Current U.S. tax incentives for higher education expenses.

• Author: Lucido, Peter D.

Congress has often attempted to assist Americans in paying for higher education by using the individual income tax laws. Between 1954 and 1996, eight education-related tax benefits were added to the Internal Revenue Code. The Taxpayer Relief Act of 1997, P.L. 105-34, introduced five new education tax benefits. Recently, the American opportunity tax credit greatly expanded the prior Hope scholarship credit. Today, at least 12 income tax provisions are designed to provide tax benefits for the pursuit of education. (1)

The education-related income tax provisions can be divided into three general categories:

1. Tax incentives to save for education;

2. Tax relief when paying current-year education expenses; and

3. Tax assistance with student loans.

Some of these tax provisions allow deductions for a portion or all of education expenditures. Some exclude otherwise taxable income from inclusion in the calculation of taxable income. Still others furnish tax credits that can provide a direct reduction of tax for each dollar of qualified expenditures.

It has been estimated that in 2017 the forgone tax revenue from these provisions may have exceeded $30 billion, (2) yet there is reason to believe that many of them will be ineffective in accomplishing their objectives.

This article examines the requirements and limitations that taxpayers face when they seek to obtain the tax benefits of some of the most significant education-related income tax provisions. (3) It then looks at the American Bar Association's and the AICPA's suggestions for simplification as well as the recommendations of National Taxpayer Advocate Nina Olson.

Tax incentives to save for education

Congress has enacted provisions to give parents, students, and other taxpayers a tax incentive to save for education costs. The Code provisions discussed here are:

* Sec. 135: Income from U.S. savings bonds used to pay higher education tuition and fees;

* Sec. 530: Coverdell education savings accounts; and

* Sec. 529: Qualified tuition programs. Each program is designed to encourage saving for education by excluding the earnings on those savings from tax.

Education savings bond interest exclusion

Potential income tax benefit:

Interest earned on U.S. savings bonds generally is taxable. Most taxpayers report the accumulated interest as income when the savings bonds are redeemed. This provision encourages taxpayers to purchase savings bonds for higher education costs by permitting the interest earned on qualifying savings bonds (up to the amount of "qualifying educational expenses") to be excluded from taxable income. The benefit to the taxpayer is equal to the amount of income tax that would otherwise have been imposed on the savings bond interest. (4)

Important requirements:

* Only certain savings bonds qualify. (5)

* The owner of the bond must be 24 years old or older before the bonds are issued. As a result, bonds gifted to a person before he or she is age 24 (e.g., at birth) do not qualify.

* Interest from other investments, including interest on other U.S. government obligations (e.g., Treasury notes, bills, and long-term bonds), does not qualify for exclusion under this provision even if the funds are used solely for education expenses.

* The exclusion can be claimed only if the proceeds are used to pay qualified expenses for the taxpayer, the taxpayer's spouse, or a dependent.

* Qualifying educational expenses include tuition and required fees at eligible educational institutions but do not include expenses for room (e.g., dormitory charges) or meals. Books are not considered a qualifying expense unless a student may not attend or enroll in a course without purchasing them.

* Qualifying educational expenses must equal or exceed redemption proceeds, not just the interest earned on the redeemed bonds. If qualifying educational expenses are less than the bond proceeds, only a portion of the interest on the redeemed bonds will be tax free. (6)

Income limits: The exclusion of savings bond interest is phased out after a taxpayer's "modified adjusted gross income" (MAGI) exceeds a threshold amount, which is adjusted each year for inflation. (7) In 2018, a taxpayer who has MAGI in excess of $79,700 ($119,550 if filing a joint return) will lose a portion or all of this benefit. (8)

Coverdell education savings account

A Coverdell account may be established to save for the qualified education expenses of a named beneficiary. Many banks, brokerage firms, and mutual fund companies offer these accounts.

Potential income tax benefit:

The earnings on amounts deposited in a Coverdell account are excluded from taxable income until the funds in the account are distributed. If distributions from a Coverdell account are equal to or less than qualified education expenses, (9) earnings will be permanently excluded from tax.

Important requirements:

* When the account is established, the beneficiary must be 18 or younger or be a special-needs beneficiary. The beneficiary does not need to be the taxpayer's dependent.

* Total contributions for any year cannot exceed $2,000 and (except for a special-needs beneficiary) cannot be made after the beneficiary attains age 18. The maximum lifetime contribution limit thus ordinarily would be $36,000. (10)

* Qualified higher education expenses are defined differently from qualifying expenses for education savings bonds. The costs of room and board, for instance, may be a qualified expense provided the student is enrolled at least "half-time." (11)

* When determining qualified expenses, education expenses are reduced by any tax-free educational assistance received and by...