In addition to loans and grants, the federal government offers a series of tax benefits for education. Most of these benefits are for students and their families to reduce the cost of higher education, but the federal government also offers a few benefits related to K-12 education.
There are twelve higher education-related tax benefits included in the Internal Revenue Code. Six of these benefits, (1) the American Opportunity Credit; (2) Lifetime Learning Credit; (3) the Tuition and Fee Deduction; (4) the Student Loan Interest Deduction; (5) Coverdell Education Savings Accounts; and (6) Qualified Tuition Program (529 Plans), are discussed in detail below.
Other federal higher education tax benefits include: (7) the tax-free status of scholarships, fellowships, grants, and tuition discounts for degree candidates; (8) the tax-free value of student loan cancellations; (9) the education exception to taxation on early withdrawals from individual retirement accounts; (10) the Education Savings Bond Program (if savings bonds are cashed in for education expenses, the bond is not included in taxable income); (11) the tax-free value of employer-provided education assistance; and finally (12) the business deduction for work-related education expenses.
Higher Education Tax Credits
The two main higher education tax benefits for individuals are the Lifetime Learning Credit and the American Opportunity Credit. Individuals enrolled in post-secondary education can select one of the two credits to decrease their tax bill. Families or spouses can claim the credit if the relevant student qualifies as their dependent.
The Lifetime Learning Credit, created in the Taxpayer Relief Act of 1997, is available for up to $2,000 annually (20% of the first $10,000 spent on higher education) for an unlimited number of years. Qualified students must be enrolled in at least one post-secondary course and need not be pursuing a degree. Eligibility for the credit is subject to an inflation-adjusted income ceiling of $60,000 ($120,000 for joint filers). The value of the credit is phased out as income approaches this ceiling.
The American Opportunity Credit was created by the American Recovery and Reinvestment Act of 2009 (the economic stimulus law) to replace the Hope Scholarship Credit, allowing more individuals to qualify for larger credits. The maximum American Opportunity Credit is $2,500, of which up to $1,000 is refundable (100% of the first $2,000 spent on higher education; 25% of the next $2,000) and can be claimed for the first four years of post-secondary, degree-seeking education. Eligibility is based on an inflation-adjusted income ceiling of $80,000 ($160,000 for joint filers) and the credit is phased out as income approaches that ceiling. The refundable portion of the credit allows beneficiaries who have no tax liability to offset to instead receive a payment from the federal government of up to $1,000. The credit can be claimed for each qualified individual, as opposed to the per-family Lifetime Credit, making the American Opportunity Credit more valuable for families with multiple students enrolled in college.
Qualified education expenses for both credits include tuition and related fees required by an institution for enrollment. The American Opportunity Credit can also be used for required course materials. Other related expenses, such as room and board, transportation, and insurance and medical expenses, cannot be claimed as qualified education expenses for the purposes of these credits. The Lifetime Learning Credit will provide taxpayers with an estimated $3.25 billion in total tax reductions in 2012, and the American Opportunity Tax Credit will provide $14.29 billion, including the refundable portion of the benefit.
|Major Higher Education Tax Benefits, Fiscal Year 2012|
|Credit||Annual Amount||Income Limit*
|Foregone Revenue (billions)|
|American Opportunity Tax Credit||Up to $2,500/student (100% of first $2,000 spent on higher ed; 25% of next $2,000); available for 4 years; up to $1,000 is refundable||$90,000 ($180,000)||$14.29|
|Lifetime Learning Credit||Up to $2,000/return (20% of first $10,000 spent on higher ed)||$60,000 ($120,000)||$3.25|
|Deduction||Annual Amount||Income Limit*
|Foregone Revenue (billions)|
|Tuition and Fees Deduction||Up to $4,000/return||$80,000 ($160,000)||$760**|
|Student Loan Interest Deduction||Up to $2,500/return||$75,000 ($150,000)||$0.85|
|Savings||Annual Amount||Income Limit*
|Foregone Revenue (billions)|
|State Prepaid Tuition and 529 Plans||Up to $13,000 contribution/contributor per beneficiary||By state, usually none||$1.78|
|Coverdell Account||Up to $2,000 contribution/contributor per beneficiary||$110,000 ($220,000)||$0.08|
|*Reflects earnings limit to qualify for maximum benefit. In many cases taxpayers are eligible for a reduced benefit when income exceeds the limit.|
|**No estimate is available for fiscal year 2012. This represents the foregone revenue for fiscal year 2010.|
Higher Education Tax Deductions
A higher education tuition and fees tax deduction is available to individuals who do not use the Lifetime Learning or American Opportunity Credit. Unlike a tax credit, which reduces the amount of taxes owed, the tuition and fees deduction reduces taxable income. Both the tuition deduction and student loan interest deductions are “above-the-line” deductions, meaning tax filers need not itemize deductions to claim the benefits. In fiscal year 2012 this policy reduced taxes for those who were eligible by $470 million.
The maximum tuition and fees deduction is $4,000 and varies according to income level. But the income ceiling is approximately $20,000 higher for the tuition and fees tax deduction than for the Lifetime Learning tax credits, making the deduction more popular for higher-income families. The tuition and fees deduction also cannot cover personal expenses such as room and board.
Individuals can also deduct the interest paid on a federal or private student loan from their taxable income. The maximum student loan interest deduction is $2,500 and decreases as income levels increase. The income ceiling for the loan interest deduction is $15,000 lower than the tuition and fees deduction. In 2012, the policy will reduce taxes for all student loan borrowers by an estimated $850 million.
Tax-Free Savings Accounts for Higher Education
The federal government also gives tax breaks to families or individuals that save money for the higher education costs of their children or other designated beneficiaries. The Coverdell Education Savings Account (ESA), formerly known as an Education IRA, is an investment trust account specifically designated for qualified education costs, which include both K-12 expenses and higher education expenses such as tuition and fees, books, and room and board for students enrolled at least part-time. Money deposited and interest earned on that money are not taxed, and withdrawals for education expenses are tax-free. Only individuals with income below $110,000 ($220,000 for joint filers) can contribute to a Coverdell ESA, and annual contributions are limited to a total of $2,000 per beneficiary. In aggregate, the policy will lower taxes for participants by $80 million in 2012.
Qualified tuition programs, also known as "529 plans," are savings plans established by states and institutions of higher education. A 529 plan allows families or individuals to prepay for a student’s qualified education expenses—tuition and fees, books, and room and board for students enrolled at least part-time—or contribute to a tax-free account specifically designated for these higher education expenses. Institutions can only sponsor prepaid plans. An estimated $1.78 billion in federal tax reductions will be provided through the benefit in 2012.
There are two types of savings plans: direct and state-administered/broker-administered. The federal tax benefits for 529 plans include tax-free earnings and distributions. There are no income restrictions for contributors under the federal benefits, and each contributor can add up to $60,000 in tax-free funds over a five year period per beneficiary. States offer a range of additional benefits, including tax deductions, tax-free earnings, and tax-free withdrawals. Some states also offer matching grants to low-income families who contribute to state plans. Contribution limits vary by state, but in general are limited to between $200,000 and $300,000 in tax-free savings.
K-12 Tax Benefits
The federal government also provides some tax benefits for K-12 education. These include a tax deduction for teachers for out-of-pocket classroom expenses, and two types of tax credit bonds for public school construction
Teacher Out-of-Pocket Classroom Expenses
The federal government offers a $250 per year above the line tax deduction to teachers for out-of-pocket classroom supply expenses. The estimated cost of the deduction is $170 million in 2012.
Tax Credit Bonds for School Construction
Two federal tax credit bond programs subsidize public educational facilities construction. The first, the Qualified Zone Academy Bond (QZAB) program, subsidizes the interest payments on up to $1.4 billion annually in bonds issued by charter schools to finance school facility construction and improvement. The Qualified School Construction Bond (QSCB) program, a new program created by the American Recovery and Reinvestment Act, subsidizes up to $11 billion in bonds issued in 2009 and 2010 by traditional public schools and school districts to finance construction.
For both bond types, the federal government provides the company or individual that holds the bonds with tax credits in lieu of interest, making the bonds essentially interest-free for the issuing school or school district. The issuing school or school district must repay the bond principal within ten years of issuance. The QZAB program is estimated to cost $400 million in foregone tax revenue in 2012.
In 2010, Congress expanded both programs under the Hiring Incentives to Restore Employment (HIRE) Act so that the federal government could make direct payments to school districts to cover most of interest on the bonds instead of giving the bond holder a tax credit. This change means that the Qualified School Construction Bond program now has outlay effects of $780 million in 2012 in addition to the income tax expenditures described above.