President’s Proposal to Help Low-Income Families Afford College through Improved Education Tax Credits

By Katherine Saunders

Early this week, leading up to Tuesday’s State of the Union address, President Obama outlined his plan to reform our complex tax codes to ensure individuals and families get ahead in the economy. These include proposals to improve higher education tax credits to make them simpler and more accessible to low-income students.

As CLASP has pointed out in the past, our system of higher education tax credits disproportionately benefits students from higher-income families. This is both unfair and reduces the effectiveness of these credits in promoting college access and completion, as most of the credits currently go to students who would be highly likely to attend college even without the credit. In addition, because there are so many tax preferences related to higher education in the tax system (credits, deductions and savings accounts), families are often confused and may fail to take full advantage of the educational benefits offered. According to the Government Accounting Office (GAO), 27 percent of families who claimed one benefit would have been better off claiming another and 14 percent of eligible families failed to claim any benefit at all.

President Obama’s proposal includes a number of new provisions consistent with CLASP’s recommendations to simplify the multiple tax benefits and make these credits more useful to low-income students.

1.       Consolidate education benefits into a permanent and improved AOTC

President Obama proposes consolidating numerous credits into a permanent and improved American Opportunity Tax Credit (AOTC). The AOTC provides a tax credit of up to $2,500 per student per year, for up to four years. It is partially refundable, meaning that students who do not owe federal income tax credits can still receive 40 percent of the credit as a refund. Under current law, the AOTC is scheduled to revert back to the Hope Credit (the less-generous and non-refundable credit it replaced in 2009) at the end of 2017. Obama’s proposal would improve the current AOTC by making it a permanent feature of the tax code and indexing the value of the AOTC to inflation beginning in 2018.

2.       Increase refundable portion of AOTC

The president’s plan seeks to increase the refundable portion of the AOTC so more working students and families can qualify for the credit. Under current law, students who don’t earn enough to owe federal income taxes can receive only up to 40 percent, or a maximum of $1,000, of the AOTC as a refundable credit. Obama’s proposal would increase the refundable portion to a flat maximum of $1,500. This change would particularly benefit students attending low-cost institutions such as community colleges who are not eligible to receive the full $1,000 refundable credit if they have less than $4,000 in qualified expenses.

3.       Expand tax credit eligibility and refund

Under current law, students must be enrolled at least half time in order to qualify for the AOTC and can only claim the credit up to four years. Obama’s proposal would expand the benefit to students attending part-time (less than half time), allowing them to claim up to $1,250 (of which up to $750 would be refundable). It would also extend the credit to five years for all eligible students. This is particularly beneficial for non-traditional students who typically attend postsecondary education institutions part-time and take longer to complete their degrees.

4.       Make it easier for students and families to apply for tax credits

Because of the complex rules regarding Pell Grants and AOTC, eligible families forgo millions of dollars of AOTC credits. Obama’s proposal would improve the coordination between Pell Grants and AOTC by exempting Pell Grants from taxable income and the AOTC calculation. This change would make it easier for the nine million Pell recipients to claim the tax benefit already available to them.

5.       Eliminate or modify other tax preferences for higher education

The president’s proposal would also eliminate other tax preferences for higher education, including the Lifetime Learning Credit and the tuition and fees deduction. Because these are not refundable, they primarily benefit higher-income students, and they add to the complexity of tax-based support for higher education. Consolidating these preferences into an improved AOTC was among the recommendations made by CLASP and our partners in our Reimagining Aid Delivery and Design (RADD) white paper, Higher Education Tax Reform: A Shared Agenda for Increasing College Affordability, Access, and Success.

In addition, under the President’s proposal, the tax preference for the 529 savings plans would revert to the pre-2001 levels for new deposits. This means that while savings could grow on a tax-deferred basis, they would not be exempt from taxation when they were withdrawn. (Existing deposits would continue under current rules.) In our previous work, we recommended that these savings incentives be reformed to better target their benefits to low-income and middle-class families by changing income limits or setting meaningful contribution limits.  As currently designed, the tax advantages for 529 programs overwhelmingly benefit wealthy families who use them as a tax shelter.  The Center on Budget and Policy Priorities estimates that 80 percent of the benefits of 529 accounts go to households with annual incomes over $150,000.  Middle-class families would still have the opportunity to use savings in 529s to set a clear expectation of college attendance for their children and would also benefit from the expanded AOTC.

Overall, the president’s new tax proposal would simplify taxes for more than 25 million students and families who claim education tax benefits and provide students up to $2,500 of assistance each year for five years. CLASP applauds President Obama’s reforms to higher education tax credits to make them simpler and more useful to low-income and middle-class students.