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CRS Updates Report on Tax-Favored Incentives for Higher Education

JAN. 13, 2006

RL32155

DATED JAN. 13, 2006
DOCUMENT ATTRIBUTES
  • Authors
    Levine, Linda
    Mercer, Charmaine
  • Institutional Authors
    Congressional Research Service
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2006-1863
  • Tax Analysts Electronic Citation
    2006 TNT 21-28
Citations: RL32155

 

CRS Report for Congress

 

Received through the CRS Web

 

 

Order Code RL32155

 

 

Updated January 13, 2006

 

 

Linda Levine

 

Specialist in Labor Economics

 

Domestic Social Policy Division

 

 

Charmaine Mercer

 

Analyst in Social Legislation

 

Domestic Social Policy Division

 

 

Summary

Reflecting the desire among Members of Congress to help middle- income families pay for the escalating cost of higher education, the Congress has passed and enhanced a variety of tax benefits since 1990. These federal income tax benefits may be categorized in two ways: (1) those intended to encourage taxpayers to save for future postsecondary education expenses, and (2) those meant to help taxpayers meet current higher education expenses. The first group, on which this report focuses, is composed of Education Savings Bonds, Section 529 (prepaid tuition and college savings) Programs, and Coverdell Education Savings Accounts (formerly, Education IRAs). The second group (e.g., the Hope Scholarship Credit, Lifetime Learning Credit, and the Higher Education Deduction) and its relationship to eligibility for traditional federal student aid is the subject of CRS Report RL31129.

An Education Savings Bond is a series EE bond issued after December 31, 1989 or a Series I bond owned by an individual who was at least 24 years old on the date the bond was issued; the bond must be registered in the name of the taxpayer and/or spouse who claim the student as a dependent on their tax return. Taxpayers, depending on their income at the time of school enrollment, may be able to exclude from income the interest earned on bonds redeemed to pay tuition and required fees. The bonds are little utilized for educational purposes. The very popular Section 529 Programs are sponsored principally by states and enable virtually anyone to make contributions toward the future higher education expenses of designated beneficiaries. Section 529 prepaid tuition plans, which operate as a hedge against tuition inflation, typically cover tuition and fees. Section 529 college savings plans, which function much like mutual funds, cover the cost of attendance. Each 529 prepaid tuition and college savings plan is controlled by its account owners, who may change beneficiaries and have the account balances refunded to them if they desire. A Coverdell Education Savings Account is a trust or custodial account that similarly allows money to be saved for a beneficiary's cost of attendance. Unlike 529 Programs, however, the "responsible individual" who manages a Coverdell Account cannot have the contributions to and tax-exempt earnings accumulated in Coverdell Accounts refunded to him/her. Typically, the balances in Coverdell Accounts must be given to the beneficiaries shortly after they reach 30 years of age.

These tax benefits may affect students' eligibility for traditional federal financial aid. For most aid applicants, this impact is felt to the extent that the net worth of these savings vehicles and income from them are expected to be contributed toward postsecondary education expenses under the traditional system; a greater expected family contribution (EFC) can lead to reduced financial need and decreased eligibility for need-based aid. The treatment of each of these tax benefits in the determination of the EFC can differ sharply. Further, applicants for federal financial aid often do not receive clear guidance from the Department of Education as to whose assets or income these are, and how they are to be reported on their applications. Congress is addressing some aspects of the relationship between traditional student aid and education savings benefits during its ongoing reauthorization of the Higher Education Act. This report will be updated as warranted.

 Contents

 

 

 Introduction

 

 

 Tax-Advantaged Higher Education Savings Provisions

 

 

      Education Savings Bonds

 

      Section 529 or Qualified Tuition Programs

 

      Coverdell Education Savings Accounts

 

 

 Relationship to Eligibility for Traditional Federal Student Aid

 

 

      Traditional Federal Student Aid and the EFC

 

      EFC Treatment of Each Savings Benefit

 

      Concluding Issues

 

 

 List of Tables

 

 

 Table 1. Major Features of Education Savings Bonds, Section 529 or

 

 Qualified Tuition Programs, and Coverdell Education Savings Accounts

 

 

Policymakers have been concerned that a college education is becoming less affordable for middle-income families because the rise in tuition has outpaced the increase in average household income for the past two decades.1 As a reflection of the desire among Members of Congress to keep postsecondary education broadly available to the U.S. population, the Congress has passed and enhanced a variety of tax benefits toward that end since 1990.

This report examines three tax-favored savings incentives for higher education, namely, Coverdell Education Savings Accounts, Section 529 or Qualified Tuition Programs, and Education Savings Bonds. It omits discussion of some other forms of tax-advantaged savings that were created primarily for other purposes (e.g., Individual Retirement Accounts)2 and for which higher education is just one of many possible uses (e.g., Uniform Gift or Transfers to Minors Accounts).3 It then explains the interaction between the three postsecondary education tax benefits and the process of determining student eligibility for traditional federal financial aid, consisting of grants, loans, or work-study income.

 

Introduction

 

 

The federal income tax measures specifically intended to assist individuals meet higher education costs may be categorized in two ways:

 

1. those provisions intended to encourage taxpayers to save for future postsecondary education expenses, and

2. those provisions meant to help taxpayers meet current postsecondary education expenses.

 

The first group is composed of Education Savings Bonds, Section 529 or Qualified Tuition Programs, and Coverdell Education Savings Accounts (formerly known as Education IRAs). To take advantage of these incentives, taxpayers must be financially able to set aside money from current income for educational costs they or others (e.g., their children) may incur in years to come. The second group includes the Hope Scholarship Credit, the Lifetime Learning Credit, and the Higher Education Deduction.4

All education tax benefits share two characteristics. First, individuals must have a federal income tax liability for the measures to be of value to them. In tax year 2005, for example, a married- couple with one child having personal and dependency exemptions of $9,600 ($3,200 x 3) and taking the standard deduction ($10,000) would have no federal income tax liability with an adjusted gross income at or below $19,600. Second, these provisions, like others in the Internal Revenue Code (IRC), are paid for through revenue losses to the government rather than through appropriations by the government.

The IRC sets forth how the tax incentives dedicated to assisting individuals finance a postsecondary education are coordinated with one another. They interact not only with each other, but also with the traditional student aid system. That is to say, the use of these tax provisions may affect the government's calculation of student eligibility for need-based federal financial assistance, such as Pell Grants. The relationship between the federal income tax system and the traditional federal student aid system, for which Congress appropriates funds, generally is determined by how certain items reported on tax returns (e.g., unearned income including interest and dividends) are treated on the Free Application for Federal Student Aid (FAFSA). The FAFSA is administered by the U.S. Department of Education (ED).

While the Committee on Ways and Means in the House and the Committee on Finance in the Senate have jurisdiction over tax matters, the Education and the Workforce Committee in the House and the Health, Education, Labor, and Pensions Committee in the Senate have jurisdiction over education issues. The Congress currently is engaged in reauthorization of the Higher Education Act (HEA, P.L. 89- 329 as amended by P.L. 105-244). The HEA last was revisited in 1998, before some of the education tax measures were in effect (e.g., the Higher Education Tax Deduction) or were made more attractive (e.g., Coverdell Education Savings Accounts and Section 529 Programs).5

The manner in which higher education tax benefits are treated in determining eligibility for traditional student aid is being addressed during reauthorization of the HEA.6 Particularly in an era of heightened concern about the ability of families to afford postsecondary education in the face of rising college prices, the Congress may consider whether steps are necessary to reconcile the tension between encouraging families to save for postsecondary education and providing financial aid based on families' need for assistance.7 Attention may be paid, as well, to questions of equity and consistency in how the traditional student aid system treats these tax-favored savings benefits.

 

Tax-Advantaged Higher Education Savings Provisions

 

 

Education Savings Bonds

Working in chronological order by date of enactment, we start with so-called Education Savings Bonds (ESBs). The program became effective in 1990 pursuant to Section 6009 of the Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647), which created a new Section 135 in the IRC. It applies to otherwise eligible owners of Series EE bonds issued after December 31, 1989 and Series I bonds. Bond owners are not required to indicate at the time the bond is purchased that the proceeds will be used for educational purposes.

Taxpayers who apply the principal and interest of these bonds toward qualified higher education expenses (QHEEs) in the same year in which the bonds are redeemed may be eligible to exclude all or part of the interest earned from their income for federal tax purposes. Ordinarily, the interest would be subject to federal income tax at the applicable marginal tax rate for individuals with tax liabilities not fully offset by their personal/dependency exemptions, deductions, and credits. For example, families with income tax liabilities who are in the 15% tax bracket would pay $75 in taxes on interest of $500 (0.15 x $500) which is recognized when the bond is redeemed, while a family in the 25% tax bracket would pay $125 (0.25 x $500).8 Generally then, the higher a taxpayer's marginal tax rate, the more valuable an exclusion from income.

In order for the interest of a bond used to pay QHEEs to be excluded from gross income, it must have been registered in the taxpayer's name and/or the spouse's name -- not in the dependent child's name alone or as co-owner.9 Bond owners also must have reached age 24 before the issue date of the bonds,10 which limits the utility of the program to students under 29 years old who file tax returns separately from their parents.11 Consequently, the program may be more useful to persons who expect to take courses during their working lives. Further, grandparents can only obtain federal tax savings from Series EE or I bonds used to pay their grandchildren's postsecondary education expenses if the students are dependents on the grandparents' income tax return.

Taxpayers with students for whom they take exemptions (e.g., themselves, their spouses, and their children) must meet income requirements in the year in which bond proceeds are used toward QHEEs in order to claim the tax benefit. Persons whose modified adjusted gross income (MAGI) is $76,200 or more ($121,850 or more for filers of joint returns) in tax year 2005 may not take the exclusion.12 The amount that can be subtracted from income is gradually reduced for taxpayers whose MAGI is above $61,200 ($91,950 for married-couples filing jointly and for qualifying widows or widowers).13 These income levels are adjusted annually for inflation. If a family at the time of bond purchase underestimates their future income, they may be unable to take the income exclusion and also may have to pay more tax on the interest than if the bond had been purchased in the child's name.14 But, if the bonds are in the student's name, it could be more disadvantageous to the student's eligibility for traditional federal aid than if the bonds were in the parents' name. (The effect on aid eligibility of who is considered an asset's owner will be examined later in the report.)

As in the case of Section 529 Programs and Coverdell Education Savings Accounts, ESBs may be used to pay the QHEEs of eligible students taking courses at the undergraduate and graduate degree level. Similarly, to be eligible for the three tax benefits, a student must be enrolled in or attend a college, university, vocational school or other postsecondary institution that participates in an ED-administered student aid program. (Table 1 provides a side-by-side comparison of the major features of ESBs, 529 Programs, and Coverdell Accounts.)

Qualified expenses are defined as tuition and related fees at eligible institutions. Contributions of ESB proceeds to 529 Programs and Coverdell Accounts also are considered QHEEs (i.e., interest may be excluded from income if the bond's redeemed value is contributed to the other education savings programs). Taxpayers may wish to contribute ESBs to the other savings vehicles if their MAGI were to exceed the threshold for tax-free treatment of bond interest when their dependents attend postsecondary school.

The bond's redeemed value is applied against adjusted qualified expenses, that is, QHEEs must be reduced by any tax-free educational assistance (e.g., Pell Grants, scholarships, veterans' educational assistance, and employer-provided educational benefits). If the proceeds from a bond are more than the student's adjusted QHEEs, the taxpayer can exclude from income only a pro rata share of the interest. For example, let us assume that (1) a dependent child attends a college charging the 2004-2005 average tuition and fees of $5,132 at four-year public institutions,15 and receives a Pell Grant of $2,400 as well as a tax-free scholarship of $1,100 and that (2) an ESB with a total value of $2,000, including $1,000 in interest, is redeemed. Under these circumstances, the taxpayer could exclude $820 from income or 82% of the bond's interest ($1,600 in adjusted QHEEs -- $5,132 less $3,500 in tax-free educational assistance -- divided by the bond's total value). Whether a family has tax savings from the ESB program will thus depend upon whether the student receives traditional aid and the composition of that aid (e.g., aid provided through loans does not reduce the value of QHEEs against which the exclusion can be taken), the amount of tuition and fees actually incurred and, as previously mentioned, the family's income level.

The ESB interest exclusion is coordinated with other IRC provisions to avoid "double-dipping." Higher education expenses paid with bond interest excluded from income cannot be used to calculate other tax benefits, including the Hope Scholarship Credit, Lifetime Learning Credit and Higher Education Deduction, as well as the taxfree portion of withdrawals from 529 Programs and Coverdell Accounts.

Uncertainty about the level of future family income, the kind of traditional financial aid a student will receive, and the amount of tuition and fees charged by the institution a student will attend likely has restrained participation in the ESB program. Factors specific to the program also could have dampened its usage (e.g., only bond owners who claim students as dependents on tax returns can utilize it and the rate of return on government bonds historically has been comparatively low). The Joint Committee on Taxation (JCT) estimates that revenue losses associated with the ESB program typically are below $50 million annually.

Section 529 or Qualified Tuition Programs

Few states sponsored Section 529 or Qualified Tuition Programs before their federal tax treatment was clarified by the Small Business Job Protection Act of 1996 (P.L. 104-188) in Section 529 of the IRC.16 The Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16) more recently promoted interest in 529 Programs by making earnings tax-exempt when withdrawn to pay QHEEs through December 31, 2010. Due in part to this and other enhancements to the program, every state and the District of Columbia is the sponsor of at least one of the two types of 529 Programs and new enrollments have driven much of the growth in their value.17 As of December 31, 2004, there were over 7 million accounts18 and their total asset value was about $65 billion.19

If projections of assets totaling in the hundreds of billions of dollars by the end of the decade prove correct,20 the 529 Program could become quite costly to the government in terms of revenue forgone (i.e., tax expenditures) and a considerable source of federal support for higher education beyond appropriated funds. Although the value excluded from income due to the Section 529 Program is not available from the IRS,21 the JCT estimates that the income exclusion could produce tax expenditures that almost double from $500 million to $900 million between FY2005 and FY2009.22

The two types of 529 Programs are:

  • prepaid tuition plans, operate as a hedge against tuition inflation. Contributors (e.g., parents, grandparents, and non-relatives) purchase tuition credits or certificates, on behalf of beneficiaries, for future QHEEs in state- sponsored programs or programs sponsored by eligible institutions of higher education (including private institutions). Contributions to prepaid tuition plans are pooled and then invested by, or on behalf of, the state or institutional sponsor with the aim of at least matching the anticipated increase in tuition. Similar to ESBs, the balances in prepaid tuition plans typically can be used for tuition and required fees.

  • College savings plans, in contrast, function much like a mutual fund by offering account owners a choice among a variety of investments that financial services firms typically manage for the state sponsors. The value of each beneficiary's account is based upon the performance of the selected investment option, which the account owner may change subject to certain limitations.23 Similar to Coverdell Accounts, the balances in college savings plans can be used to cover the cost of attendance (i.e., tuition, fees, books, supplies, and equipment required for enrollment or attendance; room and board expenses for students enrolled on at least a half-time basis; and expenses for special needs beneficiaries).

 

The majority of 529 Program assets were in prepaid tuition plans through 2000.24 The value of investments in college savings plans has increased greatly, to the point that today they account for the vast majority of 529 Program assets.25

There is no annual limit on contributions to a beneficiary's 529 plan(s). Although contributions are not deductible from income for federal tax purposes,26 many states offer a deduction for state tax purposes.27 There also are no income-related restrictions for 529 Program savers, unlike the case with those who save through ESBs and Coverdells, which likely makes the program particularly attractive to more affluent families.

Federal income tax on earnings that accumulate in the plans is deferred until withdrawn. In addition, the earnings that have built up inside the program are exempt from tax if they are withdrawn to pay QHEEs through December 30, 2010. Thereafter, according to the sunset provisions of P.L. 107-16, they will once again be subject to taxation. Both the permanent deferral and temporary exemption confer greater tax savings on more affluent families because of their higher marginal income tax rates.28

If plan distributions are not used to pay the beneficiary's QHEEs or distributions exceed QHEEs, the earnings are taxable income to the distributee (account owner or beneficiary). In addition, a 10% tax penalty on the earnings portion of nonqualified distributions is assessed the distributee, unless the beneficiary dies, becomes disabled, or receives a tax-free scholarship or educational allowance.

The Taxpayer Relief Act of 1997 (P.L. 105-34) declared that donations to 529 Programs are completed gifts from contributors to beneficiaries even though account owners maintain control of the accounts (e.g., they can change the beneficiary or have the money refunded to them). Contributors can give up to $11,000 in 2005 as a taxfree gift per beneficiary, with the amount adjusted annually for inflation. Taxpayers with substantial resources who want to assist students can gain from a special gifting provision that allows them to donate up to $55,000 per beneficiary in a single year (or $110,000 in the case of two grandparents, for example) by treating the payment as if it were made over five years.

Like the two other higher education savings provisions in the IRC, withdrawals from 529 Programs must be applied against adjusted qualified expenses of students taking courses at the undergraduate and graduate degree level who are enrolled in colleges, universities, vocational schools or other postsecondary institutions that participate in an ED-administered student aid program. That is to say, QHEEs must be reduced by any tax-free educational assistance (e.g., Pell Grants, scholarships, and veterans' educational assistance).

Qualified withdrawals from Section 529 plans also must be coordinated with the other education tax benefits in order to obtain favorable income tax treatment. Although withdrawals can be taken from a beneficiary's 529 plan and Coverdell Account in the same year, the withdrawals will be taxable to the extent they exceed adjusted QHEEs. Further, if 529 Program withdrawals are used to pay the qualified expenses against which a Hope Scholarship Credit, Lifetime Learning Credit, or Higher Education Deduction is taken, they will be subject to taxation.

Coverdell Education Savings Accounts

The most recently enacted higher education tax provision to encourage savings is the Coverdell Education Savings Account. Originated in the Taxpayer Relief Act of 1997 (P.L. 105-34) as the Education Individual Retirement Account at Section 530 of the IRC, it first became available in 1998. It was renamed in P.L. 107-22 effective July 2001, and substantially enhanced in P.L. 107-16 effective January 2002.

A Coverdell Account is a trust or custodial account that enables money to be saved toward the QHEEs of a designated beneficiary who takes undergraduate or graduate courses at any college, university, vocational school, or other postsecondary institution eligible to participate in an ED-administered student aid program. The trustee or custodian must be a bank or another IRS-approved entity. A parent or guardian typically is the "responsible individual," "authorized person," or "manager" named when the account is opened because the beneficiary is a minor at that time. The trustee or custodian generally has policies concerning the nature of the responsible individual's decision-making authority. For example, unlike a 529 Program account owner, the responsible individual cannot have a Coverdell Account's balance refunded to them. However, a trust or custodial agreement may allow the manager of a Coverdell Account to change the beneficiary.29

Among other things, the document establishing and governing a Coverdell Account must specify that the trustee or custodian can only accept contributions in cash (like a 529 Program), that contributions be made before the beneficiary attains age 18 (except for special needs beneficiaries), and that contributions to the account will not cause total contributions per beneficiary for the year to exceed the legal limit. Further, the account's funds cannot be invested in life insurance contracts and cannot be combined with other property except in a common trust fund or common investment fund. (Other than these restrictions, contributions can be invested in any options available through the trustee, such as stocks, bonds, mutual funds, and certificates of deposit.) In addition, the agreement must state that any balance remaining in an account will be distributed to the beneficiary within 30 days after the beneficiary reaches age 30 (other than a special needs beneficiary) or dies, whichever is earlier.

Earnings in Coverdell Accounts generally grow on a tax-deferred basis, which as previously noted, provides greater tax savings to more affluent families because their income is subject to higher marginal tax rates. In addition, withdrawals from the accounts that are applied toward qualified expenses at the elementary, secondary, and postsecondary levels are exempt from federal income tax.30 Unlike qualified withdrawals from the 529 Program, which are tax free only through December 31, 2010, this is a permanent feature of Coverdell Account distributions used to pay the cost of attending an eligible institution of higher education.

As information on qualified withdrawals from Coverdell Accounts does not have to be reported on federal income tax returns, the value excluded from income due to Coverdells is not available from the IRS. (As previously noted, this also is true for the 529 Program during its tax-free period.) The JCT estimates that the earnings exclusion of Coverdell Accounts could produce tax expenditures that range from $100 million annually during FY2005-FY2007 to $200 million annually in FY2008 and FY2009.31 Of the three education savings provisions, then, the 529 Program appears to be the most costly to the Treasury (i.e., provide the greatest benefit to taxpayers) and the ESB Program, the least costly (i.e., provide the smallest benefit).

Any individual taxpayer whose income is below specified levels may make after-tax contributions to Coverdell Accounts of up to $2,000 annually per beneficiary through December 31, 2010. The annual per-beneficiary contribution limit -- which was quadrupled in P.L. 107-16 -- is not adjusted for inflation and will revert to $500 in 2011, absent congressional action. Tax-free rollovers of funds from one Coverdell Account to another of the same beneficiary or to certain family members of a beneficiary do not count against the annual limit.32 Contributions receive favorable gift and estate tax treatment, although not the "5-in-1-year" provision allowed 529 Program contributors as noted above. Also unlike 529 Programs, the beneficiary must pay a 6% tax on excess contributions.

The MAGI of individual taxpayers who contribute to Coverdell Accounts must be below $110,000 ($220,000 for joint return filers).33 The annual limit on contributions is gradually reduced for individual taxpayers with incomes of more than $95,000 but less than $110,000 (more than $190,000 but less than $220,000 for joint return filers). However, parents whose incomes are above the thresholds could give a tax-free gift of up to $2,000 to their child who could deposit the entire amount in his/her account. The income ceilings are not adjusted for inflation and will (under the sunset provisions of P.L. 107-16) revert to $95,000 and $150,000, respectively, after December 31, 2010.

Contributions from corporations and tax-exempt organizations (e.g., a foundation, charity, or union) are not contingent upon income. They thus may donate the maximum annual contribution to accounts of children in families with incomes in the phase-out ranges.

Like 529 college savings plans, qualified withdrawals from Coverdells may pay for tuition, fees, books, supplies, and equipment required for enrollment or attendance; room and board expenses for students enrolled on at least a half-time basis; and special needs services required by a special needs beneficiary. QHEEs also include withdrawals from a beneficiary's Coverdell Account that are contributed to the beneficiary's 529 plan.

With some exceptions, the earnings portion of withdrawals that go toward purposes other than QHEEs or that exceed them is included in the taxable income of the distributee. These nonqualified distributions also are subject to a 10% penalty, unless they are made to a beneficiary or to the beneficiary's estate on or after the beneficiary's death, due to a beneficiary becoming disabled, or due to a beneficiary receiving a tax-free scholarship or educational allowance. In order to determine whether any portion of earnings withdrawn from a Coverdell Account is taxable, the beneficiary's QHEEs must be reduced by any tax-free educational assistance received (e.g., Pell Grants) and be coordinated with other education tax benefits as shown in Table 1.

        Table 1. Major Features of Education Savings Bonds,

 

            Section 529 or Qualified Tuition Programs, and

 

               Coverdell Education Savings Accounts

 

 ____________________________________________________________________

 

 Characteristics

 

 ____________________________________________________________________

 

 Nature of the savings vehicle

 

 

      Education Savings Bonds. -- The bond must be a Series EE bond

 

 issued after 1989, or a series I bond. It must be issued in the

 

 taxpayer's name (if sole owner) or the name of the taxpayer and

 

 spouse (if co-owners).

 

 

      Section 529 or Qualified Tuition Programs. -- A program that

 

 enables funds to accumulate for the purpose of paying the QHEEs of

 

 designated beneficiaries. There are two kinds of Section 529

 

 Programs: prepaid tuition plans and college savings plans. The

 

 former, which can be sponsored by states and higher education

 

 institutions, provides a hedge against inflation by enabling

 

 contributors to pay tuition for future courses at today's prices;

 

 contributions are pooled and invested by the plan sponsor. The

 

 latter, which can only be sponsored by states, allows individuals to

 

 contribute to one of several investment options predetermined by the

 

 plan's sponsor.

 

 

      Coverdell Education Savings Account. -- A custodial or trust

 

 account established expressly to pay the QHEEs of designated

 

 beneficiaries. Accounts may be established for beneficiaries at any

 

 bank or other IRS-approved entity. Contributions can be invested in

 

 any options (except life insurance contracts) available through the

 

 trustee, such as stocks, bonds, mutual funds, and certificates of

 

 deposit. As the beneficiaries typically are minors when the accounts

 

 are opened, parents or guardians generally act as the responsible

 

 individual who is accorded decision-making authority according to the

 

 trustee's policies.

 

 ____________________________________________________________________

 

 Nature of the tax Benefit

 

 

      Education Savings Bonds. -- Interest may be excluded from bond

 

 owner's income if both principal and interest are used to pay QHEEs

 

 of eligible students.

 

 

      Section 529 or Qualified Tuition Programs. -- Earnings on non-

 

 deductible cash contributions to 529 Programs grow tax-deferred until

 

 withdrawn.

 

 

      Coverdell Education Savings Account. -- Same as 529 Programs.

 

 

      Section 529 or Qualified Tuition Programs. -- Earnings withdrawn

 

 from a state-sponsored 529 Program to pay the QHEEs of the plan's

 

 beneficiary from 2003 through 2010 are tax-free.a If

 

 withdrawals are not used to pay QHEEs or exceed their value, the

 

 earnings portion is taxable and generally subject to a 10% additional

 

 tax penalty.

 

 

      Coverdell Education Savings Account. -- Same, except earnings

 

 withdrawn to pay QHEEs are permanently tax-exempt.

 

 

      Section 529 or Qualified Tuition Programs. -- Amounts in a 529

 

 Program can be rolled over tax-free once a year to another 529 plan

 

 of the same beneficiary or to a 529 plan of a member of the

 

 beneficiary's family. The account owner can change a 529 plan's

 

 beneficiary without tax consequences, but the new beneficiary must be

 

 a family member of the original beneficiary.b

 

 

      Coverdell Education Savings Account. -- Same as 529 Programs.

 

 ____________________________________________________________________

 

 For whom can the savings be used?

 

 

      Education Savings Bonds. -- The student must be someone for whom

 

 the bond owner takes a federal income tax exemption (e.g., children,

 

 spouse, or themselves).

 

 

      Section 529 or Qualified Tuition Programs. -- Beneficiaries and

 

 contributors do not have to be family members.

 

 

      Coverdell Education Savings Account. -- Same as 529 Programs.

 

 

      Education Savings Bonds. -- The bond owner must be at least 24

 

 years old before the bond's issue date.

 

 

      Section 529 or Qualified Tuition Programs. -- No age limit on

 

 contributors or on beneficiaries.

 

 

      Coverdell Education Savings Account. -- Accounts can be

 

 established for persons under age 18, or for special needs

 

 beneficiaries regardless of age. When the beneficiary (other than

 

 special needs beneficiary) reaches age 30 or upon the death of the

 

 beneficiary, the account generally must be closed and the earnings

 

 included in the beneficiary's or estate's income.

 

 ____________________________________________________________________

 

 Income eligibility limits

 

 

      Education Savings Bonds. -- Individuals whose MAGI is $76,200 or

 

 more ($121,850 or more for joint filers) in tax year 2005 cannot

 

 claim the tax benefit for bonds redeemed to pay QHEEs. The amount of

 

 the benefit is gradually reduced for taxpayers whose MAGI is above

 

 $61,200 (above $91,850 for married couples filing joint returns and

 

 for qualifying widower(s)). The income ranges are adjusted annually

 

 for inflation.

 

 

      Section 529 or Qualified Tuition Programs. -- No income

 

 eligibility limits or phase-out of the value of contributions

 

 contingent on income.

 

 

      Coverdell Education Savings Account. -- Through December 31,

 

 2010, individuals may contribute if their MAGI is below $110,000

 

 ($220,000 for those filing joint returns). The contribution amount is

 

 gradually reduced for individuals whose MAGI is between $95,000 and

 

 $110,000 ($190,000 and $220,000 for those filing joint returns).

 

 Contributions of organizations (e.g., corporations, unions, and

 

 trusts) are not income-limited.

 

 ____________________________________________________________________

 

 Annual contribution limits

 

 

      Education Savings Bonds. -- The standard yearly purchase limit

 

 on bonds applies ($30,000 face value for an individual and $60,000

 

 face value for a married couple owning bonds jointly in the case of

 

 Series EE bonds and $30,000 face value in the case of Series I

 

 bonds).

 

 

      Section 529 or Qualified Tuition Programs. -- None

 

 

      Coverdell Education Savings Account. -- Contributors may make a

 

 total of $2,000 in nondeductible cash contributions annually per

 

 beneficiary (excluding rolled over amounts). The contribution limit

 

 is not indexed for inflation. The beneficiary must pay a 6% tax on

 

 excess contributions.

 

 ____________________________________________________________________

 

 Level of postsecondary education and eligible institutions

 

 

      Education Savings Bonds. -- Any college, university, vocational

 

 school, or other postsecondary institution eligible to participate in

 

 an ED-administered student aid program. For courses at the

 

 undergraduate and graduate degree level.

 

 

      Section 529 or Qualified Tuition Programs. -- Same

 

 

      Coverdell Education Savings Account. -- Same

 

 ____________________________________________________________________

 

 Qualified Expenses

 

 

      Education Savings Bonds. -- Tuition and required fees. Bond

 

 proceeds also may be rolled into Section 529 Programs and Coverdell

 

 Accounts.

 

 

      Section 529 or Qualified Tuition Programs. -- In practice,

 

 prepaid tuition plans generally are limited to coverage of tuition

 

 and required fees. College savings plans can cover the cost of

 

 attendance (i.e., tuition, fees, books, supplies, and equipment

 

 required for enrollment; room and board for students enrolled at

 

 least half-time; and expenses for special needs beneficiaries).

 

 

      Coverdell Education Savings Account. -- Cost of attendance (see

 

 Section 529 Program column for definition). Withdrawals from

 

 Coverdell accounts also may be used to make contributions to 529

 

 plans on behalf of the Coverdell accounts' beneficiaries.

 

 

      Education Savings Bonds. -- These expenses must be reduced by

 

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

 

 veterans' educational assistance, and employer-provided educational

 

 benefits).

 

 

      Section 529 or Qualified Tuition Programs. -- Same

 

 

      Coverdell Education Savings Account. -- Same

 

 ____________________________________________________________________

 

 Coordination of benefits (i.e., no double benefit allowed)

 

 

      Education Savings Bonds. -- The interest exclusion cannot be

 

 taken for the same QHEEs used to compute an education tax credit and

 

 higher education deduction, paid with any tax-free educational

 

 assistance, or paid with expenses used to calculate the tax-free

 

 portion of withdrawals from a 529 Program or Coverdell Account.

 

 

      Section 529 or Qualified Tuition Programs. -- Section 529 plan

 

 withdrawals will not be taxfree if used to pay the same QHEEs used to

 

 compute an education tax credit and higher education deduction, paid

 

 with any tax-free educational assistance, or paid with ESBs. A

 

 beneficiary may receive withdrawals from a Coverdell Account and a

 

 529 plan in the same year, but the withdrawals will be taxable to the

 

 extent they exceed adjusted QHEEs.

 

 

      Coverdell Education Savings Account -- Same as 529 Programs.

 

 ____________________________________________________________________

 

 Source: The tax information was derived from Internal Revenue

 

 Service, Tax Benefits for Education, Publication 970; provisions of

 

 the Internal Revenue Code; and commentary.

 

 

 Note: MAGI may be defined differently depending on the tax

 

 benefit. It is equal to AGI for most taxpayers.

 

 

                          FOOTNOTES TO TABLE

 

 

      a Until 2004, beneficiaries of 529 Programs sponsored

 

 by higher education institutions had to pay tax on earnings

 

 withdrawals for qualified expenses.

 

 

      b Amounts in 529 Programs and Coverdell Accounts may be

 

 transferred to the designated beneficiary's spouse; their son or

 

 daughter or descendant of son or daughter; stepson or stepdaughter;

 

 brother, sister, stepbrother, or stepsister; father or mother or

 

 ancestor of either; stepfather or stepmother; son or daughter of a

 

 brother or sister; brother or sister of father or mother; son-in-law,

 

 daughter-in-law, father-in-law, mother-in-law, brother-in-law, or

 

 sister-in-law; the spouse of any individual previously mentioned;

 

 and first cousin.

 

END OF FOOTNOTES TO TABLE

 

 

Relationship to Eligibility for Traditional

 

Federal Student Aid

 

 

ESBs, Section 529 Programs, and Coverdell Accounts can influence eligibility for traditional federal student aid (grants, loans, and work-study earnings) by affecting the determination of the financial resources students and their families are expected to direct toward postsecondary education, the so-called expected family contribution (EFC).34 To the extent the balances in these savings vehicles (assets) and the withdrawals from them (income) are expected to be contributed toward postsecondary expenses, students will be determined to have higher EFCs and possibly less financial need for traditional federal student aid.

This section analyzes how the education savings benefits are treated in the calculation of the EFC, focusing specifically on the calculation for students considered under the student aid system to be financially dependent upon their parents.35 These are among the primary students for whom difficult issues may arise regarding the treatment of these education savings benefits in the EFC calculation.36

The section begins with an overview of the traditional federal student system and describes key features of the calculation of the EFC for dependent students and their families. It then presents an analysis of the EFC treatment of each of the education savings benefits separately. It concludes by identifying several major issues raised by the current treatment of these benefits in determining dependent students' EFCs.

Traditional Federal Student Aid and the EFC

At the heart of the system of federal student aid are those programs established under provisions of the HEA. In recent years, postsecondary education students have received between $50 and $60 billion annually in the form of grants, loans, and work-study earnings supported by HEA programs. Much of this aid is awarded to students based on their financial need. In general, students have need when their price of attendance exceeds their EFC.37

Federal student aid applicants fill out the FAFSA either on paper or on the Web, providing financial information used by the federal government to calculate aid applicants' EFCs based on rules defined by the HEA and by ED. With the exception of the Section 529 prepaid tuition plans (their different treatment is discussed below), these education savings benefits can affect a dependent student's EFC by the inclusion on the FAFSA of their net worth among assets or the income portion of their distributions as part of total income. A fundamental distinction significantly influencing the impact of these savings vehicles is whether net worth and income are reported on the FAFSA as being those of parents or of the dependent child:

  • Assets: Parental assets are reduced by an education savings and asset protection allowance (i.e., this amount of assets is shielded from the expected contribution) that varies depending upon the age of the older parent; in contrast, no portion of a dependent student's own assets is similarly sheltered from consideration. More critically, the discretionary net worth of parental assets (net worth minus the education savings and asset protection allowance) is taxed within the EFC calculation at a much lower rate than are the assets of a dependent student -- not more than 5.64% for parental assets,38 and a fixed 35% for a dependent student's assets.

  • Income: Parental income is afforded a substantially more generous income protection allowance than is a dependent student's income. Further, parental available income (total income minus various allowances including the income protection allowance) is taxed within the EFC process on a progressive schedule with an assessment rate ranging from 22% to 47%; in contrast, a fixed 50% of a dependent student's available income is expected to be contributed toward college expenses.

 

As a result, for nearly all dependent students, it is more advantageous for the net worth of savings and income derived from those savings to be considered those of their parents in the EFC calculation.39 To illustrate, consider the different amounts a hypothetical dependent student will be expected to contribute toward postsecondary expenses if $10,000 in savings is treated as a parental asset or as his/her own. Based on the 2005-2006 rules for determining the EFC, for a dependent student from a family of four (including two parents and a younger sibling) with parental available income (AI)40 of $50,000, student AGI of $1,000, and parental assets of $47,700,41 the estimated EFC is approximately $5,800.42 If, in contrast, the additional $10,000 in savings is treated as the student's own, the EFC rises to an estimated $9,300, a 60% increase. Depending upon the student's postsecondary expenses, this difference may have a substantial negative effect on eligibility for federal need-based aid.43

Further, even if the assets are intended to benefit students, but are considered to be those of individuals other than parents or students (e.g., grandparents), they escape consideration in the EFC calculation completely. Some families may deliberately do this in an effort to reduce the EFC and increase need for student aid.

EFC Treatment of Each Savings Benefit

To delineate the impact of each savings benefit on the EFC and students' financial need, we consider the following questions for each:

  • What does the HEA specify as the EFC treatment of the benefit?

  • What is ED's intended policy regarding the reporting on the FAFSA of the benefit and its EFC treatment?

  • What guidance do FAFSA filers generally have regarding how to report the benefit on the FAFSA?

 

It is this last question that is perhaps the most telling. Regardless of what the HEA requires and ED intends, it is FAFSA filers' understanding of what they are to do on the FAFSA that will determine for many students the impact these tax benefits have on their EFC and financial need. As will be delineated below, it is likely that many individuals, including even those paying close attention to the instructions they receive in print or on the Web, will find limited or confusing guidance or, at times, no guidance.

The text of the HEA is the source for consideration of the first question. The 2005-2006 Federal Student Aid Handbook is the primary source consulted for the second.44 This resource is intended for financial aid administrators, not FAFSA filers. On January 22, 2004, in an effort to clarify its intended treatment in the calculation of the EFC of Coverdell Accounts, Section 529 Programs (prepaid tuition and college savings), and ESBs, ED published a Dear Colleague letter to institutions participating in the student aid programs.45 The primary importance of this letter lies in its statement regarding treatment of untaxed income from Coverdell Accounts. We note below where this letter differs from the Handbook in its expression of ED's intent.

In terms of guidance for FAFSA filers, the focus is on the resources that individuals filing the paper or Web forms are most likely to have access to. These are the instructions accompanying the form itself for 2005-200646 -- individuals filling out either the paper or Web versions receive relatively similar instructions -- and an online set of instructions separate from the Web FAFSA that is available to all FAFSA filers.47 The former are referred to subsequently in this report as the "FAFSA- accompanying instructions." The latter are referred to as the "online instructions."

Education Savings Bonds -- Asset Treatment. HEA Section 480(f) defines "assets" for purposes of calculating the EFC as including bonds, among other financial resources. The HEA does not address ESBs per se. The Handbook is silent regarding the asset treatment of ESBs. ED, in the Dear Colleague letter, identifies ESBs as assets of the bond owner.

FAFSA filers are informed through all of the sets of instructions that investments to be reported include bonds, though ESBs are not identified specifically. In fact, there is no guidance as to whose asset the bonds should be considered. If filers understand "bonds" to include ESBs, their inclusion among assets may increase the EFC. Filers reporting ESBs as assets are likely to report them as their parents' since the bonds, to be used toward tuition and fees, must be in the taxpayers' (typically, the parents') name. As described earlier, a much smaller portion of parental assets are expected to be contributed compared to student assets.

Education Savings Bonds -- Income Treatment. HEA Section 480(a)(1) provides that total income for purposes of determining the EFC includes "untaxed income." Untaxed income is defined in Section 480(b)(5) as including "interest on tax-free bonds" but these is no reference to ESBs. The Handbook provides no guidance regarding treatment of ESB untaxed income.

The FAFSA-accompanying instructions are silent regarding whether and how aid filers are to report untaxed ESB income specifically. Worksheet B is one of three worksheets that filers complete in order to calculate amounts of income, assets, or tax benefits to be reported on the FAFSA. Worksheet B is used to determine the amount of untaxed income and benefits to be included in determining total income. While not asking about ESB interest directly, it does include two questions which may lead to the inclusion of untaxed ESB income in the EFC calculation. Worksheet B asks filers to report any tax- exempt interest income which they have reported on line 8b of their 1040 or 1040A federal income tax return. Line 8b is used to report any "tax-exempt interest" received (untaxed ESB income is not explicitly identified for inclusion by the instructions for the federal income tax return). In addition, Worksheet B has an open- ended request that filers provide the amount of "[a]ny other untaxed income or benefits not reported elsewhere [on the FAFSA]." All of the instructions list a number of examples of such untaxed income and benefits, without mentioning ESBs. For this question, all instructions also direct the filer not to include student aid.

Thus, it is unclear whether most FAFSA filers with untaxed ESB income will report it on their aid application. This depends in part on whether they report ESB interest on line 8b of either the 1040 or 1040A federal income tax return.48 As to whom the income should be credited, none of the instructions offer guidance, although, similar to the ESB asset treatment, it is likely filers will assume this is the parents' income.

Section 529 Prepaid Tuition Plans -- Asset Treatment. The HEA delineates precisely how Section 529 prepaid tuition plans are to be treated in determining a student's eligibility for federal student aid. Unlike the other tax benefits considered here, the HEA provides that the asset value of these plans is to have no impact on the calculation of the EFC; as a result, prepaid tuition plans are not to be reported as assets on the FAFSA. Rather, under HEA Section 480(j)(2), a payment of qualified expenses from a prepaid tuition plan serves to reduce a student's cost of attendance on a dollar-for- dollar basis.49 As a consequence, the HEA provides that a student's financial need for need-based federal aid will decrease by the amount of any qualified withdrawal made from a prepaid tuition plan. In essence, there is a 100% tax rate applied to the prepaid tuition plan distribution in the determination of student's financial need. The Handbook describes this treatment similarly.50

The FAFSA-accompanying instructions state that the prepaid tuition plans are not to be reported as an asset. It states, "The value of a pre-paid tuition plan not counted as an asset; rather distributions are treated as a resource or a reduction in the COA." The online instructions reiterate that admonition and also state that "The annual value of the tuition prepayment will be taken into account when the school packages your aid and will reduce your financial need."

Section 529 Prepaid Tuition Plans -- Income Treatment. As has been described, withdrawals from Section 529 plans (both prepaid tuition plans and states' college savings plans) to pay QHEEs are excluded from income for federal tax purposes. The HEA does not explicitly address the treatment of income from these plans, though Section 480(b)(14) describes the untaxed income to be considered in determining the EFC as including "any other untaxed income and benefits . . . ." The Handbook similarly states that "the IRS does not tax distributions from plans used for higher education purposes."51

The FAFSA-accompanying instructions and the online instructions are silent with regard to the treatment of qualified withdrawals from Section 529 prepaid tuition plans. As noted, FAFSA Worksheet B does ask for information on "other untaxed income and benefits," although the second sentence in the instructions for this open-ended question ("Don't include student aid, . . .") may suggest that they not report withdrawn earnings.

Section 529 College Savings Plans -- Asset Treatment. Section 480(f) of the HEA defines assets for purposes of the EFC calculation as including such savings vehicles as stocks and mutual funds. Absent language to the contrary, Section 529 college savings plans apparently should be considered as assets included in EFC calculations. The Handbook not only states that college savings plans are to be included as assets, but also that "The value of a college saving plan should be treated as an asset of the owner (not the beneficiary [i.e., the dependent student] because the owner can change the beneficiary at any time) and will be reported on the FAFSA if the owner's assets are reported."52 Thus, college savings plans are, according to this ED guidance, to be treated as parental assets if the parents are the owners. As illustrated earlier, this provides them with a much more favorable treatment in the EFC calculation. Further, if others such as grandparents are the owners of these assets, they are not reflected in the EFC calculation at all.

The FAFSA-accompanying instructions, while clearly stating that college savings plans are to be included as assets, do not provide any direction as to whose assets they are. At the same time, the online instructions list college saving plans as assets in the instructions for a question posed to the student regarding his or her assets, but not in the instructions for a similar question for the student's parents. As a result of this lack of clarity across all sets of instructions, it is uncertain the extent to which filers will follow ED's intention as delineated in the Handbook that college savings plans owned by parents be treated as parental assets.

Section 529 College Savings Plans -- Income Treatment. The HEA does not address the treatment of untaxed income from college savings plans, though, as noted previously, it has a broad requirement that other untaxed income is to be included in total income. The Handbook categorically states that qualified withdrawals from college saving plans "should not be treated as untaxed income or as resources."53

All sets of FAFSA instructions are silent regarding this treatment. As was described for the Section 529 prepaid tuition plans (see above), filers could include this income among "any other untaxed income and benefits" called for by Worksheet B, or may be dissuaded by the caution in the Worksheet B instructions that this untaxed income is not to include student aid.

Coverdell Education Savings Accounts -- Asset Treatment. The HEA does not address Coverdell Accounts directly. The definition of assets in HEA Section 480(f)(1) includes trusts, suggesting that Coverdells are to be included among reported assets. In the Handbook as recently amended, ED states that these assets are to be included and, further, that "[t]heir value should be reported on the FAFSA as an asset of the account owner."54 Although "account owner" is apparently intended to refer to a dependent student's parents or guardians, the term in the context of Coverdells is ambiguous and may not provide clear guidance as to whose asset this is to be considered for EFC purposes.55

The FAFSA-accompanying instructions require the inclusion of Coverdell Accounts as investments but are silent as to whose they are to be considered. In contrast, the online instructions reflect ED's prior policy (as previously described in the Handbook), calling on students to report as their own assets any Coverdell Accounts "in your name." Further, they state, "The money in an Education IRA is an asset for the student beneficiary because an Education IRA is not a retirement account. It is essentially a savings account to be used for the student's education expenses. Therefore, you must report the amount in your Education IRA with your [student filer's] investments." As a result, none of the instructions provided to FAFSA filers reflect what appears to be ED's currently intended policy regarding treatment of Coverdell assets. If the applicant's parents have a Coverdell Account in his/her name, the instructions state that the parents should report them as assets.

Coverdell Education Savings Accounts -- Income Treatment. The HEA does not address the treatment of untaxed Coverdell withdrawals beyond the language already described suggesting a broad reach to the definition of untaxed income and benefits. The Handbook stipulates that untaxed Coverdell interest income is to be included among "other untaxed income and benefits" on Worksheet B.56 In direct conflict, the Dear Colleague letter states that such income is not to be included as parental or student income in calculating the EFC.

FAFSA filers do not receive this message about what ED appears to intend because the FAFSA-accompanying instructions and the online instructions are silent as to the treatment of the untaxed income. Filers may report withdrawals from the accounts in response to Worksheet B's open-ended question regarding "other untaxed income and benefits" or consider them to be student aid excluded from that question.57

Concluding Issues

There are two major issues that can be identified from the preceding analysis of the treatment of these tax-favored savings vehicles in the determination of need for the federal student aid system. First, FAFSA filers often do not receive clear guidance, either through the FAFSA-accompanying instructions or the online instructions, about whether the asset value of these tax-favored savings or the untaxed income derived from them are to be reported at all or whose they are to be considered for EFC purposes. As a consequence, students and their families with similar financial and other characteristics can be treated in very different ways depending upon how they interpret the instructions they do receive, or how they act in the absence of guidance. As discussed, choosing to report an asset as a parental asset or as a dependent student's asset has very real consequences for aid eligibility.

Second, the treatment of these tax-advantaged savings vehicles can differ substantially from benefit to benefit. The HEA clearly and explicitly identifies the financial aid treatment for only one of these specific benefits -- Section 529 prepaid tuition plans -- and its treatment diverges markedly from that likely to be afforded the other savings benefits. As stipulated in the HEA, the prepaid tuition plans have no impact on the EFC at all; rather, their distributions cause a dollar-for-dollar reduction in financial need. In contrast, depending upon FAFSA filers' understanding of their instructions, the assets or income of the other saving vehicles may be included in resources considered in the EFC calculation, potentially increasing the EFC and reducing need for need-based federal aid.

Further, among those other benefits, the treatment as described in the Handbook seems to differ for two relatively similar savings vehicles -- Coverdell Accounts and 529 college savings plans. With regard to income, the Handbook states that untaxed income from Coverdells is to be included in the EFC calculation, while that from Section 529 college savings plans is not. Such an inconsistent treatment of income potentially would have a more adverse impact on eligibility for need-based federal aid for families who save through Coverdell Accounts as compared to Section 529 college savings plans.58 The most recent statement of ED intention (in the Dear Colleague letter) conflicts with the Handbook in this regard, by stating that Coverdell Accounts and 529 college savings plans "receive equal treatment in the calculation of federal financial aid eligibility," and untaxed Coverdell income is not to be considered in the determination of the EFC.

Finally, ED's policy, as expressed in the recent changes to the Handbook and in the Dear Colleague letter, to treat Coverdell Account assets as parental assets in the EFC calculation may have the same inconsistent and negative outcome currently possible with this treatment of Section 529 college savings plans. That is, equity among families with similar levels of resources may be jeopardized because more knowledgeable families may avoid any consideration of these assets in the EFC calculation by having someone other than the parents (e.g., grandparents) be the responsible individuals for these accounts.

 

FOOTNOTES

 

 

1 For more information see CRS Report RL32100, College Costs and Prices: Background and Issues for Reauthorization of the Higher Education Act, by Rebecca R. Skinner.

2 In brief, funds withdrawn from an Individual Retirement Account (IRA) to pay for qualified higher education expenses are exempt from the 10% tax penalty on distributions taken before age 59 1/2. The earnings portion of withdrawals remains subject to taxation. Qualified expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at any college, university, vocational school, or other postsecondary institution eligible to participate in a student aid program administered by the U.S. Department of Education for courses taken at the undergraduate and graduate degree level, less any tax-free educational assistance (e.g., Pell Grants). Also included in qualified expenses are the room and board costs of students enrolled at least half-time as well as special needs services incurred by or for special needs students in connection with their education. The IRA's owner must be the student, their spouse, or either of their children or grandchildren.

3 In brief, these accounts are irrevocable gifts to minors. Parents typically act as custodians of the accounts, which are offered by banks and other financial entities authorized by the Internal Revenue Service (IRS). The custodians control the accounts until minors reach age 18 or 21, depending upon the state. At that time, the beneficiaries can utilize the funds for any purposes they choose. Custodial accounts, which are subject to taxation annually, allow families to minimize their tax bills: when children are under age 14, the first $800 of unearned income is not taxed, the second $800 is taxed at the child's lower tax rate, and any remainder is taxed at the parents' rate; once children attain 14 years of age, the first $800 of unearned income is not taxed and all of the remainder is taxed at the child's lower tax rate. The preceding discussion relates to tax year 2005, and the $800 threshold is indexed annually for inflation.

4 For information on these measures, 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. Other higher education tax benefits that are not broadly available are not addressed in this report (e.g., employer educational assistance and the miscellaneous business expense deduction).

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

6 For background on this reauthorization, see CRS Issue Brief IB10097, The Higher Education Act: Reauthorization Status and Issues, by Adam Stoll.

7 For an individual family, its savings may reduce its eligibility for need-based federal aid.

8 U.S. savings bonds confer a tax benefit whether or not they are applied toward QHEEs. They, like other U.S. government obligations, are exempt from state and local income taxes.

9 Otherwise eligible bonds that were bought to qualify for the ESB program but were registered in the child's name may be reissued in the taxpayer's and/or their spouse's name provided the bonds were not purchased with money belonging to the child. The purchaser must complete a form, have their signature guaranteed or certified, and submit the form along with the bonds to the appropriate regional Federal Reserve Bank.

10 Before enactment of the ESB benefit, taxpayers could claim the dependency exemption for children of any age attending postsecondary school full-time. The revenue cost of the benefit was paid for by allowing taxpayers to claim as dependents only those children enrolled in postsecondary school full-time who are under age 24.

11 Independent students who purchase bonds at age 24 would not be able to redeem them for five years if they want earnings to accumulate at the variable market rate. Bonds held less than five years earn a lower fixed rate so the tax savings these students could obtain by redeeming the bonds in that period to pay QHEEs might not outweigh the lower return.

12 For the typical taxpayer, MAGI is the same as adjusted gross income (AGI). In the case of ESBs, MAGI is AGI before taking into account the bond interest exclusion, the higher education deduction and the student loan interest deduction, the exclusion for adoption benefits received under an employer's adoption assistance program, the foreign income exclusion, and the exclusion for income from sources in U.S. territories and Puerto Rico; and after applying the partial exclusion of social security and tier 1 railroad retirement benefits, amounts deducted for contributions to individual retirement arrangements, and adjustments for limitations on passive activity losses and credits.

13 Married couples who own bonds must file joint returns to take the exclusion.

14 Taxpayers who own series EE and I bonds can choose to defer recognition of interest until the bond is redeemed or they can pay tax on the interest annually as it accrues. If a bond is purchased in a child's name and interest is recognized annually, it can be offset by the child's standard deduction. Other taxpayers with children whose income exceeds the child's standard deduction might be better off deferring recognition of unearned income (e.g., bond interest) until the children attain age 14.

15 The College Board, Trends in College Pricing 2004.

16 It had previously appeared that earnings might be subject to taxation while they were building up inside the program. The legislation clarified that the earnings would not be included in an individual's income until withdrawn, i.e., earnings grow tax- deferred.

17 Peter Schmidt, "Prepaid-Tuition Plans Feel the Pinch," Chronicle of Higher Education, Sept. 12, 2003. (Hereafter cited as Schmidt, Prepaid-Tuition Plans Feel the Pinch.)

18 The number of accounts exceeds the number of beneficiaries because there is no limit to the number of accounts that can be established on behalf of a beneficiary.

19 Quarterly data on value of assets in each state- sponsored 529 Program and number of accounts/contracts by type of plan are available at [http://www.collegesavings.org].

20 Schmidt, Prepaid-Tuition Plans Feel the Pinch.

21 From 2002 through 2010 beneficiaries of state- sponsored plans do not have to report qualified earnings distributions as "other taxable income" on the 1040 Form because P.L. 107-16 conferred them tax-exempt status during the period; the same holds for prepaid tuition plans sponsored by eligible institutions of higher education starting in 2004.

22 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2005-2009, JCS-1-05, Jan. 12, 2005. (Hereafter cited as JCT, Estimates of Federal Tax Expenditures for Fiscal Years 2005-2009.)

23 Account owners are restricted to the specific investment options offered by the college savings programs they have selected. However, account owners are able to transfer funds between the investment options of a state's program, without tax consequences and without changing beneficiaries, once every 12 months. Similarly, they may make nontaxable transfers of funds between a program's investment options if they change accounts' beneficiaries to close relatives of the original beneficiaries (i.e., the original beneficiary's spouse; children, grandchildren, and stepchildren; brothers, sisters, and stepsiblings; parents, stepparents, and grandparents; aunts and uncles; nieces and nephews; sons-in-law, daughters-in-law, fathers-in-law, mothers-in-law, brothers-in-law, and sisters-in-law; spouses of the aforementioned individuals; and first cousins of the original beneficiary). Account owners also may annually make same-beneficiary, nontaxable rollovers into the program of another state with investment strategies the owners prefer to those offered by the original state's programs, for example.

24 Schmidt, Prepaid-Tuition Plans Feel the Pinch.

25 As of December 31, 2004, the asset value of prepaid tuition plans was about $12.5 billion (19%) and of college savings plans about $52.2 billion (81%) of the $64.7 billion in statesponsored Section 529 Programs.

26 Programs have set high and varying limits on the total value that a college savings account can reach.

27 For information about how different states tax contributions to 529 Programs and for a more in-depth discussion of them see CRS Report RL31214, Saving for College Through Qualified Tuition (Section 529) Programs, by Linda Levine.

28 The following example illustrates how a deferral results in tax savings and how the value of savings is greater for those at higher income levels. Two families contribute $2,000 into an investment at the end of each year for 15 years. The investment pays a 6% return per annum. The balance would increase to $46,552 if earnings accumulate tax-free ($30,000 in contributions and $16,552 in earnings). If the families instead had to pay federal income tax on the earnings each year, the family in the 15% bracket would have amassed $43,483; the family in the 28% bracket, $41,013. Consequently, the deferral is worth $3,069 to the lower income family compared to $5,539 to the higher income family. If states follow the federal law, the tax deferral is worth even more to each family.

29 The new beneficiary must be one of the following family members of the original beneficiary: the original beneficiary's spouse; children, grandchildren, and stepchildren; brothers, sisters, stepbrothers, stepsisters; parents, stepparents, and grandparents; aunts and uncles; nieces and nephews; sons-in-law, daughters-in-law, fathers-in-law, mothers-in-law, brothers-in-law, and sisters-in-law; spouses of the aforementioned individuals; and first cousins of the original beneficiary.

30 Effective after Dec. 31, 2001 and through Dec. 31, 2010, funds invested in Coverdells may be used toward certain expenses incurred in connection with attending public or private elementary and secondary schools. For more information see CRS Report RL31439, Federal Tax Benefits for Families' K-12 Education Expenses in the Context of School Choice, by Linda Levine and David Smole.

31 JCT, Estimates of Federal Tax Expenditures for Fiscal Years 2005-2009.

32 Eligible family members are the same as those previously described for the Section 529 Program.

33 In the case of Coverdells, MAGI is equal to AGI plus the exclusions for foreign earned income, foreign housing costs, and income from sources in U.S. territories and Puerto Rico.

34 As described below, Section 529 prepaid tuition plans do not affect the EFC. Rather, payments from these plans reduce financial need directly.

35 For federal student aid purposes and the calculation of the EFC, an individual is considered dependent on his or her parents (i.e., parental income and assets are considered in determining the EFC), unless the individual is at least 24 years old by Dec. 31 of the award year, is an orphan or ward of the state (or was until age 18), is a veteran of the armed forces, is a graduate or professional student, is married, has dependents other than a spouse, or is deemed independent by a financial aid officer for "other unusual circumstances."

36 The findings regarding the clarity of the instructions provided FAFSA filers applies to independent student as well.

37 Under the Pell Grant program, considered to be the foundation program for federal student aid, a student's need for this specific grant is generally defined as the amount by which the maximum appropriated Pell Grant for the year exceeds his or her EFC. For additional information about the Pell Grant program see CRS Report RL31668, Federal Pell Grant Program of the Higher Education Act: Background and Reauthorization, by Charmaine Mercer.

38 The EFC rules provide that the discretionary net worth of parental assets is first taxed at a 12% rate; this determines the so-called "contribution from assets." That asset contribution is added to parental available income yielding "adjusted available income." Adjusted available income is then taxed under a progressive contribution table, with 47% being the highest tax rate in this table. As a result, the maximum possible contribution from the discretionary net worth of parental assets is equal to 47% of 12%, or 5.64%.

39 There are two conditions under which the process described above is greatly modified, particularly rendering differences in the treatment of assets inconsequential. Under the simplified needs test, no assets are considered in calculating the EFC for a dependent student if his or her parents' AGI is less than $50,000 and the student and parents meet certain conditions applied to their federal income tax returns. Further, there is an automatic zero EFC applicable when the parents of a dependent student have AGI that is not greater than $15,000 (threshold for 2005-2006 award year) and meet the same conditions regarding federal tax returns as apply for the simplified needs test.

40 Available income (AI) is the amount of income that remains after all allowances have been subtracted from total income or AGI, in the need analysis formula.

41 These total assets are $10,000 more than the $37,700 asset protection allowance provided in the EFC rules to a family whose older parent is 45 years of age. Thus, a portion of the $10,000 will be expected in contribution toward education expenses.

42 This estimate is based on the following allowances for parent's income: only one parent having earned income; 2004 taxable income being assessed at 15%; 5% of total income being reserved for state and other taxes, and 7.65% of income for Social Security taxes.

43 This distinction in the treatment of an asset is more likely to affect families with AGIs of $50,000 and above because they are ineligible for the simplified needs test, under which no asset contribution is expected. Families with AGIs below $50,000 may be eligible for the simplified needs test depending upon the type of tax return they file (see discussion above).

44 This a multi-volume document of which the part entitled Application and Verification Guide is the source for the citations in this CRS report. For convenience, we refer simply to the Handbook in all subsequent references. All volumes of the 2005-2006 Handbook can be found at [http://ifap.ed.gov/IFAPWebApp/currentSFAHandbooksYearPag.jsp?p1= 2005-2006&p2=c]. The discussion in this report reflects the version of the Handbook posted on the Web as of May 6, 2005.

45 The letter is identified as DCL ID: GEN-04-02, and referred to subsequently in this report as the Dear Colleague letter. The letter is available at [http://ifap.ed.gov/dpcletters/GEN0402.html].

46 The 2005-2006 paper FAFSA forms and instructions can be found at [http://ifap.ed.gov/fafsa/attachments/0506FAFSA101204.pdf].

47 The separate online instructions for 2005-2006 can be found at [http://studentaid.ed.gov/students/attachments/siteresources/ CompletingtheFAFSA05-06.pdf]. The discussion in this report reflects the version of these online instructions posted on the Web as of May 6, 2005. Though the Handbook is available on the Web as well, FAFSA filers are not directed to it, so it is likely that very few would consult the Handbook as they fill out their applications.

48 Tax filers calculate the exclusion of interest from ESBs on IRS form 8815 and report the "excludable interest" on Schedule B. Instructions for these forms do not direct the tax filer to also include this interest income on line 8b.

49 Under some circumstances, the prepaid distribution is treated as other financial resources received by the student and subtracted from the cost of attendance. The impact is the same.

50Handbook, pp. AVG-19, AVG-20.

51 Ibid., p. AVG-20.

52 Ibid.

53 Ibid.

54 Ibid. Prior to Nov. 6, 2003, the Handbook stated categorically that Coverdell Education Savings Accounts were to be treated as student assets.

55 As described earlier, the terms used typically for Coverdell Accounts are "responsible individual," "authorized person," or "manager."

56Handbook, p. AVG-16. The reference here is to "Education IRAs."

57 The Worksheet B question regarding untaxed interest reported on line 8b of 1040 or 1040A federal income tax returns presumably is not an alternative means of including Coverdell Accounts untaxed earnings in the EFC calculations. The instructions for these federal income tax returns clearly exclude Coverdell Accounts untaxed earnings from inclusion on line 8b.

58 Susan Dynarski, in Tax Policy and Education Policy: Collision or Coordination? A Case Study of the 529 and Coverdell Saving Incentives, delineates in detail the financial consequences of the different treatment of several savings vehicles in the traditional federal need analysis system. Available at [http://www.ksg.harvard.edu/research/working_papers/].

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Levine, Linda
    Mercer, Charmaine
  • Institutional Authors
    Congressional Research Service
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2006-1863
  • Tax Analysts Electronic Citation
    2006 TNT 21-28
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