Tax Savings for Higher Education

Tax Savings for Higher Education Students Often Miss Out

By Charles Pekow

Congress has gone into overtime debating whether and how to cut, increase or otherwise change federal student aid sources. But whatever it does with loans and grants, it has created a labyrinth with another vastly underutilized source of student aid: federal tax provisions. The good news is, Senate leaders have pledged to look into improving the situation.

Most eligible students aren’t taking maximum advantage of tax code provisions designed to help pay the cost of postsecondary education. That’s because they’re not choosing the best options. The fault lies not in our stars but in ourselves – everyone from Congress weaving a tangled web of tax provisions that confuse students and families, to taxpayers flustered by the process and unfamiliar with the benefits, to tax accountants not making the right decisions and student aid officials not providing adequate guidance.

Getting loans and grants requires plenty of paperwork, but tax preferences require more responsibility on the part of students because they must identify applicable preferences, understand complex rules concerning their use, and correctly calculate and claim credits or deductions, according to the Government Accountability Office (GAO) in a new report entitled Student Aid and Postsecondary Tax Preferences. The GAO examined tax returns from the 2002 Statistics of Income data set and found that about half of filers (about 223,000) weren’t selecting the best option when faced with a choice of competing tax provisions. For example, 27 percent of eligible filiers didn’t claim a single tuition deduction or credit. They paid an average of $169 more in taxes than was necessary (with 10 percent paying more than $500 more than needed.)

The GAO estimates that 21 percent (51,000) of those who took the tuition deduction would have saved an average of $83 more if they had taken the Lifetime Learning Credit instead of the deduction. Another 8,000 taxpayers would have saved an average of $138 if they took the deduction instead of the credit. Even when professional tax preparers completed the returns, they often didn’t make the best choices.

The tax code includes 12 different tuition tax preferences involving savings accounts, credits and deductions. And they all come with different eligibility criteria, benefits and phase-out levels. Taking one often means you can’t take another or only can take it at a reduced rate. Options include up to $1,500 for the Hope Tax Credit and up to $2,000 for the Lifetime Learning Credit. Families can also deduct up to $4,000 for higher education tuition and fees. Taxpayers can take a deduction of $2,500 for interest on student loans and get tax advantages for Section 529 qualified tuition programs and Coverdell Education Savings Accounts. A Tuition Deduction that expires at the end of this year offers deductions of up to $4,000, similar to the Lifetime Learning Credit.

Eligibility for some tax benefits can vary each year if a taxpayer’s income bracket changes, which makes them more difficult to plan for as compared with loans and grants, where students get the aid at the beginning of the year. Benefits of the Student Loan Interest Deduction may not accrue until after graduation. Those in income phase-out zones must calculate (and recalculate annually if their income changes) whether they prefer a deduction or credit.

The Lifetime Learning Credit, for instance, reduces its benefit for individuals with adjusted gross incomes between $40,000 and $50,000, double the range for married couples. And while the Department of Education determines eligibility for direct aid, taxpayers themselves have to figure out if they’re eligible for tax preferences. Schools aren’t required to help. Choices include more than 100 different 529 plans, all with different contribution limits, investment strategies, fees, and penalties. Those getting direct federal aid such as Pell Grants and loans get reduced credits, further complicating the choices. “The federal government’s primary role with respect to higher education tax preferences is limited to the promulgation of rules; the provision of guidance to tax filers; and to the processing of tax returns,” the GAO noted. And the hodge-podge of tax preferences and their complexity “may lead some not to claim a credit because they judge the added costs of filing for the credit to outweigh its benefits,” the report concludes. The GAO also said no one has adequately studied the issue of how well tax credits actually make school affordable, affect choice of school, or keep students in school.

Internal Revenue Service spokesperson Bruce Friedland said the “IRS’ job is to administer the tax code. We don’t take stands on tax policy.” However, the IRS has provided a publication, Tax Benefits for Education, to assist filers.

Tom Ochsenschlager, vice president of the American Institute of Certified Public Accountants. suggested that Congress consider combining the Hope, Lifetime Learning Credit, and Coverdell and 529 plans “so people wouldn’t have to try to figure out each year which is best for them.” Winfield Crigler, executive director of the Student Loan Servicing Alliance, said “you almost need to have a spreadsheet and run your options or have a tax program and run your options before you can figure out which provision is the right one for you.” The alliance is trying to convince Congress to simplify the Student Loan Interest Deduction. The “rules are the most complicated rules in the entire (tax) code. It is sort of ridiculous to think you could figure it out for yourself.”

Shortly after the GAO issued its report, a federal panel came up with a specific idea to knock out at least some of the confusion. Last January, President Bush appointed a bipartisan President’s Advisory Panel on Federal Tax Reform, which offered at the start of November a series of recommendations for simplifying the tax code. The panel suggested that Congress knock out all education savings plans, as well as all retirement and health savings accounts. (Don’t worry if you’ve already got one; the panel said existing ones could continue although you couldn’t add more money to them.)

The panel would replace all tax free savings plans and educational tax deductions with Save for Family Accounts. Taxpayers could contribute up to $10,000 a year to one account to cover their choice of education, medical and retirement benefits as well as the cost of a new home. Savers could withdraw money from the accounts at any time.

“Overall, the (current) structure of the tax benefits for education expenses generally provides the largest benefit to families with students who attend schools with higher tuition. These tax benefits may allow educational institutions to increase tuition and fees because a portion of these costs is offset through the tax code,” the panel’s report, Simple, Fair and Pro-Growth: Proposals to Fix America’s Tax System, explained. “It is not clear that the structure of these benefits actually encourages individuals to obtain more education than they would have in the absence of these tax benefits.” The panel also recommended creating a Family Credit allowance of $1,500 for families with full-time students 20 and under – but not for older students.

What’s next? Leaders of the Senate Finance Committee, who requested the GAO study, issued a joint statement pledging to look into the matter. Congress needs to take a hard look at how to make these programs more accessible and therefore more effective.

Charles Pekow is a senior writer for Community College Week and contributor to Quinlan Publishing newsletters. He has covered the field of education for over 20 years and has won many journalism awards, with his work appearing in the Washington Post, the International Herald-Tribune, and Baltimore Magazine.