CRS Updates Report on Education Tax Benefits

The Taxpayer Relief Act of 1997 (P.L. 105-34) established two permanent federal income tax credits -- the Hope Scholarship and Lifetime Learning Credits -- for qualified postsecondary education expenses. Since tax year 1998, persons with income tax liabilities¹ may subtract from them the tuition and related fees paid on behalf of students (e.g., a child, spouse, or themselves) claimed as exemptions on their returns. Before determining the amount of the tuition and fees for which the credits can be claimed, qualified expenses must be reduced by any tax-free scholarships and financial aid (e.g., Pell Grants) awarded to the student. The two credits are intended to aid different student populations: for the Hope credit, students enrolled at least half-time in a program leading to an educational credential who are in their first two years of postsecondary school; and for the Lifetime credit, students enrolled in one or more courses at the undergraduate or graduate level who need not be pursuing an educational credential. The Hope credit is capped at $1,500 per student in tax year 2005, and the Lifetime credit at $2,000 per return. Only one of the credits may be claimed for a given student. In tax year 2005, the amount of the credits is gradually reduced for a single return tax filer with a modified adjusted gross income (AGI) between $43,000 and $53,000 (a joint filer, between $87,000 and $107,000). AGI limits may be adjusted annually for inflation.²

The Education Savings Bond program, which became effective in 1990 pursuant to Section 6009 of the Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647) is permanent as well. Bond owners who apply the principal and interest of Series EE and I bonds toward tuition and related fees on behalf of a dependent student at the undergraduate or graduate level in the same year in which the bonds are redeemed may be eligible to exclude the interest from their taxable income. The bond must be registered in the taxpayer's and/or spouse's name rather than the dependent's name. The taxpayers must claim an exemption for the student and must meet AGI limits in the year in which bond proceeds are used toward tuition and related fees. In tax year 2005, the exclusion begins to phase out at an AGI above $61,200 for a single filer and above $91,850 for a joint filer. The exclusion cannot be taken by single filers whose AGI is at least $76,200 (for joint filers, $121,850). AGI limits may be adjusted annually for inflation.³

Temporarily Authorized Provisions

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, P.L. 107-16) extended through December 31, 2010 the temporary exclusion for employer-provided educational assistance, which was set to expire for courses beginning after December 31, 2001. It also allowed the $5,250 annual limit on education assistance to again cover graduate as well as undergraduate courses. The income exclusion originated with enactment of the Revenue Act of 1978 (P.L. 95-600).⁴

The Higher Education Deduction originated in EGTRRA. It was authorized for tax years 2002 through 2005. Unless extended by the 109^th Congress, it will not be available to taxpayers filing 2006 returns. Both itemizers and non-itemizers were able to deduct tuition and related fees from taxable income (i.e., it is "above-the-line"). It was meant to assist the same student population as the Lifetime credit, but the deduction extended to taxpayers with incomes somewhat above the limit for the credit (i.e., an AGI of $65,000 or less for a single filer/$130,000 or less for a joint filer). It was capped at $4,000 per return in tax years 2004 and 2005, and could not be taken for the same student for whom a Hope or Lifetime credit is claimed. A smaller deduction, capped at $2,000 annually, was temporarily available to higher income taxpayers whose AGI did not exceed $80,000 for a single return and $160,000 for a joint return in tax years 2004 and 2005. Neither the amount of the deduction nor the AGI limits were adjusted for inflation, and the amount of the deduction was not phased out as AGI increases.⁵

The above-the-line deduction for classroom expenses of elementary and secondary (K-12) school educators initially was authorized for tax years 2002 and 2003 in the Job Creation and Worker Assistance Act of 2002 (P.L. 107-147). It was reauthorized retroactive to its expiration date and through December 31, 2005 as part of the Working Families Tax Relief Act of 2004 (P.L. 108-311). Like the higher education deduction, it too will be unavailable to taxpayers filing 2006 returns unless the classroom expense deduction is reauthorized by the 109^th Congress. The deduction was available to teachers, instructors, counselors, principals, and aides employed at least 900 hours in a school year at public and private K- 12 schools. It was limited to $250 for purchases of certain items (e.g, books and supplies) used by educators in the classroom.⁶

Permanently Authorized Provisions with Temporary Amendments

EGTRRA changed temporarily, typically for tax years 2002 through 2010, certain aspects of three other permanently authorized education tax benefits. Two of the benefits are meant to encourage individuals to save toward future educational expenses (i.e., the Coverdell Education Savings Accounts and Section 529 Programs). The third is the Student Loan Interest Deduction.

Coverdell Education Savings Accounts (CESAs). These trust or custodial accounts originated as Education IRAs in P.L. 105-34 for the purpose of providing a tax-free savings vehicle for higher education expenses. They became available in 1998. The appeal of the permanently authorized CESAs was enhanced in EGTRRA starting in tax year 2002, but on January 1, 2011, absent congressional action, the following modifications will be supplanted by their prior versions:⁷

• The annual limit on individuals' after-tax contributions to a beneficiary's account was quadrupled to $2,000 from $500.

• The "marriage penalty" was eliminated as well, such that a joint filer with an AGI below $220,000 is now eligible to make contributions to CESAs compared to prior law when their AGI had to be below $160,000.

• CESA withdrawals accorded tax-free treatment were extended from payment of qualified higher education expenses (e.g., tuition, books, and supplies) to payment of qualified K-12 expenses (e.g., tuition, tutoring, computers, supplies, and uniforms).

• Higher education expenses were expanded to include, for example, special needs services for special needs beneficiaries.⁸ For special needs beneficiaries, the under-18 age limit for contributions to CESAs was eliminated, as was the requirement that funds in CESAs generally be distributed to beneficiaries by age 30.

• The date by which contributions to CESAs can be made was extended to the tax filing date for that year (e.g., April 15, 2005 for 2004 contributions rather than December 31, 2004). The length of time for corrective withdrawals of excess contributions and associated earnings to avoid a 6% excise tax was extended to June 1 from the due date of the beneficiary's tax return for the contribution year (e.g., from April 15 to June 1, 2005 for 2004 contributions).

• The definition of a beneficiary's family members was extended to first cousins into whose accounts funds may be rolled over tax-free from existing accounts and who may be named as new beneficiaries of existing accounts. This too is the case for Section 529 Programs (see below).

• Before determining the qualified expenses that CESA withdrawals can offset, expenses must be reduced by the amount of tax-free scholarships and financial aid (e.g., Pell Grants). Taxpayers then can claim a Hope or Lifetime Credit or a Higher Education Deduction for the remaining tuition and fees of a given student, as well as make tax-free withdrawals from CESAs if the withdrawals do not go toward the same expenses for which the other benefits are claimed. (Before January 1, 2002, taxpayers could not claim the credits unless they waived the tax-free treatment of CESA withdrawals.) If, through December 31, 2010, CESA withdrawals become taxable because of receipt of tax-free assistance and of education credits or deductions, the withdrawals will not be subject to the 10% tax penalty usually assessed nonqualified distributions. The Section 529 Program is similarly governed through tax year 2010, during which time qualified withdrawals are not taxable.

Student Loan Interest Deduction. An above-the-line deduction from taxable income of up to $2,500 in annual interest payments on student loans was permanently authorized as of 1998 in the Taxpayer Relief Act of 1997. The loans must have been used toward the cost of attendance for students enrolled at least half-time in undergraduate and graduate programs leading to an educational credential. In tax years 2002 through 2010, the deduction no longer is restricted to interest paid within the first 60 months during which interest payments are required. Unlike under prior law, EGTRRA also allows voluntary payments of interest to be deducted over the period. In addition, the act temporarily raises the AGI of a taxpayer who may claim the tax benefit (from $55,000 to $65,000 for a single filer and from $75,000 to $130,000 for a joint filer) effective in 2002. From tax year 2003 through 2010, the income limits may be adjusted annually for inflation.

• Subtitle A -- Education Savings Incentives;

• Subtitle B -- Educational Assistance;

• Subtitle C -- Liberalization of Tax-Exempt Financing Rules for Public School Construction; and

• Subtitle D -- Other Provisions (i.e., section 431's establishment of the Higher Education Deduction (HED).

H.R. 1380 would repeal Title IX as it relates to Subtitles A, B, and D of Title IV, and make the HED permanent through repeal of Section 222(e) of the Code. Unlike H.R. 1380, H.R. 941 would eliminate application of EGTRRA's Title IX to Subtitle D (the HED) only. Like H.R. 1380, H.R. 941 would make the deduction permanent by repealing Section 222(e) of the IRC. In contrast, S. 15 and S. 759 (a broadly crafted bill) would remove application of EGTRRA's Title IX to the HED at Subtitle D, while H.R. 117 and H.R. 2564 would make the HED permanent by deleting Section 222(e).

H.R. 1380 also addresses EGTRRA's temporary increase in the annual limit on contributions to CESAs. The bill would further raise the cap from $2,000 to $5,000 effective beginning after December 31, 2005, rather than allowing the ceiling to revert to its original level of $500 on January 1, 2011 due to the sunset provision. S. 75 would similarly increase the CESA contribution limit to $5,000 and make the change permanent.

H.R. 2386/S. 1112 and H.R. 2994 would repeal EGTRRA's sunset provision as it relates to the act's enhancement of Section 529 programs.

² For additional information, see CRS Report RL31129, Higher Education Tax Credits and Deduction: An Overview of the Benefits and Their Relationship to Traditional Student Aid, by Adam Stoll and Linda Levine. (Hereafter cited as CRS Report RL31129, Higher Education Tax Credits and Deduction.)

³ For additional information, see CRS Report RL32155, Tax-Favored Higher Education Savings Benefits and Their Relationship to Traditional Federal Student Aid, by Linda Levine and James B. Stedman. (Hereafter cited as CRS Report RL32155, Tax-Favored Higher Education Savings Benefits.)

⁴ For additional information, see CRS Report 97-243, The Current Status of Employer Education Assistance, by Linda Levine.

⁵ CRS Report RL31129, Higher Education Tax Credits and Deduction.

⁶ For additional information, see CRS Report RS21682, The Tax Deduction for Classroom Expenses of Elementary and Secondary School Teachers, by Linda Levine.

⁷ For additional information, see CRS Report RL32155, Tax-Favored Higher Education Savings Benefits.

⁸ Definitional changes relate to room and board as well. They similarly apply to Section 529 Programs.

⁹ CRS Report RL32155, Tax-Favored Higher Education Savings Benefits; and CRS Report RL31214, Saving for College Through Qualified Tuition (Section 529) Programs, both by Linda Levine.