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CRS Updates Report on Tax-Favored Savings Benefits for Higher Education

SEP. 28, 2006

RL32155

DATED SEP. 28, 2006
DOCUMENT ATTRIBUTES
  • Authors
    Levine, Linda
  • Institutional Authors
    Congressional Research Service
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2006-21187
  • Tax Analysts Electronic Citation
    2006 TNT 199-29
Citations: RL32155

 

CRS Report for Congress

 

Received through the CRS Web

 

 

Order Code RL32155

 

 

Updated September 28, 2006

 

 

Linda Levine

 

Specialist in Labor Economics

 

Domestic Social Policy Division

 

 

Charmaine Mercer

 

Analyst in Social Legislation

 

Domestic Social Policy Division

 

 

Tax-Favored Higher Education Savings Benefits and Their

 

Relationship to Traditional Federal Student Aid

 

 

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 has addressed some aspects of the relationship between traditional student aid and education savings benefits in the Deficit Reduction Act of 2005. 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

 

      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

 

Tax-Favored Higher Education Savings Benefits and Their

 

Relationship to Traditional Federal Student Aid

 

 

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 2006, for example, a married couple with one child having personal and dependency exemptions of $9,900 ($3,300 x 3) and taking the standard deduction ($10,300) would have no federal income tax liability with an adjusted gross income at or below $20,200. 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, CRS started with socalled 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 $78,100 or more ($124,700 or more for filers of joint returns) in tax year 2006 may not take the exclusion.12 The amount that can be subtracted from income is gradually reduced for taxpayers whose MAGI is above $63,100 ($94,700 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, assume that (1) a dependent child attends a college charging the 2005-2006 average tuition and fees of $5,491 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 $4,000, including $2,000 in interest, is redeemed. Under these circumstances, the taxpayer could exclude 50% of the bond's interest or $1,000 from income ($1,991 in adjusted QHEEs -- $5,491 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, the composition of any aid received (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 (EGTRRA, 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. Subsequently, the Pension Protection Act of 2006 (P.L. 109-280) made EGTRRA's changes to Section 529 plans permanent. Due in part to the program enhancements, 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 March 31, 2006, there were 8.6 million accounts18 and their total asset value was $89.5 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 $700 million to $1 billion between FY2006 and FY2010.22

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 incomerelated 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. Both the deferral and 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 $12,000 in 2006 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 $60,000 per beneficiary in a single year (or $120,000 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

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 FY2006-FY2008 to $200 million annually in FY2009 and FY2010.31 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 in tax year 2006 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

 

 

 Education Savings Bonds

 

 

 Section 529 or Qualified Tuition Programs

 

 

 Coverdell Education Savings Account

 

 _____________________________________________________________________

 

 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 IRSapproved 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.

 

 _____________________________________________________________________

 

 Characteristics

 

 

      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.

 

 

      Earnings withdrawn from a state-sponsored 529 Program to pay the

 

 QHEEs of the plan's beneficiary are tax-free. 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.

 

 

      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.a

 

 

 Coverdell Education Savings Account

 

 

      Same as 529 Programs.

 

 

      Same, except earnings withdrawn to pay QHEEs are permanently

 

 tax-exempt.

 

 

      Same as 529 Programs.

 

 _____________________________________________________________________

 

 Characteristics

 

 

      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).

 

 

      The bond owner must be at least 24 years old before the bond's

 

 issue date.

 

 

 Section 529 or Qualified Tuition Programs

 

 

      Beneficiaries and contributors do not have to be family members.

 

 

      No age limit on contributors or on beneficiaries.

 

 

 Coverdell Education Savings Account

 

 

      Same as 529 Programs.

 

 

      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.

 

 _____________________________________________________________________

 

 Characteristics

 

 

      Income eligibility limits

 

 

 Education Savings Bonds

 

 

      Individuals whose MAGI is $78,100 or more ($124,700 or more for

 

 joint filers) in tax year 2006 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 $63,100 (above $94,700 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.

 

 _____________________________________________________________________

 

 Characteristics

 

 

      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) through December 31, 2010. The contribution limit is not

 

 indexed for inflation. The beneficiary must pay a 6% tax on excess

 

 contributions.

 

 _____________________________________________________________________

 

 Characteristics

 

 

      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

 

 _____________________________________________________________________

 

 Characteristics

 

 

      Qualified expenses

 

 

 Education Savings Bonds

 

 

      Tuition and required fees. Bond proceeds also may be rolled into

 

 Section 529 Programs and Coverdell Accounts.

 

 

      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

 

 

      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).

 

 

      Same

 

 

 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.

 

 

      Same

 

 _____________________________________________________________________

 

 Characteristics

 

 

      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 tax-free 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.

 

 

                           FOOTNOTE TO TABLE

 

 

      a 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 FOOTNOTE TO TABLE

 

 

Relationship to Eligibility for Traditional Federal Student

 

Aid

 

 

Higher education savings benefits and federal student aid, specifically the federal need analysis system, are closely interrelated. A change in the treatment of higher education savings benefits can impact the need analysis calculation, by affecting the amount determined to be available from income and assets -- also known as the expected family contribution (EFC) -- to contribute toward postsecondary education expenses.34 To the extent that the balances in these savings vehicles (assets) and the withdrawals from them (income) are expected to be contributed toward postsecondary expenses, an aid recipient would be determined to have a higher EFC and less financial need for federal student aid.

Although the relationship between higher education savings benefits and federal student aid is interrelated, over the years the treatment of the various types of plans in the federal need analysis calculation has differed and/or lacked clarity. The Deficit Reduction Act of 2005 (DRA) (P.L. 109-171) attempted to clarify some of the confusion surrounding the treatment of the different education savings benefits. Specifically, DRA enacted the following changes:

  • A qualified education benefit is defined as a qualified tuition plan under section 529 of the IRC or other prepaid tuition plan offered by a state, and Coverdell Accounts;

  • a qualified education benefit shall not be considered an asset of the dependent student for the purposes of determining need for federal financial aid; and

  • the value of a qualified education benefit shall be the refund value of any tuition credits or certificates purchased for prepaid tuition plans, and the current balance of the account for college savings plans.

 

This section analyzes how education savings benefits are treated in the calculation of the EFC, focusing specifically on the calculation for dependent students because many of the difficult issues associated with the treatment of education savings benefits in need analysis are likely to be experienced by dependent students.35

This section begins with an overview of the federal need analysis system, including a brief description of the key steps for calculating the EFC for dependent students. It is followed by an analysis of the EFC treatment of each of the education savings benefits separately. It concludes with a discussion of selected issues relating to need analysis and education savings benefits.

Federal Student Aid and the EFC

The federal need analysis system underlies the annual allocation of billions of dollars (more than $73 billion in FY2006) in student financial aid supported by Title IV (grants, loans, work-study) of the Higher Education Act (HEA) (P.L. 89-329, as amended). It entails gathering financial data, which are provided by the student via the free application for federal student aid (FAFSA); calculating the EFC; and packaging of the applicant's financial aid award by the postsecondary institution's financial aid administrator (FAA).

EFC. The EFC is the amount that the federal need analysis system determines a family has available to contribute toward postsecondary education expenses. In calculating the EFC, consideration is given to available income (a combination of taxable and untaxed income and benefits), and for some families, available assets. In addition, living expenses, retirement needs, and federal and state tax liabilities are considered. The income contribution is calculated by determining the total income of a student and his or her family (where applicable), and determining available income by subtracting a series of allowances from total income; a percentage of that available income is considered as an income contribution toward postsecondary education costs. A contribution from assets is similarly calculated. The combination of the available income contribution and asset contribution divided by the number of individuals in the family enrolled in college constitutes the EFC. The EFC process looks back a year for its income data and federal income tax liability. That is, for award year 2006-2007,36 2005 income and federal income tax data were used.

EFC and Packaging. FAFSA data are submitted to a Central Processor (an entity working under contract for the U.S. Department of Education) that calculates the aid applicant's EFC based on statutorily defined rules. From the Central Processor, the EFC and other summary data are reported to FAAs and to the FAFSA filer. The FAA determines the student's need for federal student aid and other sources of aid, based primarily upon the EFC and cost of attendance (COA). This is true for all federal student aid programs (e.g., loans, campus-based programs) except for the Pell Grant program. For nearly all Pell recipients, the award is calculated by subtracting the EFC from the maximum appropriated Pell Grant for the year (i.e., without regard to the COA). The FAA determines need in conjunction with each program's award rules and puts together the financial aid award or package, which consists of the specific sources and amounts of student aid the applicant will receive to help pay for his or her education-related expenses.

EFC Calculation for Dependent Recipients. The EFC is influenced by the inclusion of income and assets, such as the net worth or the distribution from an education savings benefit. The EFC is further impacted by the reported ownership of the education savings benefit. The need analysis calculation assesses parental income and assets at a lower rate than the income and assets of dependent students (discussed below).

Parents' income is afforded a more generous income protection allowance (IPA) than is a dependent student's income. For example, for the 2006-2007 award year, the lowest parental IPA is $11,960 (this amount varies by family size and the number of students in college), whereas the IPA for dependent students is a fixed $2,550. 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 dependent student's available income is assessed at a fixed 50%.

Parental assets are reduced by an education savings and asset protection allowance (i.e., the amount of assets that is shielded from the expected family 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,37 and a fixed 35% for a dependent student's assets.

As a result of these assessments, 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.38 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 2006-2007 rules for determining the EFC, for a dependent student from a family of four (including two parents, the oldest parent being 45 years of age, and a younger sibling) with total parental income (TI)39 of $50,000, student AGI of $1,000, and parental assets of $50,000,40 that includes the $10,000, the estimated EFC is approximately $3,300.41 If, in contrast, the additional $10,000 in savings is treated as the student's asset, the EFC rises to an estimated $6,800 -- more than twice the EFC when treated as a parental asset. Depending upon the student's postsecondary expenses, this difference may have a substantial negative effect on his/her eligibility for federal need-based aid.

EFC Treatment of Each Savings Benefit

To delineate the impact of each savings benefit on the EFC and students' financial need, CRS considered 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 2006-2007 Federal Student Aid Handbook is the primary source consulted for the second.42 It should be noted that this publication was printed and made publically available prior to the enactment of the DRA of 2005, which made several revisions to the need analysis formula, including the treatment of education savings benefits -- these changes thus are not reflected in the Handbook. In addition to the Handbook, over the years ED has issued several letters intended to provide policy guidance on this issue for financial aid administrators. For example, on January 22, 2004, in an effort to clarify its intended treatment of Coverdell Accounts, Section 529 programs (prepaid tuition and college savings), and ESBs in calculating the EFC, ED published a Dear Colleague letter to institutions participating in the student aid programs.43 Additionally, following the enactment of the DRA, two Dear Colleague letters were released in April and June of 2006 to provide guidance in the calculation of the EFC and COA adjustment.44 These two letters are important because they are the most recent guidance that FAAs have regarding the changes enacted by the DRA. Although Dear Colleague letters are intended to provide FAAs with ED's interpretation of the legislation regarding the treatment of education savings benefits for the purposes of calculating the EFC, there is no guarantee that all FAAs will receive and/or read the letters.

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 2006-200745 -- 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.46 The former are referred to subsequently in this report as the "FAFSA-accompanying instructions." The latter are referred to as the "online instructions." It is important to mention that the FAFSA, both the paper and Web version, were available as early as January 1, 2006, prior to implementation of the DRA changes. Thus, these instructions to filers did not reflect the changes enacted by the DRA at the time the filer completed the application. While it is possible that a filer could resubmit his/her FAFSA in light of these changes, it is unlikely that a student would be aware of such changes.

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 2004 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') names. 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 there 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, one of three worksheets that filers complete in order to calculate amounts of income, assets, or tax benefits to be reported on the FAFSA, 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 "Other untaxed income not reported elsewhere on Worksheets A and B." All of the instructions list a number of examples of untaxed income and benefits, such as workers' compensation 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 would report it on their aid application. It would appear to depend in part on whether they report ESB interest on line 8b of either the 1040 or 1040A federal income tax return.47 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 would assume this is the parents' income.

Section 529 Prepaid Tuition Plans -- Asset Treatment. The HEA, as amended by the DRA, delineates how Section 529 prepaid tuition plans are to be treated in determining a student's eligibility for federal student aid. Previously, the asset value of prepaid tuition plans did not have an impact on the calculation of the EFC and was not reported on the FAFSA. Rather, payment of qualified expenses from a prepaid tuition plan reduced a student's cost of attendance on a dollar-for-dollar basis. As a consequence, a student's financial need for federal need-based aid was decreased by the amount of any qualified withdrawal made from a prepaid tuition plan -- effectively applying a 100% tax rate to the distribution when determining financial need. The DRA amended this provision so that prepaid tuition plans are considered assets in calculating the EFC. Section 480(f) now states, "A qualified education benefit shall not be considered an asset of a student for purposes of Section 475 [EFC calculation for dependent students]." The HEA also now specifies that the value of these plans are to be determined by ascertaining the refund value of any tuition credits of certificates purchased. ED's April and June 2006 Dear Colleague letters state further that the plan's value shall be included in the EFC calculation only if the account is owned by the parent.

However, the FAFSA-accompanying instructions, released in January 2006, state that prepaid tuition plans are not to be reported as an asset. It states, "The value of a pre-paid tuition plan is not counted as an asset." 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." The Handbook also offers a similar interpretation.

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."

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, which suggests that Section 529 college savings plans should be considered as assets included in the EFC calculation. 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." Both Section 529 college savings plans and prepaid tuition are, according to ED's guidance, to be treated as parental assets only if the parents are the owners. Because there are several instances whereby a dependent student can be an owner of a college savings plan or prepaid tuition plan, the plan's assets in those cases would not be reflected in the EFC calculation.48

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 interpretation of the DRA stating 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." Similarly, the 2004 Dear Colleague letter declares that untaxed 529 distributions, "are not counted as parent or student income."

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. Prior to the enactment of the DRA, the HEA did not address Coverdell Accounts directly. Coverdell Education Savings Accounts are now defined as a qualified education benefit for the purposes of Title IV. Thus, as in the case of 529 prepaid and college savings plans, the HEA now specifies that they are not considered an asset of the dependent student when calculating the EFC. All three Dear Colleague letters declare that Coverdells shall be included as parental assets in the EFC calculation if the parent is the account owner. In the Handbook, ED also 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." "Account owner" is apparently intended to refer to a dependent student's parents or guardians, but the term in the context of Coverdells is ambiguous.

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, call 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, if you own the account, you must report the amount in your Coverdell Education Savings Account with your investments." As a result, none of the instructions provided to FAFSA filers for the 2006-2007 award year, reflect ED's interpretation of the DRA's amendments to the HEA regarding the treatment of Coverdell 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. In direct conflict, the 2004 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.

Concluding Issues

There are two major issues that can be identified from the preceding analysis. First, FAFSA filers often do not receive clear or timely guidance, either through the FAFSA-accompanying instructions or the online instructions, about whether and how the asset value of these tax-favored savings or the untaxed income derived from them are to be reported. Consequently, 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.

Second, the DRA addressed the different treatment in the need analysis system accorded to 529 prepaid plans versus college savings plans. But the issue of account ownership remains unclear. Although the HEA was amended to clarify that a qualified education benefit shall not be considered an asset of a dependent student when calculating the EFC, this action assumed that a dependent student would not be the owner of the benefit. This assumption is further evidenced by ED's justification of 529 college savings plans: in the Handbook, it states that the plans are considered parental assets because the owner can change the beneficiary (dependent student). However, the 2004 Dear Colleague letter called for equal asset treatment of both Coverdells and 529 college savings plans, despite the Coverdell "account owner" not always being able to change beneficiaries. In any event, there are some instances in which dependent students can be owners of qualified education benefits. The DRA and ED's April and June 2006 Dear Colleague letters effectively mean that in cases where a dependent student owns a qualified education benefit, the assets escape consideration in the EFC calculation. Furthermore, because qualified education benefits can be opened by persons other than a parent or guardian (e.g., grandparents), the asset or income levels from such investments have never reflected in the EFC calculation.

 

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. 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.

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 Report RL33040, 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 2005.

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 2006-2010, JCS-3-06, Apr. 25, 2006. (Hereafter cited as JCT, Estimates of Federal Tax Expenditures for Fiscal Years 2006-2010.)

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 Mar. 31, 2006, the asset value of prepaid tuition plans was more than $14 billion (16%) and of college savings plans more than $75 billion (84%) of the $89.5 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 P. Smole.

31 JCT, Estimates of Federal Tax Expenditures for Fiscal Years 2006-2010.

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 For additional information regarding the calculation of the EFC, see CRS Report RL33266, Federal Student Aid Need Analysis System: Background, Description, and Legislative Action, by Charmaine Mercer.

35 There are three separate dependency classifications for individual applicants: dependent student, independent student with dependents, and independent student without dependents. Parental financial information is not considered if the applicant meets the statutory definition of an independent student. To be classified as statutorily independent [Title IV, Section 480(d)], an applicant must meet one of the following conditions: be 24 years of age or older by Dec. 31 of the award year; married; enrolled in a graduate or professional program; have a dependent other than a spouse; orphan or ward of the court; or a military veteran or active duty service member.

36 The 2006-2007 award year began July 1, 2006, and ends on June 30, 2007.

37 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%.

38 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 $20,000 (the threshold for 2006-2007 award year) and meet the same conditions regarding federal tax returns as apply for the simplified needs test.

39 Total income (TI) includes the adjusted gross income (taxable income from all sources) amount that is calculated for federal tax filing purposes, income earned from work, and untaxed income and benefits claimed for federal income tax.

40 These total assets are $5,700 more than the $44,300 asset protection allowance provided in the EFC rules to a family whose older parent is 45 years of age. Thus, a portion of the $5,700 will be expected in contribution toward education expenses.

41 This estimate is based on the following allowances for parent's income: only one parent having earned income; 2005 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.

42 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, CRS refers simply to the Handbook in all subsequent references. All volumes of the 2006-2007 Federal Student Aid Handbook can be found at [http://www.ifap.ed.gov/IFAPWebApp/ currentSFAHandbooksYearPag.jsp?p1=2006-2007&p2=c]. The discussion in this report reflects the version of the Handbook posted on the Web as of July 13, 2006.

43 The letter is identified as DCL ID: GEN-04-02, and referred to subsequently in this report as the 2004 Dear Colleague letter. The letter is available at [http://ifap.ed.gov/dpcletters/ GEN0402.html].

44 The April 2006 letter is identified as DCL ID: GEN-06-05, and is referred to subsequently in this report as the April Dear Colleague letter. The June 2006 letter is identified as DCL ID: GEN-06-10, and is referred to subsequently in this report as the June Dear Colleague letter. The April 2006 letter is available at [http://www.ifap.ed.gov/dpcletters/attachments/GEN0605.pdf]. The June 2006 letter is available at [http://www.ifap.ed.gov/ dpcletters/attachments/GEN0610.pdf].

45 The 2006-2007 paper form and instructions can be accessed at [http://www.ifap.ed.gov/fafsa/attachments/0607FAFSAApplication(eng) 100605.pdf].

46 The separate online instructions for 2006-2007 can be found at [http://www.studentaid.ed.gov/students/publications/completing_ fafsa/2006_2007/ques2.html]. The discussion in this report reflects the version of these online instructions posted on the Web as of July 13, 2006. The Handbook is available on the Web as well, but because FAFSA filers are not directed to it, it is likely that very few filers would consult the Handbook as they complete their application.

47 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.

48 According to the College Savings Plan Network, several states allow minors to be owners of prepaid tuition and college savings plans, but depending upon the age of the minor, a state may require that an individual be named to manage the account on the minor's behalf. In addition, if Uniform Gift to Minors Act and Uniform Transfer to Minors Act accounts are liquidated and reinvested in Section 529 plans, their assets continue to belong to the student.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Levine, Linda
  • Institutional Authors
    Congressional Research Service
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2006-21187
  • Tax Analysts Electronic Citation
    2006 TNT 199-29
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