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Section One The New Federal Tuition Tax: Provisions Regarding Postsecondary Education

A. Overview
For the past two decades, tuition and fees at private and public colleges and universities have increased more than twice as fast as inflation and roughly 50 percent faster than family incomes. To help relieve some of the burden of these escalating college costs, President Clinton made tuition tax credits a centerpiece of his 1996 re-election campaign. Soon after that election, the 105th Congress modified and expanded the Clinton plan, enacting several tuition tax provisions in the Taxpayer Relief Act of 1997.

This new law -- in effect as of January 1998 -- provides to eligible students and, in many cases, their families, an array of federal income tax benefits, including tax credits, incentives for college savings, and a deduction for interest on student loans. In 1998, the U.S. Department of Education projects the credits to cost the federal government about $9 billion in foregone revenues. This annual cost is expected to increase over the next several years as more taxpayers take advantage of the provisions. From 1998 to 2002, the credits are projected to total about $40 billion.

The features of the new tax provisions are described below.

1. New Federal Income Tax Credits

HOPE Scholarship Tax Credit. Students who are enrolled at least half-time in their first two years of college are eligible for up to a 100% federal income tax credit on the first $1,000 of their tuition and required fees, plus up to a 50% credit on the second $1,000. The tax credit cannot exceed the amount of tuition and required fees minus the amount of funding received as grants, scholarships, or other tax-free educational assistance. The tax credit is available to eligible students who file their own federal taxes, or to families who claim an eligible student as a dependent. Those students or families whose incomes are too low to pay federal income taxes would not receive any benefit (see Table A). The tax credit is phased out for upper income earners (see Table A).

Lifetime Learning Tax Credit. Students who are enrolled past their first two years of college or who are enrolled less than half-time are eligible for up to a 20% federal income tax credit on the first $5,000 of tuition expenses paid each year through 2002. After 2002, the $5,000 amount will increase to $10,000. As with the HOPE Scholarship, the Lifetime Learning tax credit cannot exceed the amount of tuition and required fees minus all funding received as grants, scholarships, or other tax-free educational assistance. The credit is available to eligible students who file their taxes independently, or to families who claim an eligible student as a dependent. Like the HOPE Scholarship, those students or families whose incomes are too low to pay federal income taxes would not receive any benefit (see Table B). The Lifetime Learning tax credit is phased out for upper income earners at the same levels as the HOPE Scholarship (see Table B).

2. New Federal Income Tax Incentives for College Savings
Education IRA. For each dependent child under age 18, families may deposit up to $500 per year into an Education Individual Retirement Account (IRA). Contributions to Education IRAs are not deductible from federal income taxes, but interest earnings are exempt from taxation, and withdrawals are excluded from the beneficiary's gross income if used for qualifying higher education expenses. Those wishing to contribute to an Education IRA must meet the income requirements listed in Table C. Students who receive tax-free distributions from Education IRAs may not, in the same year, receive the HOPE or Lifetime Learning tax credits.

IRA Withdrawals. Funds may be withdrawn from regular existing IRAs for the postsecondary education expenses of the taxpayer, spouse, child, or grandchild. In these cases, the individual withdrawing the funds will owe income tax on at least part of the distribution, but will not have to pay the 10% tax on early withdrawals.

Prepaid Tuition Plans. Under the new law, families can now use their state-sponsored tuition savings programs to save for the costs of room and board. Interest earned on savings continues to be federally tax-free (as it has been since 1996). Students and families using funds from these plans are also eligible for the HOPE and Lifetime Learning tax credits.

3. New Federal Income Tax Provisions Regarding Student Loans
Student Loan Interest Deduction. The new law allows students or their families to take a federal income tax deduction for interest paid in the first 60 months of repayment on student loans, regardless of whether they itemize their other deductions. The maximum deduction is $1,000 in 1998, $1,500 in 1999, $2,000 in 2000, and $2,500 in 2001 and beyond. To be eligible for the interest deduction, taxpayers must meet the income requirements listed in Table C.

Student Loan Forgiveness. Tax-exempt charitable or educational institutions sometimes forgive all or part of student loan debts for students who meet certain criteria. In the past, the amount of loan forgiveness was federally taxable for the student as a gift. Under the new law, the amount of loan forgiveness is not taxable for those students who take community service jobs that address unmet community needs and who have part or all of their loans forgiven by a tax-exempt charitable or educational institution.

B. Existing Federal Student Aid Programs
With few exceptions, students who qualify for the new tax credits must be enrolled at colleges eligible to participate in existing federal student aid programs, which are listed below.

Pell Grants and Supplemental Educational Opportunity Grants. These need-based grants are awarded to students and do not need to be repaid. President Clinton and Congress also increased the maximum Pell grant award and the number of low income and independent students who could receive Pell grants in 1997. The Pell grant maximum was increased to $3,000 -- a $300 increase over the 1996 level. The Pell grant program was also increased by $400 million to expand eligibility for independent students and dependent students who work.

Subsidized Student Loans. These loans, which are awarded on the basis of income, must be repaid, but the government pays the interest while the student is in school and for six months after graduation.

Unsubsidized Student Loans. These loans are available regardless of need and are offered to students at a lower interest rate than most loans available in the private market.

C. Which Students Benefit from the New Tax Provisions?

1. Family Income
The primary beneficiaries of the new federal income tax provisions are middle and upper-middle income families, as described below.

1.a. HOPE and Lifetime Learning Tax Credits

Middle and upper-middle income students and their families benefit most.

The new tax credits provide a reduction in federal taxes to eligible students (or to the families of dependent eligible students). Students or their families can benefit from the tax credits to the extent that they owe taxes at all. Lower income students (or their families) who owe no federal taxes do not benefit from the new tax credits. Dependent students whose families have tax bills that are less than the credit receive partial tax credit, equal to the amount they would have owed in taxes. For example, a dependent student from a family of four with two parents filing jointly and a 1997 taxable income of $20,000 is not eligible for the full tax credit, since their tax burden is not high enough to qualify for the maximum allowable credit (see Appendix, Table 3). At the other end of the scale, the tax credits are phased out for high income earners.

Table 4 shows how families and students at different income levels can use federal student aid programs to help pay for college. In general, families who qualify for need-based support (through the Pell grant and loan subsidies) cannot receive the maximum tax credit from the HOPE Scholarship. For instance, a family with a student in a public community college and with a taxable income of $40,000 or less is not eligible for the maximum HOPE tax credit. Similarly, a family with a student in a four-year public college and with a taxable income of $30,000 or less will not receive the maximum HOPE tax credit.

Figure 1 illustrates that for families with taxable incomes from $40,000 to $90,000 a year, the HOPE tax credit reduces the burden of sending a child to a four-year public college or university. Families in these income ranges will find that the HOPE tax credit reduces (by 1% to 3%) the percentage of their income needed to pay for a four-year public college, including tuition, fees, and room and board expenses. In contrast, families earning $30,000 a year or less will not benefit from the tuition tax credits. Figure 1 also displays the percentage of family income required to pay for attendance at four-year public colleges, by income level. For families with taxable family incomes of $10,000 (not shown in Figure 1), the price of attendance at four-year public colleges requires, on average, about 61% of their annual income.

Students at higher priced institutions benefit more than students at lower priced institutions.

This occurs for two reasons. First, students at public community colleges can get some or all of their tuition and fees paid by federal need-based Pell grants. Only community college students with family incomes between $50,000 and $80,000 are eligible for the maximum HOPE tax credit; students with family incomes of about $40,000 per year receive a partial credit (see Table 4). Comparatively, students attending more expensive private four-year colleges can receive the maximum HOPE tax credit when their family income falls between $30,000 and $80,000 because the Pell grant pays only a fraction of the more expensive tuition and fees. Secondly, lower priced community colleges enroll a higher number of students with incomes too low to qualify for the tax credit. Over the last 15 years, in fact, the percentage of lower income students attending community colleges has increased. In 1994, between one-third and one-half of all college students whose families made $30,000 or less attended a public community college. As Table 4 indicates, community college students who receive Pell grants and loan subsidies and whose families make $30,000 or less are not eligible to receive any tax credit.

1.b. Savings Provisions

Many of the same students eligible for the HOPE and Lifetime Learning tax credits are also most likely to participate in the new savings programs.

Findings from an August 1995 U.S. General Accounting Office study of state prepaid tuition programs showed that these plans most benefit middle and upper income families. In Kentucky, 61% of the participating families had incomes higher than $50,000, while only 10% of participants were from families with incomes under $25,000. In Florida, 51% of the participating families had incomes above $100,000, and another third had incomes between $50,000 and $100,000; only 5% of participants were from families with incomes less than $25,000. In Alabama, almost 60% of participants had family incomes above $50,000, while only 10% had incomes below $25,000. In Texas, half of the participants were in the $50,000 to $100,000 range, with just 5% under $25,000.¹

1.c. Student Loan Interest Deduction

Families at all income levels will benefit from this provision.

The U.S. General Accounting Office reported earlier this year that students whose family incomes are below $45,000 are two and a half times more likely to borrow than students whose family income falls between $60,000 and $100,000. This suggests that students from families with lower incomes will be affected by the student loan interest deduction allowable under the new law. On the other hand, students with higher incomes tend to borrow more; their large interest payments would qualify them to file for larger income tax deductions.²

2. Age of the Student
Traditional college-age students (ages 18 to 24) and their families are the primary beneficiaries of the HOPE Scholarship and Lifetime Learning tax credits. This is because younger students tend to be dependent and tend to rely on their family's incomes to help pay for college. In 1995-96, the average dependent student was 20 years old. In comparison, independent students, who are on average 33 years old, tend to pay for college with their own incomes. Even though independent students qualify for the HOPE tax credit at lower income levels than dependent students, they are still less likely to be eligible for some or all of the tax credits. Based on income data from 1995-96, 47% of independent undergraduates would be ineligible for any tax credit, compared to 26% of dependent undergraduates.

D. How Does Eligibility for the Tax Credits Vary by State?
Although the federal income tax credits flow directly to individuals and families, they have significant implications for state higher education finance. In 1998, California's students and families are projected to receive $1.2 billion in HOPE and Lifetime Learning tax credits, which represents the highest state total. California's students and families received $785 million in 1995-96 for all other federal financial aid combined (including Pell grants, state student incentive grants, and guaranteed student loan subsidies). Alaska's students and families are projected to receive $19 million in tuition tax credits in 1998, which represents the lowest state total. Alaska's students and families received $4.6 million in 1995-96 for other federal financial aid.³

The total amount of tax credits received by the residents of a particular state depends on:

• the income levels of college students and their families in that state,
• the distribution of students among lower and higher priced institutions,
• the effects of state-sponsored financial aid, and
• the number of college students or their families who file federal income taxes.

In general, states with a relatively large proportion of low income students enrolled in college will have fewer students and families claiming the maximum tax credit. States that rely heavily on higher priced public and private colleges and universities are likely to have more students and families claiming the maximum tax credit. States that send a large number of students out-of-state will also tend to have more families claiming the maximum tax credit, because the credit is based on the taxpayer's--not the dependent student's--residence, and those taxpayers sending students out of state tend to pay higher tuition, thereby qualifying them for the full tax credit. Finally, states with large student financial aid programs of their own will find that residents at some income levels will not qualify for the full federal tax credit if those residents receive state student financial aid. This is because the amount of the tax credit received by each individual is based on tuition and required fees minus all grants and scholarships. Because of this dollar decrease in the federal tax credit for every dollar an individual receives from state grant sources, those states providing significant state grants and scholarships will find that fewer of their residents will qualify for the full federal tax credit.⁴

Since each state has a unique blend of the above characteristics, the effects of the HOPE and Lifetime Learning tax credits will vary significantly by state. The following examples are derived from Table 2 (see Appendix).

Illinois. Illinois has one of the highest rates of students attending college out-of-state. In addition, tuition and fees at Illinois' public four-year colleges are above the national average. These factors help to explain why about 4% of Illinois' students are projected to be ineligible for any tax credit, compared to the national average of 9% and a high of almost 23% in Montana.

Pennsylvania. Pennsylvania's tuition and fees for its public and private colleges and universities are significantly higher than the national average, yet the average tax credit per student in the state is slightly lower than the national average primarily because the state has an extensive need-based scholarship program. This state-sponsored scholarship program offsets an individual's eligibility for a tax credit dollar-for-dollar, thereby lowering the state's average tax credit per student.

New York. Despite having the largest state-sponsored student aid program in the nation, New York's students are projected to receive a higher than average tax credit per eligible student. This is primarily because the state relies heavily on its private colleges to provide college opportunity (41% of all enrolled students in New York attend a private four-year college), and tuition and fees at the state's private colleges are higher than the national average (based on 1995-96 data). On the other hand, 12% of the state's college students are projected to be ineligible for any tax credit. This is higher than the national average because New York's college population has a high percentage of low income students, and because New York offers extensive need-based financial aid through its Tuition Assistance Program.

Montana. About 23% of Montana's college students are projected to be ineligible to receive either the HOPE or the Lifetime Learning tax credits. This high percentage--the highest of all 50 states--is primarily due to the fact that a large proportion of its college population (38%) is made up of lower and lower-middle income students. However, the average tax credit per eligible student is projected to be higher than the national average because Montana has one of the smallest state-sponsored scholarship programs in the country.

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© 1998 The National Center for Public Policy and Higher Education