in this report.)

Unlike the Hope credit, students eligible for the Lifetime Learning credit are those enrolled in one or more courses of undergraduate or graduate instruction to acquire or improve job skills. There is no limit on the number of years for which the Lifetime Learning credit may be claimed.

The Lifetime Learning credit cannot be claimed for a student if the Hope credit is claimed for the same student in the same tax year. Individuals for whom a Lifetime Learning credit is claimed cannot concurrently benefit from the tax deduction for qualified higher education expenses. The Lifetime Learning credit also coordinates with other education tax benefits in the same manner as the Hope credit.

Higher Education Deduction. The above-the-line deduction for taxpayers who pay qualified higher education expenses for eligible students became effective in 2002.8 It sunsets for tax years beginning after December 31, 2005, unless Congress acts to extend the deduction or make it permanent.9

For 2004 and 2005, EGTRRA set the maximum deduction at $4,000 per return. (For 2002 and 2003, it was set at $3,000 per return.) This deduction can be taken by individuals with an AGI of up to $65,000 ($130,000 in the case of filers of joint returns). Neither the amount of the deduction nor the income ceilings are adjusted for inflation. The amount of the deduction is not gradually reduced by formula as the AGI of taxpayers rises within an income range. EGTRRA also provided a smaller deduction of $2,000 in 2004 and 2005 for taxpayers whose AGI is more than $65,000 but not more than $80,000 (more than $130,000 but not more than $160,000 for those filing joint returns).10

  Table 1. Major Features of the Higher Education Tax Credits and

 

  Deduction Characteristic Hope Scholarship Credit Lifetime Learning

 

                 Credit Higher Education Deduction

 

 

 Characteristic: Nature of the tax benefit

 

 

 Hope Scholarship Credit: The credit reduces income tax

 

 liability. It is referred to as a "nonrefundable credit" because

 

 it can only be claimed by individuals who have tax liabilities

 

 remaining after they have taken personal/dependency exemptions,

 

 standard or itemized deductions, and other personal credits. As a

 

 result, the taxpayer may not be able to realize the full value of the

 

 Hope Credit.

 

 

 Lifetime Learning Credit: Same

 

 

 Higher Education Deduction: The deduction reduces taxable

 

 income. It is referred to as an "above-the-line" deduction

 

 because it is claimed as an adjustment to income on the 1040 form,

 

 and therefore is available to taxpayers who do not itemize

 

 deductions. The actual value of the deduction depends on the

 

 taxpayer's marginal tax rate. Generally, the higher the tax rate, the

 

 larger the deduction.

 

 ______________________________________________________________________________

 

 Characteristic: Who can claim it?

 

 

 Hope Scholarship Credit: Taxpayers who claim an exemption on

 

 their returns for a student with qualified higher education expenses

 

 (e.g., a child, a spouse, or themselves).

 

 

 Lifetime Learning Credit: Same

 

 

 Higher Education Deduction: Same

 

 ______________________________________________________________________________

 

 Characteristic: For whom can it be claimed?

 

 

 Hope Scholarship Credit: A student enrolled at least half-

 

 time for at least one academic period in a program leading to

 

 an educational credential at an eligible educational

 

 institution, who is in their first two years of

 

 postsecondary school and who has not had a felony drug

 

 conviction. The credit is available for two years per student.

 

 

 Lifetime Learning Credit: A student enrolled in one or

 

 more courses at the undergraduate level or graduate

 

 level at an eligible educational institution who need not be

 

 pursuing an educational credential.

 

 

 Higher Education Deduction: Same as Life Learning Credit

 

 ______________________________________________________________________________

 

 Characteristic: Qualified expenses

 

 

 Hope Scholarship Credit: Tuition and related expenses

 

 required for enrollment or attendance at an eligible educational

 

 institution.

 

 

 Lifetime Learning Credit: Same

 

 

 Higher Education Deduction: Same

 

 

 Hope Scholarship Credit: These expenses must be reduced by any

 

 tax-free educational assistance (e.g., Pell Grants, scholarships,

 

 Veterans' educational assistance, and employer-provided educational

 

 benefits).

 

 

 Lifetime Learning Credit: Same

 

 

 Higher Education Deduction: Same

 

 ______________________________________________________________________________

 

 

 Characteristic: Eligible institutions

 

 

 Hope Scholarship Credit: Any college, university, vocational

 

 school, or other postsecondary institution eligible to participate in

 

 an ED-administered student aid program.

 

 

 Lifetime Learning Credit: Same

 

 

 Higher Education Deduction: Same

 

 ______________________________________________________________________________

 

 

 Characteristic: Maximum value of the benefit

 

 

 Hope Scholarship Credit: $1,500 per

 

 student in tax year 2005. (100% of the first $1,000 of

 

 qualified expenses and 50% of the second $1,000 per student. Each

 

 of the $1,000 amounts is indexed for inflation annually.)

 

 

 Lifetime Learning Credit: $2,000 per

 

 return in tax year 2005. (20% of the first $10,000 of

 

 qualified expenses per return.)

 

 

 Higher Education Deduction: $4,000 per

 

 return in tax year 2005.

 

 ______________________________________________________________________________

 

 

 Characteristic: Income eligibility limits

 

 

 Hope Scholarship Credit: Taxpayers whose AGI is $53,000 or

 

 more ($107,000 or more for those filing joint returns) are not

 

 eligible for the credit in tax year 2005. The credit amount is

 

 gradually reduced for taxpayers whose AGI is between $43,000 and

 

 $53,000 ($87,000 and $107,000 for those filing joint returns). The

 

 income ranges are adjusted annually for inflation.

 

 

 Lifetime Learning Credit: Same

 

 

 Higher Education Deduction: The deduction is not available to

 

 taxpayers whose AGI is more than $65,000 (more than $130,000 for

 

 those filing joint returns). There is no phase-out and the

 

 income threshold is not indexed for inflation. Persons

 

 with AGIs more than $65,000 but not more than $80,000 (more than

 

 $130,000 but not more than $160,000 for joint filers) are eligible

 

 for a lower maximum of $2,000 in tax year 2005.

 

 ______________________________________________________________________________

 

 Characteristic: Coordination of benefits (i.e., no double

 

 benefit allowed)

 

 

 Hope Scholarship Credit: The Hope Credit cannot be claimed if

 

 the Lifetime Learning Credit, Tuition and Fees Deduction, or business

 

 expense deduction is taken for the same student in the same year.

 

 

 Lifetime Learning Credit: Same

 

 

 Higher Education Deduction: Same

 

 

 Hope Scholarship Credit: The Hope Credit cannot be claimed for

 

 the same qualified expenses paid with tax-free educational

 

 assistance, with tax-free withdrawals from Coverdell Accounts and

 

 from Section 529 Plans, and with taxfree interest on U.S. Savings

 

 Bonds.

 

 

 Lifetime Learning Credit: Same

 

 

 Higher Education Deduction: Same as Hope Credit except, with

 

 regard to QTPs, the deduction cannot be claimed for the same

 

 qualified expenses paid with only the tax-free earnings

 

 portion of withdrawals.

 

 

 Hope Scholarship Credit: It can be claimed for qualified

 

 expenses paid with the proceeds of a loan.

 

 

 Lifetime Learning Credit: Same

 

 

 Higher Education Deduction: Same

 

 

 Source: The tax information was derived from IRS, Tax

 

 Benefits for Education, Publication 970; provisions of the

 

 Internal Revenue Code; and commentary.

 

 

 Note: These education tax benefits cannot be claimed by

 

 married individuals who file separate returns. AGI refers to

 

 "modified AGI" (e.g., AGI plus foreign earned income and housing

 

 exclusions), which are identical for most taxpayers.

 

 ______________________________________________________________________________

 

 

Although the deduction reduces a taxpayer's AGI dollar for dollar, it ultimately is worth different amounts to taxpayers depending upon their marginal tax rates.11 For example, the deduction would be worth $450 in reduced tax liability to a taxpayer in the 15% tax bracket with $3,000 in qualified expenses (0.15 x $3,000). For an individual in the 25% tax bracket with the same amount of qualified expenses, the deduction would produce $750 in tax savings (0.25 x $3,000).

Taxpayers can take the deduction if they pay their own qualified higher education expenses or those of their spouses or dependents for whom they claim tax exemptions. As with the Lifetime Learning credit, there are no limitations on the level of postsecondary education enrollment (undergraduate and graduate enrollment) or the intensity of enrollment (a single course of study, half-time enrollment, or fulltime enrollment). The qualified higher education expenses for the deduction are defined as they are for the two credits.

The deduction cannot be taken for the qualified higher education expenses of any individual for whom the Hope or Lifetime Learning credits are claimed. For the most part, qualified higher education expenses are reduced by tax-free educational assistance and coordinated with other tax benefits in the same fashion as they are for the credits. (See Table 1 for more detail.)

Function -- Intended Beneficiaries and Benefit Size

Overview. Higher education tax incentives, like other forms of federal financial aid, represent investments in human capital that are expected to yield benefits for society beyond those realized by individual recipients. The tax benefits are not available to everyone seeking to meet postsecondary education expenses; rather, they are primarily focused on specific groups of individuals and provide them with different amounts of assistance.

The tax benefits were enacted to help preserve and enhance access to postsecondary education for students from middle- and upper middle-income families. This group of families is not centrally targeted by most other federal aid programs, which place primary emphasis on assisting students with the greatest amount of financial need. Yet, students of middle-income families make up a large proportion of the college population, and these families face the challenge of meeting costs of higher education that have been increasing at a rate that has consistently outpaced inflation in recent decades.

Available data on tax benefit recipients indicate that the higher education tax credits and deduction are, as intended, primarily serving middle- and upper middleincome individuals. Preliminary IRS data reveal that 36% of the 2003 tax returns that claimed the education credits were from filers with an AGI of $50,000 or more, and 53% of the returns that claimed the deduction were from filers in that AGI-range as well. (See Table 2.) These tax filers accounted for 43% of the total amount claimed in these credits, and 57% in the deduction, for 2003. In contrast, only 9% of the returns claiming the credits, and 18% taking the deduction, were from tax filers with an AGI of less than $15,000; these returns accounted for 4% of the total amount of the two credits claimed and 19% of the amount of the deduction taken.

    Table 2.  Preliminary 2003 IRS Data for the Hope and Lifetime

 

          Learning Credits and the Higher Education Deduction

 

                                          ($ in thousands)

 

 

                                    Adjusted gross income

 

 

                                                       $15,000

 

                                           Under         under

 

                          All returns      $15,000     $30,000

 

 Number of returns

 

 claiming credits          7,358,508      675,687    1,931,723

 

 % of all returns

 

 claiming credits               100%           9%          26%

 

 Amount of credits

 

 claimed                  $5,900,877     $210,683   $1,355,430

 

 % of total claimed             100%           4%          23%

 

 Number of returns

 

 claiming deduction        3,603,729      640,139      469,160

 

 % of all returns

 

 claiming deduction             100%          18%          13%

 

 Amount of deduction

 

 claimed                  $6,737,825   $1,308,175     $787,845

 

 

 % of total claimed             100%          19%          12%

 

 

                           [Table Continued]

 

 

                                   Adjusted gross income

 

 

                            $30,000      $50,000    $100,000

 

                              under        under       under

 

                            $50,000     $100,000    $200,000

 

 Number of returns

 

 claiming credits         2,078,547    2,647,141      25,353

 

 % of all returns

 

 claiming credits               28%          36%          0%

 

 Amount of credits

 

 claimed                 $1,748,981   $2,548,286       1,418

 

 % of total claimed             30%          43%          0%

 

 Number of returns

 

 claiming deduction         564,812    1,203,027     726,593

 

 % of all returns

 

 claiming deduction             16%          33%         20%

 

 Amount of deduction

 

 claimed                   $823,012   $2,218,873  $1,599,920

 

 

 % of total claimed             12%          33%         24%

 

 

 Source: IRS, Individual Income Tax Returns, Preliminary Data, 2003.

 

 

 Note: Sum of percentages may not equal 100% due to rounding.  Data

 

 are not available for each credit individually.

 

 

Intended Role for Each Benefit. In simplest terms, the role envisioned for each benefit can be characterized in the following manner:
  • The Hope credit was intended to help ensure middle-income students have universal access to the first two years of postsecondary education.

  • The Lifetime Learning credit was designed to offer continued support to such traditional undergraduate students, not limited to the first two years of study. It also offers support to graduate students and "lifetime learners" (i.e., those not necessarily pursuing degrees).

  • The higher education tax deduction was meant to support the same set of postsecondary educational pursuits as the Lifetime Learning credit.

 

The Hope credit is targeted to a narrower group of postsecondary students -- those in the first two years of postsecondary study, and enrolled half-time or more in pursuit of a degree, certificate, or credential -- than either the Lifetime Learning credit or the higher education deduction. Beyond their first two years of postsecondary education, individuals enrolled half-time could be able to benefit from either the Lifetime Learning credit or the deduction.

Significantly, the Lifetime Learning credit and the deduction, which can be claimed for an unlimited number of years, support traditional and nontraditional students regardless of their enrollment or degree status. Part-time and full-time students can qualify, as can graduate, undergraduate and non-degree students. As a consequence, the Lifetime Learning credit and the deduction occupy a unique niche in the student aid landscape: the two tax incentives are widely available benefits that can support students who are taking occasional courses but are not necessarily enrolled in an educational credential or degree program. They may be a major source of direct financial aid available to many individuals who want to take courses periodically over the course of their careers to upgrade their skills.12

Even though the Lifetime Learning credit and the deduction have been designed to provide aid to a wide array of students, they likely will provide a good deal more benefit to traditional undergraduate and graduate students on a per year basis than to sporadic course-takers. This is due to the fact that the credit covers a maximum of $2,000 of eligible expenses incurred within a year's time and the deduction, $4,000 in 2005, and traditional students are likely to incur more costs. However, sporadic course-takers can receive support for an unlimited number of years, and may ultimately gain more value from the credit over a series of years than traditional students.

Relative Worth of Each Benefit to Taxpayers. Since many students are eligible for more than one of these benefits, taxpayers likely will attempt to choose the one that provides the maximum value of tax savings to them. In general, when examining the relative worth of the benefits the following rules of thumb apply:

  • For those middle-income taxpayers filing a joint return with one student who is eligible for the Hope credit and with incomes below the phase-out range, the Hope credit generally is more valuable than Lifetime Learning credit if qualified expenses are less than $7,500. For families with more than one student eligible for the Hope credit, the better choice for each child between the Hope credit and the Lifetime Learning credit will depend upon the qualified expenses of the additional student(s).13

  • For those middle-income taxpayers filing a joint return with a student eligible to receive either credit and with incomes below the phase-out range, the value of the higher education deduction never exceeds that of the Hope credit and only exceeds that of the Lifetime Learning credit when the amount of qualified expenses is $4,000 or less and the taxpayer's marginal tax rate is more than 20%.

  • As income increases, the income thresholds at which the credits and deduction are eliminated become increasingly important in determining who can receive which benefit. The deduction's income ceiling is higher than that of the credits.

 

The figures in Table 3 can be used to illustrate some of these points. For a married-couple family in the 15% tax bracket with one child eligible for the Hope credit who is attending a college at which tuition and fees total $10,000 for tax year 2004, the Lifetime Learning credit is worth its maximum of $2,000 in tax savings -- higher than either the Hope credit maximum of $1,500 (which is reached when qualified expenses meet or exceed $2,000) or the deduction's value of $600 (0.15 x $4,000, the maximum amount of qualified tuition and fees that can be subtracted from income). If the same family had a second child who also is eligible for the Hope credit and who is attending a two-year public institution that charges tuition of $1,000, then the Hope credit would be the better choice for the second child ($1,000) and the Lifetime Learning credit would continue to be the better choice for the first child ($2,000); the total tax savings for the family from the education credits would be $3,000. Other combinations of the credits, or of the credits and the deduction, would produce a smaller tax savings for the family. For example, if the family claimed a Hope credit for each child the family's total education tax benefit would be $2,500 ($1,500 for the first student plus $1,000 for the second student) rather than $3,000.

The importance of the amount of qualified expenses in determining the relative value of the three tax benefits can be seen by looking at each expense level in the table's first column and then across the corresponding row. It is not until qualified tuition and fees exceed $7,500 that the Lifetime Learning credit produces more tax savings than the Hope credit for a family with one eligible student. Because EGTRRA capped the maximum amount of qualified expenses that may be taken as an adjustment against income at $4,000, the reduction in income tax liability yielded by the deduction cannot match the tax savings of the Hope credit.

The comparative value of the deduction and the Lifetime Learning credit for families is more complex, being affected both by the deduction's limit on qualified expenses and a taxpayer's marginal tax rate. The $4,000 tuition and fee cap means that the higher education deduction produces a maximum reduction in income tax liability of $600 for a family with a 15% marginal tax rate and of $1,000 for family with a 25% marginal tax rate, both of whom have an AGI below the credit's income phase-out range. At $4,000 in qualified expenses, the Lifetime Learning credit is worth $800 (0.20 x $4,000), which is a smaller tax savings than the deduction affords for the family with the higher (25%), but not lower (15%), marginal tax rate.

Generally, for families who have an AGI that allows them to take the full Lifetime Learning credit or the deduction, who incur tuition and fees of $4,000 or less, and who have a marginal tax rate above 20%, the deduction will be worth more than the credit.

   Table 3. Examples of Tax Savings from the Higher Education

 

                   Tax Credits and Deduction

 

 

                                 Value of tax benefit per return

 

 

                                                     Higher education deduction

 

 

                     Hope           Lifetime           15%             25%

 

  Tuition and     Scholarship       Learning        marginal tax   marginal tax

 

      fees           Credit           Credit           ratea           rateb

 

 

       $350           $350              $70             $53              $88

 

      1,000          1,000              200             150              250

 

      2,000c         1,500              400             300              500

 

      4,000          1,500              800             600            1,000

 

      5,000d         1,500            1,000             600            1,000

 

      7,500          1,500            1,500             600            1,000

 

     10,000          1,500            2,000             600            1,000

 

     20,000e         1,500            2,000             600            1,000

 

 

 Source: Congressional Research Service.

 

 

                               FOOTNOTES

 

 

      a Represents married-couple family filing jointly with

 

 one child enrolled full-time in the freshman year of college at an

 

 eligible institution of higher education with an AGI of $56,000,

 

 which is below the Hope and Lifetime Learning credits' income phase-

 

 out range.

 

 

      b Represents married-couple family filing jointly with

 

 one child enrolled full-time in the freshman year of college at an

 

 eligible institution of higher education with an AGI of $82,000,

 

 which is below the Hope and Lifetime Learning credits' income phase-

 

 out range.

 

 

      c Average tuition and fees at two-year public

 

 postsecondary institution is $2,076 in 2004-2005, according to The

 

 College Board, Trends in College Pricing 2004.

 

 

      d Average tuition and fees at four-year public

 

 postsecondary institution is $5,132 in 2004-2005, according to The

 

 College Board, Trends in College Pricing 2004.

 

 

      e Average tuition and fees at four-year private

 

 postsecondary institution is $20,082 in 2004-2005, according to The

 

 College Board, Trends in College Pricing 2004.

 

END OF FOOTNOTES

 

 

Factors That Determine Benefit Size and Eligibility. The very structure of the Hope and Lifetime Learning credits and the higher education deduction dictates their focus on enhancing postsecondary access for students from middle- and upper middle- income families. For example, as described above, the intensity and level of enrollment can determine whether one is eligible for a Hope credit (i.e., available only to individuals enrolled at least half- time in their first two years of undergraduate education). Two additional sets of factors that pay central roles in determining eligibility and benefit size -- income and tax liability, and qualified and related expenses -- are examined below.

Income and Tax Liability. The Hope and Lifetime Learning credits benefit middle-income families while the deduction extends federal tax benefits for postsecondary education higher up the income scale. (A taxpayer having income above the eligibility ceiling with a student who qualifies for the dependent exemption might decide not to make such a claim in the case of the credits, thereby enabling the student to claim the credit's full value if he/she has income below the phase-out threshold and has income tax liability against which a credit could be taken.)

An individual's tax liability level essentially functions as a floor for the credits. In other words, the Hope and Lifetime Learning credits can only provide assistance to those whose income is not completely offset by standard deductions and personal or dependent exemptions. If an individual's tax liability is below the maximum value of the credit, only the lesser amount may be claimed. According to one analysis based upon tax returns for 1999, "half of the higher education tax credit beneficiaries were not able to take the full credit for which they were eligible."14 Insufficient tax liability to claim an education credit's maximum value can come about not only through low income levels but also through "competing credits." In other words, other tax credits for which an individual is eligible, such as the dependent care tax credit, may reduce the filer's income tax liability below the amount of the education credits. For instance, if a tax filer has $1,000 in tax liability and qualifies for a $480 dependent care tax credit, $1,500 Hope credit for one student, and a $1,000 Lifetime Learning credit for another student, the filer can only receive a total tax benefit of $1,000 (i.e., the tax liability is less than the aggregate of credits for which the taxpayer is eligible).

Taxpayers seeking to claim the education credits also may be affected by the alternative minimum tax provisions that limit the aggregate nonrefundable personal credits a taxpayer can claim. As a result, some of these taxpayers may find the deduction to be a preferable option.

In contrast to the credits which reduce an individual's tax liability on a dollar for dollar basis, the deduction reduces a taxpayer's AGI. As previously shown, the potential impact of that reduction on tax liability is realized through the taxpayer's marginal tax rate. Further, some taxpayers may have such limited tax liability before the application of the deduction that its actual benefit will be small.

Qualified Tuition and Related Expenses. Students attending postsecondary education institutions where the qualified higher education expenses are less than the maximum allowable tax benefits will not be able to claim their full benefits. At many public institutions, low tuition and fee levels are likely to limit the ability to realize the full tax benefits. For the Hope credit, qualified higher education expenses must be at least $2,000 for the maximum credit to be realized. As noted in Table 3, two-year public institutions have tuition and fees in 2004-2005 that are -- on average -- about that level ($2,076). Realizing the full value of the Lifetime Learning credit may be difficult for many students at public institutions in general: qualified expenses have to be at least $10,000 to actualize the maximum Lifetime Learning credit of $2,000, while the average tuition and fees at four-year public institutions in 2004-2005 is a much lower $5,132.

For the deduction, a taxpayer can claim the maximum tax-rate- dependent value only if qualified expenses were $4,000 in 2005. At $4,000, only the average tuition and fees at two-year public institutions are less. The cap on qualified expenses remains below but is close to the average of $5,132 at four-year public institutions in 2004-2005. In contrast, the average tuition and fees of $20,082 at four-year private institutions in 2004-2005 far exceeds any of the tax benefit maximums. Tuition and fees are probably sufficiently high at many of these institutions to pose no barrier on their own to realization of the full value of the credits and deduction.

The ability to capture the full value of these tax benefits is further limited by their being claimed to reimburse students and their families only for the net cost of qualified expenses, that is, the qualified expenses remaining after any non-taxable educational assistance received (exclusive of loans and gifts) is subtracted. This reduces if not eliminates the tax benefits for many students receiving relatively large amounts of grant or scholarship aid. This is particularly the case for students receiving relatively large federal Pell Grant awards. Pell Grants are need-based grants that, in the 2004-2005 award year, provide a maximum of $4,050 to the neediest students (i.e., students whose families are expected to contribute no resources toward postsecondary education costs). Students attending institutions with low tuition and fee charges and receiving large Pell Grants may have little or no net qualified expenses remaining for which to claim an education credit or deduction. At the same time, these low-income students and their families may not have much if any tax liability, also restricting their ability to benefit from the credits or deduction.

As a result, students attending higher cost institutions, and those receiving relatively little grant or scholarship aid, are well positioned to capture a good deal of the potential value of their Hope and Lifetime Learning credits and higher education deduction, assuming their families have sufficient tax liability to realize the maximum benefit from the credits or deduction.

Relationship to the Traditional Student Aid Delivery System

The introduction of the higher education tax benefits represented a departure from the federal government's more common practice of primarily making aid available through the traditional student aid delivery system. Given that the federal government is the primary provider of direct aid to students, and tax benefits have quickly grown to become a major component of the federal aid effort, considerable discussion has emerged related to the merits of providing aid through the tax system.

Providing student financial support toward meeting the costs of college through the federal income tax system has a number of advantages and disadvantages relative to the traditional process of providing grants, loans, and work support. Relevant issues are explored below.

Timing of Awards. One issue that distinguishes the traditional student aid system and the tax system is the timing of the awards. The traditional system provides aid such as grants and loans just in advance of the arrival of tuition bills. Tax credits and deductions, in contrast, require families to make an initial capital outlay which is reimbursed in the form of tax refunds arriving near the end of or after an academic year. This difference may limit the attractiveness of the tax system, particularly for lower income students who may not be able to meet current expenses that will be partly or fully reimbursed by a later tax benefit. Nevertheless, it is possible for taxpayers to adjust their tax withholding throughout the year in order to realize the tax benefits earlier. This would require some sophistication on the part of taxpayers. Further, for students enrolling in consecutive years, the tax benefit for a previous year may be provided in time to help meet the upcoming year's educational expenses. Finally, to the extent that the current tax benefits are available primarily to middle- and upper middle-income individuals, the timing issue may be less important.

Disbursement of Aid. Tax credits and deductions may offer the advantage of streamlined delivery of funds to aid recipients who directly claim their financial assistance as part of their annual tax-filing process. Most other aid is delivered through relatively cumbersome and labor-intensive processes that require considerable effort on the part of financial aid officers, ED personnel, and loan servicers, in the case of loans, who must collectively certify student eligibility for aid, monitor enrollment status, disburse funds, and deal with refunds and account reconciliation.

Still, some have criticized the complexity of the process for taxpayers seeking to claim the tax benefits.15 Further, there are institutional reporting requirements associated with the tax provisions that initially were viewed by some in the higher education community as potentially burdensome and expensive. TRA, as interpreted by the IRS, requires educational institutions to report to the IRS a broad array of data for any individual enrolled for academic credit for whom the institution receives tuition and fee payments. Of particular concern had been the requirement for institutions to report to the IRS for each student: the identity of the taxpayer claiming the student as a tax dependent and the aggregate amounts of qualified expenses paid, scholarship and grant aid received, and aggregate refunds made. Although the IRS limited the reporting requirements during the first four years of implementation (1998-2001) to less than those stipulated by the TRA, even these more limited reporting requirements were criticized as costing institutions substantial resources.16 P.L. 107-131 (signed into law on January 16, 2002) modifies some of the reporting requirements. Among other changes, it repeals the requirement regarding reporting of information about taxpayers who can claim students as dependents, and permits reporting of either the aggregate amounts of qualified expenses paid or the aggregate amounts billed to students. To reflect the changes made by the legislation, the IRS partially withdrew proposed regulations issued June 16, 2000 and proposed new regulations on April 29, 2002 (67 Federal Register 20923).

Overall Complexity of College Financing. Given the extensive system already in place, the addition of the tax benefits, albeit delivered through an arguably more streamlined process, may actually increase the complexity of the overall national effort to help students and their families meet college costs. With the availability of the tax credits and the deduction, students and their families seeking to realize as much federally financed support as possible for college expenses must navigate not only the traditional financial aid system but also the federal income tax system. Potentially, the tax benefits may more likely be claimed successfully by sophisticated filers.

Direct Effect of Tax Benefits on Traditional Student Aid. The potential for a direct effect of these tax benefits on traditional student aid differs substantially between federal aid and non-federal aid.

Effect on Federal Student Aid. By statute, the receipt of the tax credits is to have no effect on a student's eligibility for, or level of, federal student aid. First, in calculating what a student and his or her family is expected to contribute toward college costs (expected family contribution or EFC) under the Higher Education Act (HEA) student aid programs, HEA Section 480(a)(2) states that the tax credits cannot be considered income or assets for purposes of that calculation. Second, HEA Section 480(j)(3) provides that the determination of need for HEA Title IV aid programs -- student's cost of attendance minus the EFC and non-Title IV assistance -- is not to include the credits as non- Title IV assistance. Any non-Title IV assistance included in this calculation reduces a student's need and, hence, his or her eligibility and level of assistance under need-based Title IV aid. There is no comparable language in the HEA governing the interaction between the higher education deduction and the Title IV assistance. As a result, it is possible that some taxpayers who benefit from the deduction (i.e., have less federal income tax liability) will, in turn, be found to have less financial need for traditional student aid.

Tax benefits and Title IV aid may interact, however, in the federal funding process. It is possible that, in congressional deliberations over the budget and spending for federal programs, the forgone tax revenue associated with the tax benefit provisions may have a negative impact on the willingness or ability of the Congress to devote funds to the traditional federal student aid programs.

Effect on Packaging of Other Aid. The limited evidence available suggests that financial aid officers are far from uniform in whether or how they consider the tax benefits when packaging financial aid for students. Indeed, it is not clear whether the majority actively factors the tax benefits into this process at all.

Financial aid officers who want to factor the tax credits into their aid packaging calculations may find the effort complicated by the absence of information about the actual value of the tax benefits students will receive. As noted earlier, tax benefits are claimed and their value known by April 15 of the year after the payment for qualified expenses are made.

Certain other aspects of the design of the tax benefits may make it difficult to infer their value before they are claimed. The actual value of the tax benefits to recipients is affected by a series of offsets and limitations that are built into the design of the tax system (for example, as explored earlier, a recipient must have sufficient tax liability to claim the credit and even then the value of the credit may be reduced by competing credits that can be claimed). The potential effects of these internal offsets and limitations make it hard for financial aid officers to project the value of the credit when packaging aid.

Those financial aid officers who would take the tax provisions into account in packaging aid, and thereby, reduce other kinds of aid for recipients, must make assumptions about the benefits' value. If gaps exist between the credits' actual and assumed value the recipients may receive more or less aid than intended.

Effect on State Decisions Related to Tuition Levels and Available Sources of Aid. The effect of the tax benefits on the setting of tuition levels by states is largely unknown. State higher education officials face challenges similar to those faced by financial aid officers stemming from the hidden value of tax credits. They must make decisions about tuition levels at state institutions and about the structure and targeting of state aid programs which can be shaped in part by assumptions about the value of aid that they expect will be available to students. Precisely gauging the net financial benefit flowing from the tax benefits is problematic; however, some states have considered, at least, raising the tuition and fees in some schools in order to enable their students to "capture" as much of the tax benefits as possible. Some states have also considered targeting their state grant programs in ways that avoid inhibiting students' ability to capture the full value of other credits.17 Such decisions regarding tuition and aid will affect whether and how the tax benefits will enhance recipients' ability to finance postsecondary education.

 

FOOTNOTES

 

 

1 Internal Revenue Service, "Individual Income Tax Returns, Preliminary Data, 2003," Statistics of Income Bulletin, winter 2004-2005. (Hereafter cited as IRS, Individual Income Tax Returns, Preliminary Data, 2003.)

2 A minority of new loan volume consists of federal funds; the majority is private capital supported by federal loan guarantees and subsidies.

3 While still dominant, the portion of student aid that is being awarded dependent on need may be declining. As reported by the Advisory Committee on Student Financial Assistance, "At the state level, new grant aid has shifted steadily in favor of merit-based aid and against need-based aid." (Access Denied: Restoring the Nation's Commitment to Equal Educational Opportunity, Feb. 2001, p. 8.) The Committee reports that 18.6% of state grant aid funds is now merit-based.

4 Only individuals with income tax liability can benefit from a nonrefundable tax credit. A nonrefundable credit cannot be worth more than the amount of the tax liability. In contrast, if the value of a refundable credit exceeds tax liability, the federal government pays the taxpayer the amount of the difference between the two.

5 Expenses paid by a dependent or someone other than the filer, spouse, or dependent are treated as if paid by the taxpayer.

6 The first two years of postsecondary education can include two one-year certificate programs. See 67 Federal Register 76687 (Dec. 26, 2002), where the Hope and Lifetime Learning credits' final regulations are published.

7 In general, taxpayers' modified adjusted gross income equals their adjusted gross income (AGI). For taxpayers who exclude income earned abroad or from certain U.S. territories or possessions, modified AGI is their AGI increased by those excluded amounts.

8 An above-the-line deduction is taken as an adjustment to taxpayer's gross income on IRS 1040 form, and therefore can be claimed whether or not the taxpayer itemizes deductions. A deduction affects the calculation of AGI. Unlike a credit, it does not directly affect income tax liability.

9 For additional information, see CRS Report RS21870, Education Tax Benefits: Are They Permanent or Temporary? by Linda Levine.

10 Unlike the credits, if an eligible student qualifies as a dependent of his/her parents -- regardless of whether the parents take an exemption for their child -- the parents can take the higher education deduction only if they actually pay the qualified expenses. Even if the dependent student paid the qualified expenses, no one could claim the higher education deduction.

11 The marginal tax rate is the tax rate applied to the last additional dollar of income.

12 Among other more narrowly targeted benefits for individuals seeking to upgrade skills is employer education assistance.

13 Before 2003, when the Lifetime Learning credit was 20% of the first $5,000 in qualified expenses for a maximum of $1,000 per return, the Hope credit generally was more valuable regardless of the number of eligible students and the amount of qualified expenses.

14 Bridget Terry Long, The Impact of Federal Tax Credits for Higher Education Expenses, NBER Working Paper 9553 (Cambridge, MA: National Bureau of Economic Research, Feb. 2003). (Hereafter cited as Long, The Impact of Federal Tax Credits.)

15 See, for example Thomas R. Wolanin, Rhetoric and Reality: Effects and Consequences of the HOPE Scholarship, The Institute for Higher Education Policy, Apr. 2001. (Hereafter cited as Wolanin, Rhetoric and Reality.)

16 The IRS partially withdrew proposed regulations issued June 16, 2000 that would have implemented most of the information reporting requirements in the TRA. To take into account changes made by P.L. 107-131, the IRS proposed new regulations on Apr. 29, 2002 (67 Federal Register 20923). Institutions would be required to file information returns that report on, among other things, the aggregate amounts of qualified expenses paid during a calendar year with respect to a student, scholarships or grants for payment of a student's costs of attendance that the institution administered and processed during the calendar year, any reimbursements or refunds of qualified expenses during the calendar year with respect to a student that relate to payments of qualified expenses reported by the institution for a prior calendar year, and the amount of any reductions to scholarships or grants for payment of a student's costs of attendance reported by the institution for a prior calendar year. The IRS would not require institutions to report the name, address, and taxpayer identification number of taxpayers who claim students as dependents for federal income tax purposes.

17 One recent analysis that has explored available information on this issue concludes that the Hope Scholarship provides resources that "are an incentive for private and public institutions of higher education to increase tuition or to reduce aid to students. Indeed, the HOPE Scholarship benefits institutions of higher education only if they raise tuition or decrease student aid. Several states have considered or undertaken strategies to capture the HOPE Scholarship through either tuition increases or aid reduction." (Wolanin, Rhetoric and Reality, p. 29) Another analysis suggests that the inception of the credits was associated with disproportionately large tuition increases among schools whose previous tuition levels were less than needed to maximize the Hope credit. (Long, The Impact of Federal Tax Credits.)

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Stoll, Adam
    Levine, Linda
  • Institutional Authors
    Congressional Research Service
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2005-11635
  • Tax Analysts Electronic Citation
    2005 TNT 102-46
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