Order Code RL32155
CRS Report for Congress
Received through the CRS Web
Tax-Favored Higher Education Savings Benefits
and Their Relationship to
Traditional Federal Student Aid
Updated July 28, 2006
Linda Levine
Specialist in Labor Economics
Domestic Social Policy Division
Charmaine Mercer
Analyst in Social Legislation
Domestic Social Policy Division
Congressional Research Service ˜ The Library of Congress

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Tax-Favored Higher Education Savings Benefits and
Their Relationship to Traditional Federal Student Aid
Summary
Reflecting the desire among Members of Congress to help middle-income
families pay for the escalating cost of higher education, the Congress has passed and
enhanced a variety of tax benefits since 1990. These federal income tax benefits may
be categorized in two ways: (1) those intended to encourage taxpayers to save for
future postsecondary education expenses, and (2) those meant to help taxpayers meet
current higher education expenses. The first group, on which this report focuses, is
composed of Education Savings Bonds, Section 529 (prepaid tuition and college
savings) Programs, and Coverdell Education Savings Accounts (formerly, Education
IRAs). The second group (e.g., the Hope Scholarship Credit, Lifetime Learning
Credit, and the Higher Education Deduction) and its relationship to eligibility for
traditional federal student aid is the subject of CRS Report RL31129.
An Education Savings Bond is a series EE bond issued after December 31, 1989
or a Series I bond owned by an individual who was at least 24 years old on the date
the bond was issued; the bond must be registered in the name of the taxpayer and/or
spouse who claim the student as a dependent on their tax return. Taxpayers,
depending on their income at the time of school enrollment, may be able to exclude
from income the interest earned on bonds redeemed to pay tuition and required fees.
The bonds are little utilized for educational purposes. The very popular Section 529
Programs are sponsored principally by states and enable virtually anyone to make
contributions toward the future higher education expenses of designated
beneficiaries. Section 529 prepaid tuition plans, which operate as a hedge against
tuition inflation, typically cover tuition and fees. Section 529 college savings plans,
which function much like mutual funds, cover the cost of attendance. Each 529
prepaid tuition and college savings plan is controlled by its account owners, who may
change beneficiaries and have the account balances refunded to them if they desire.
A Coverdell Education Savings Account is a trust or custodial account that similarly
allows money to be saved for a beneficiary’s cost of attendance. Unlike 529
Programs, however, the “responsible individual” who manages a Coverdell Account
cannot have the contributions to and tax-exempt earnings accumulated in Coverdell
Accounts refunded to him/her. Typically, the balances in Coverdell Accounts must
be given to the beneficiaries shortly after they reach 30 years of age.
These tax benefits may affect students’ eligibility for traditional federal financial
aid. For most aid applicants, this impact is felt to the extent that the net worth of
these savings vehicles and income from them are expected to be contributed toward
postsecondary education expenses under the traditional system; a greater expected
family contribution (EFC) can lead to reduced financial need and decreased eligibility
for need-based aid. The treatment of each of these tax benefits in the determination
of the EFC can differ sharply. Further, applicants for federal financial aid often do
not receive clear guidance from the Department of Education as to whose assets or
income these are, and how they are to be reported on their applications. Congress has
addressed some aspects of the relationship between traditional student aid and
education savings benefits in the Deficit Reduction Act of 2005. This report will be
updated as warranted.

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Tax-Advantaged Higher Education Savings Provisions . . . . . . . . . . . . . . . . . . . . 3
Education Savings Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Section 529 or Qualified Tuition Programs . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Coverdell Education Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Relationship to Eligibility for Traditional Federal Student Aid . . . . . . . . . . . . . 15
Federal Student Aid and the EFC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
EFC Treatment of Each Savings Benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Concluding Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
List of Tables
Table 1. Major Features of Education Savings Bonds,
Section 529 or Qualified Tuition Programs,
and Coverdell Education Savings Accounts . . . . . . . . . . . . . . . . . . . . . . . . 12

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Tax-Favored Higher Education Savings
Benefits and Their Relationship to
Traditional Federal Student Aid
Policymakers have been concerned that a college education is becoming less
affordable for middle-income families because the rise in tuition has outpaced the
increase in average household income for the past two decades.1 As a reflection of
the desire among Members of Congress to keep postsecondary education broadly
available to the U.S. population, the Congress has passed and enhanced a variety of
tax benefits toward that end since 1990.
This report examines three tax-favored savings incentives for higher education,
namely, Coverdell Education Savings Accounts, Section 529 or Qualified Tuition
Programs, and Education Savings Bonds. It omits discussion of some other forms
of tax-advantaged savings that were created primarily for other purposes (e.g.,
Individual Retirement Accounts)2 and for which higher education is just one of many
possible uses (e.g., Uniform Gift or Transfers to Minors Accounts).3 It then explains
the interaction between the three postsecondary education tax benefits and the
1 For more information see CRS Report RL32100, College Costs and Prices: Background
and Issues for Reauthorization of the Higher Education Act, by Rebecca R. Skinner.
2 In brief, funds withdrawn from an Individual Retirement Account (IRA) to pay for
qualified higher education expenses are exempt from the 10% tax penalty on distributions
taken before age 59½. The earnings portion of withdrawals remains subject to taxation.
Qualified expenses include tuition, fees, books, supplies, and equipment required for
enrollment or attendance at any college, university, vocational school, or other
postsecondary institution eligible to participate in a student aid program administered by the
U.S. Department of Education for courses taken at the undergraduate and graduate degree
level, less any tax-free educational assistance (e.g., Pell Grants). Also included in qualified
expenses are the room and board costs of students enrolled at least half-time as well as
special needs services incurred by or for special needs students in connection with their
education. The IRA’s owner must be the student, their spouse, or either of their children or
grandchildren.
3 In brief, these accounts are irrevocable gifts to minors. Parents typically act as custodians
of the accounts, which are offered by banks and other financial entities authorized by the
Internal Revenue Service (IRS). The custodians control the accounts until minors reach age
18 or 21, depending upon the state. At that time, the beneficiaries can utilize the funds for
any purposes they choose. Custodial accounts, which are subject to taxation annually, allow
families to minimize their tax bills: when children are under age 14, the first $800 of
unearned income is not taxed, the second $800 is taxed at the child’s lower tax rate, and any
remainder is taxed at the parents’ rate; once children attain 14 years of age, the first $800
of unearned income is not taxed and all of the remainder is taxed at the child’s lower tax
rate. The preceding discussion relates to tax year 2005, and the $800 threshold is indexed
annually for inflation.

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process of determining student eligibility for traditional federal financial aid,
consisting of grants, loans, or work-study income.
Introduction
The federal income tax measures specifically intended to assist individuals meet
higher education costs may be categorized in two ways:
1. those provisions intended to encourage taxpayers to save for future
postsecondary education expenses, and
2. those provisions meant to help taxpayers meet current postsecondary
education expenses.
The first group is composed of Education Savings Bonds, Section 529 or Qualified
Tuition Programs, and Coverdell Education Savings Accounts (formerly known as
Education IRAs). To take advantage of these incentives, taxpayers must be
financially able to set aside money from current income for educational costs they or
others (e.g., their children) may incur in years to come. The second group includes
the Hope Scholarship Credit, the Lifetime Learning Credit, and the Higher Education
Deduction.4
All education tax benefits share two characteristics. First, individuals must have
a federal income tax liability for the measures to be of value to them. In tax year
2005, for example, a married-couple with one child having personal and dependency
exemptions of $9,600 ($3,200 x 3) and taking the standard deduction ($10,000)
would have no federal income tax liability with an adjusted gross income at or below
$19,600. Second, these provisions, like others in the Internal Revenue Code (IRC),
are paid for through revenue losses to the government rather than through
appropriations by the government.
The IRC sets forth how the tax incentives dedicated to assisting individuals
finance a postsecondary education are coordinated with one another. They interact
not only with each other, but also with the traditional student aid system. That is to
say, the use of these tax provisions may affect the government’s calculation of
student eligibility for need-based federal financial assistance, such as Pell Grants.
The relationship between the federal income tax system and the traditional federal
student aid system, for which Congress appropriates funds, generally is determined
by how certain items reported on tax returns (e.g., unearned income including interest
and dividends) are treated on the Free Application for Federal Student Aid (FAFSA).
The FAFSA is administered by the U.S. Department of Education (ED).
4 For information on these measures, see CRS Report RL31129, Higher Education Tax
Credits and Deduction: An Overview of the Benefits and Their Relationship to Traditional
Student Aid, by Adam Stoll and Linda Levine. Other higher education tax benefits that are
not broadly available are not addressed in this report (e.g., employer educational assistance
and the miscellaneous business expense deduction).

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While the Committee on Ways and Means in the House and the Committee on
Finance in the Senate have jurisdiction over tax matters, the Education and the
Workforce Committee in the House and the Health, Education, Labor, and Pensions
Committee in the Senate have jurisdiction over education issues. The Congress
currently is engaged in reauthorization of the Higher Education Act (HEA, P.L. 89-
329 as amended by P.L. 105-244). The HEA last was revisited in 1998, before some
of the education tax measures were in effect (e.g., the Higher Education Tax
Deduction) or were made more attractive (e.g., Coverdell Education Savings
Accounts and Section 529 Programs).5
The manner in which higher education tax benefits are treated in determining
eligibility for traditional student aid is being addressed during reauthorization of the
HEA.6 Particularly in an era of heightened concern about the ability of families to
afford postsecondary education in the face of rising college prices, the Congress may
consider whether steps are necessary to reconcile the tension between encouraging
families to save for postsecondary education and providing financial aid based on
families’ need for assistance.7 Attention may be paid, as well, to questions of equity
and consistency in how the traditional student aid system treats these tax-favored
savings benefits.
Tax-Advantaged Higher Education
Savings Provisions
Education Savings Bonds
Working in chronological order by date of enactment, we start with so-called
Education Savings Bonds (ESBs). The program became effective in 1990 pursuant
to Section 6009 of the Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-
647), which created a new Section 135 in the IRC. It applies to otherwise eligible
owners of Series EE bonds issued after December 31, 1989 and Series I bonds. Bond
owners are not required to indicate at the time the bond is purchased that the
proceeds will be used for educational purposes.
Taxpayers who apply the principal and interest of these bonds toward qualified
higher education expenses (QHEEs) in the same year in which the bonds are
redeemed may be eligible to exclude all or part of the interest earned from their
income for federal tax purposes. Ordinarily, the interest would be subject to federal
income tax at the applicable marginal tax rate for individuals with tax liabilities not
fully offset by their personal/dependency exemptions, deductions, and credits. For
example, families with income tax liabilities who are in the 15% tax bracket would
pay $75 in taxes on interest of $500 (0.15 x $500) which is recognized when the
5 For further information, see CRS Report RS21870, Education Tax Benefits: Are They
Permanent or Temporary?, by Linda Levine.
6 For background on this reauthorization, see CRS Report RL33040, The Higher Education
Act: Reauthorization Status and Issues, by Adam Stoll.
7 For an individual family, its savings may reduce its eligibility for need-based federal aid.

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bond is redeemed, while a family in the 25% tax bracket would pay $125 (0.25 x
$500).8 Generally then, the higher a taxpayer’s marginal tax rate, the more valuable
an exclusion from income.
In order for the interest of a bond used to pay QHEEs to be excluded from gross
income, it must have been registered in the taxpayer’s name and/or the spouse’s
name — not in the dependent child’s name alone or as co-owner.9 Bond owners also
must have reached age 24 before the issue date of the bonds,10 which limits the utility
of the program to students under 29 years old who file tax returns separately from
their parents.11 Consequently, the program may be more useful to persons who
expect to take courses during their working lives. Further, grandparents can only
obtain federal tax savings from Series EE or I bonds used to pay their grandchildren’s
postsecondary education expenses if the students are dependents on the grandparents’
income tax return.
Taxpayers with students for whom they take exemptions (e.g., themselves, their
spouses, and their children) must meet income requirements in the year in which
bond proceeds are used toward QHEEs in order to claim the tax benefit. Persons
whose modified adjusted gross income (MAGI) is $76,200 or more ($121,850 or
more for filers of joint returns) in tax year 2005 may not take the exclusion.12 The
amount that can be subtracted from income is gradually reduced for taxpayers whose
MAGI is above $61,200 ($91,950 for married-couples filing jointly and for
qualifying widows or widowers).13 These income levels are adjusted annually for
inflation. If a family at the time of bond purchase underestimates their future income,
8 U.S. savings bonds confer a tax benefit whether or not they are applied toward QHEEs.
They, like other U.S. government obligations, are exempt from state and local income taxes.
9 Otherwise eligible bonds that were bought to qualify for the ESB program but were
registered in the child’s name may be reissued in the taxpayer’s and/or their spouse’s name
provided the bonds were not purchased with money belonging to the child. The purchaser
must complete a form, have their signature guaranteed or certified, and submit the form
along with the bonds to the appropriate regional Federal Reserve Bank.
10 Before enactment of the ESB benefit, taxpayers could claim the dependency exemption
for children of any age attending postsecondary school full-time. The revenue cost of the
benefit was paid for by allowing taxpayers to claim as dependents only those children
enrolled in postsecondary school full-time who are under age 24.
11 Independent students who purchase bonds at age 24 would not be able to redeem them for
five years if they want earnings to accumulate at the variable market rate. Bonds held less
than five years earn a lower fixed rate so the tax savings these students could obtain by
redeeming the bonds in that period to pay QHEEs might not outweigh the lower return.
12 For the typical taxpayer, MAGI is the same as adjusted gross income (AGI). In the case
of ESBs, MAGI is AGI before taking into account the bond interest exclusion, the higher
education deduction and the student loan interest deduction, the exclusion for adoption
benefits received under an employer’s adoption assistance program, the foreign income
exclusion, and the exclusion for income from sources in U.S. territories and Puerto Rico;
and after applying the partial exclusion of social security and tier 1 railroad retirement
benefits, amounts deducted for contributions to individual retirement arrangements, and
adjustments for limitations on passive activity losses and credits.
13 Married couples who own bonds must file joint returns to take the exclusion.

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they may be unable to take the income exclusion and also may have to pay more tax
on the interest than if the bond had been purchased in the child’s name.14 But, if the
bonds are in the student’s name, it could be more disadvantageous to the student’s
eligibility for traditional federal aid than if the bonds were in the parents’ name. (The
effect on aid eligibility of who is considered an asset’s owner will be examined later
in the report.)
As in the case of Section 529 Programs and Coverdell Education Savings
Accounts, ESBs may be used to pay the QHEEs of eligible students taking courses
at the undergraduate and graduate degree level. Similarly, to be eligible for the three
tax benefits, a student must be enrolled in or attend a college, university, vocational
school or other postsecondary institution that participates in an ED-administered
student aid program. (Table 1 provides a side-by-side comparison of the major
features of ESBs, 529 Programs, and Coverdell Accounts.)
Qualified expenses are defined as tuition and related fees at eligible institutions.
Contributions of ESB proceeds to 529 Programs and Coverdell Accounts also are
considered QHEEs (i.e., interest may be excluded from income if the bond’s
redeemed value is contributed to the other education savings programs). Taxpayers
may wish to contribute ESBs to the other savings vehicles if their MAGI were to
exceed the threshold for tax-free treatment of bond interest when their dependents
attend postsecondary school.
The bond’s redeemed value is applied against adjusted qualified expenses, that
is, QHEEs must be reduced by any tax-free educational assistance (e.g., Pell Grants,
scholarships, veterans’ educational assistance, and employer-provided educational
benefits). If the proceeds from a bond are more than the student’s adjusted QHEEs,
the taxpayer can exclude from income only a pro rata share of the interest. For
example, let us assume that (1) a dependent child attends a college charging the
2004-2005 average tuition and fees of $5,132 at four-year public institutions,15 and
receives a Pell Grant of $2,400 as well as a tax-free scholarship of $1,100 and that
(2) an ESB with a total value of $2,000, including $1,000 in interest, is redeemed.
Under these circumstances, the taxpayer could exclude $820 from income or 82% of
the bond’s interest ($1,600 in adjusted QHEEs — $5,132 less $3,500 in tax-free
educational assistance — divided by the bond’s total value). Whether a family has
tax savings from the ESB program will thus depend upon whether the student
receives traditional aid and the composition of that aid (e.g., aid provided through
loans does not reduce the value of QHEEs against which the exclusion can be taken),
the amount of tuition and fees actually incurred and, as previously mentioned, the
family’s income level.
14 Taxpayers who own series EE and I bonds can choose to defer recognition of interest until
the bond is redeemed or they can pay tax on the interest annually as it accrues. If a bond is
purchased in a child’s name and interest is recognized annually, it can be offset by the
child’s standard deduction. Other taxpayers with children whose income exceeds the child’s
standard deduction might be better off deferring recognition of unearned income (e.g., bond
interest) until the children attain age 14.
15 The College Board, Trends in College Pricing 2004.

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The ESB interest exclusion is coordinated with other IRC provisions to avoid
“double-dipping.” Higher education expenses paid with bond interest excluded from
income cannot be used to calculate other tax benefits, including the Hope Scholarship
Credit, Lifetime Learning Credit and Higher Education Deduction, as well as the tax-
free portion of withdrawals from 529 Programs and Coverdell Accounts.
Uncertainty about the level of future family income, the kind of traditional
financial aid a student will receive, and the amount of tuition and fees charged by the
institution a student will attend likely has restrained participation in the ESB
program. Factors specific to the program also could have dampened its usage (e.g.,
only bond owners who claim students as dependents on tax returns can utilize it and
the rate of return on government bonds historically has been comparatively low).
The Joint Committee on Taxation (JCT) estimates that revenue losses associated with
the ESB program typically are below $50 million annually.
Section 529 or Qualified Tuition Programs
Few states sponsored Section 529 or Qualified Tuition Programs before their
federal tax treatment was clarified by the Small Business Job Protection Act of 1996
(P.L. 104-188) in Section 529 of the IRC.16 The Economic Growth and Tax Relief
Reconciliation Act of 2001 (P.L. 107-16) more recently promoted interest in 529
Programs by making earnings tax-exempt when withdrawn to pay QHEEs through
December 31, 2010. Due in part to this and other enhancements to the program,
every state and the District of Columbia is the sponsor of at least one of the two types
of 529 Programs and new enrollments have driven much of the growth in their
value.17 As of December 31, 2004, there were over 7 million accounts18 and their
total asset value was about $65 billion.19
If projections of assets totaling in the hundreds of billions of dollars by the end
of the decade prove correct,20 the 529 Program could become quite costly to the
government in terms of revenue forgone (i.e., tax expenditures) and a considerable
source of federal support for higher education beyond appropriated funds. Although
the value excluded from income due to the Section 529 Program is not available from
the IRS,21 the JCT estimates that the income exclusion could produce tax
16 It had previously appeared that earnings might be subject to taxation while they were
building up inside the program. The legislation clarified that the earnings would not be
included in an individual’s income until withdrawn, i.e., earnings grow tax-deferred.
17 Peter Schmidt, “Prepaid-Tuition Plans Feel the Pinch,” Chronicle of Higher Education,
Sept. 12, 2003. (Hereafter cited as Schmidt, Prepaid-Tuition Plans Feel the Pinch.)
18 The number of accounts exceeds the number of beneficiaries because there is no limit to
the number of accounts that can be established on behalf of a beneficiary.
19 Quarterly data on value of assets in each state-sponsored 529 Program and number of
accounts/contracts by type of plan are available at [http://www.collegesavings.org].
20 Schmidt, Prepaid-Tuition Plans Feel the Pinch.
21 From 2002 through 2010 beneficiaries of state-sponsored plans do not have to report
qualified earnings distributions as “other taxable income” on the 1040 Form because P.L.
(continued...)

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expenditures that almost double from $500 million to $900 million between FY2005
and FY2009.22
The two types of 529 Programs are
! prepaid tuition plans, operate as a hedge against tuition inflation.
Contributors (e.g., parents, grandparents, and non-relatives) purchase
tuition credits or certificates, on behalf of beneficiaries, for future
QHEEs in state-sponsored programs or programs sponsored by
eligible institutions of higher education (including private
institutions). Contributions to prepaid tuition plans are pooled and
then invested by, or on behalf of, the state or institutional sponsor
with the aim of at least matching the anticipated increase in tuition.
Similar to ESBs, the balances in prepaid tuition plans typically can
be used for tuition and required fees.
! College savings plans, in contrast, function much like a mutual fund
by offering account owners a choice among a variety of investments
that financial services firms typically manage for the state sponsors.
The value of each beneficiary’s account is based upon the
performance of the selected investment option, which the account
owner may change subject to certain limitations.23 Similar to
Coverdell Accounts, the balances in college savings plans can be
used to cover the cost of attendance (i.e., tuition, fees, books,
supplies, and equipment required for enrollment or attendance; room
and board expenses for students enrolled on at least a half-time
basis; and expenses for special needs beneficiaries).
21 (...continued)
107-16 conferred them tax-exempt status during the period; the same holds for prepaid
tuition plans sponsored by eligible institutions of higher education starting in 2004.
22 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years
2005-2009, JCS-1-05, Jan. 12, 2005. (Hereafter cited as JCT, Estimates of Federal Tax
Expenditures for Fiscal Years 2005-2009.)
23 Account owners are restricted to the specific investment options offered by the college
savings programs they have selected. However, account owners are able to transfer funds
between the investment options of a state’s program, without tax consequences and without
changing beneficiaries, once every 12 months. Similarly, they may make nontaxable
transfers of funds between a program’s investment options if they change accounts’
beneficiaries to close relatives of the original beneficiaries (i.e., the original beneficiary’s
spouse; children, grandchildren, and stepchildren; brothers, sisters, and stepsiblings; parents,
stepparents, and grandparents; aunts and uncles; nieces and nephews; sons-in-law,
daughters-in-law, fathers-in-law, mothers-in-law, brothers-in-law, and sisters-in-law;
spouses of the aforementioned individuals; and first cousins of the original beneficiary).
Account owners also may annually make same-beneficiary, nontaxable rollovers into the
program of another state with investment strategies the owners prefer to those offered by the
original state’s programs, for example.

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The majority of 529 Program assets were in prepaid tuition plans through 2000.24
The value of investments in college savings plans has increased greatly, to the point
that today they account for the vast majority of 529 Program assets.25
There is no annual limit on contributions to a beneficiary’s 529 plan(s).
Although contributions are not deductible from income for federal tax purposes,26
many states offer a deduction for state tax purposes.27 There also are no income-
related restrictions for 529 Program savers, unlike the case with those who save
through ESBs and Coverdells, which likely makes the program particularly attractive
to more affluent families.
Federal income tax on earnings that accumulate in the plans is deferred until
withdrawn. In addition, the earnings that have built up inside the program are
exempt from tax if they are withdrawn to pay QHEEs through December 30, 2010.
Thereafter, according to the sunset provisions of P.L. 107-16, they will once again
be subject to taxation. Both the permanent deferral and temporary exemption confer
greater tax savings on more affluent families because of their higher marginal income
tax rates.28
If plan distributions are not used to pay the beneficiary’s QHEEs or distributions
exceed QHEEs, the earnings are taxable income to the distributee (account owner or
beneficiary). In addition, a 10% tax penalty on the earnings portion of nonqualified
distributions is assessed the distributee, unless the beneficiary dies, becomes
disabled, or receives a tax-free scholarship or educational allowance.
The Taxpayer Relief Act of 1997 (P.L. 105-34) declared that donations to 529
Programs are completed gifts from contributors to beneficiaries even though account
owners maintain control of the accounts (e.g., they can change the beneficiary or have
the money refunded to them). Contributors can give up to $11,000 in 2005 as a tax-
free gift per beneficiary, with the amount adjusted annually for inflation. Taxpayers
24 Schmidt, Prepaid-Tuition Plans Feel the Pinch.
25 As of Dec. 31, 2004, the asset value of prepaid tuition plans was about $12.5 billion
(19%) and of college savings plans about $52.2 billion (81%) of the $64.7 billion in state-
sponsored Section 529 Programs.
26 Programs have set high and varying limits on the total value that a college savings account
can reach.
27 For information about how different states tax contributions to 529 Programs and for a
more in-depth discussion of them see CRS Report RL31214, Saving for College Through
Qualified Tuition (Section 529) Programs, by Linda Levine.
28 The following example illustrates how a deferral results in tax savings and how the value
of savings is greater for those at higher income levels. Two families contribute $2,000 into
an investment at the end of each year for 15 years. The investment pays a 6% return per
annum. The balance would increase to $46,552 if earnings accumulate tax-free ($30,000
in contributions and $16,552 in earnings). If the families instead had to pay federal income
tax on the earnings each year, the family in the 15% bracket would have amassed $43,483;
the family in the 28% bracket, $41,013. Consequently, the deferral is worth $3,069 to the
lower income family compared to $5,539 to the higher income family. If states follow the
federal law, the tax deferral is worth even more to each family.

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with substantial resources who want to assist students can gain from a special gifting
provision that allows them to donate up to $55,000 per beneficiary in a single year
(or $110,000 in the case of two grandparents, for example) by treating the payment
as if it were made over five years.
Like the two other higher education savings provisions in the IRC, withdrawals
from 529 Programs must be applied against adjusted qualified expenses of students
taking courses at the undergraduate and graduate degree level who are enrolled in
colleges, universities, vocational schools or other postsecondary institutions that
participate in an ED-administered student aid program. That is to say, QHEEs must
be reduced by any tax-free educational assistance (e.g., Pell Grants, scholarships, and
veterans’ educational assistance).
Qualified withdrawals from Section 529 plans also must be coordinated with the
other education tax benefits in order to obtain favorable income tax treatment.
Although withdrawals can be taken from a beneficiary’s 529 plan and Coverdell
Account in the same year, the withdrawals will be taxable to the extent they exceed
adjusted QHEEs. Further, if 529 Program withdrawals are used to pay the qualified
expenses against which a Hope Scholarship Credit, Lifetime Learning Credit, or
Higher Education Deduction is taken, they will be subject to taxation.
Coverdell Education Savings Accounts
The most recently enacted higher education tax provision to encourage savings
is the Coverdell Education Savings Account. Originated in the Taxpayer Relief Act
of 1997 (P.L. 105-34) as the Education Individual Retirement Account at Section 530
of the IRC, it first became available in 1998. It was renamed in P.L. 107-22 effective
July 2001, and substantially enhanced in P.L. 107-16 effective January 2002.
A Coverdell Account is a trust or custodial account that enables money to be
saved toward the QHEEs of a designated beneficiary who takes undergraduate or
graduate courses at any college, university, vocational school, or other postsecondary
institution eligible to participate in an ED-administered student aid program. The
trustee or custodian must be a bank or another IRS-approved entity. A parent or
guardian typically is the “responsible individual,” “authorized person,” or “manager”
named when the account is opened because the beneficiary is a minor at that time.
The trustee or custodian generally has policies concerning the nature of the
responsible individual’s decision-making authority. For example, unlike a 529
Program account owner, the responsible individual cannot have a Coverdell
Account’s balance refunded to them. However, a trust or custodial agreement may
allow the manager of a Coverdell Account to change the beneficiary.29
29 The new beneficiary must be one of the following family members of the original
beneficiary: the original beneficiary’s spouse; children, grandchildren, and stepchildren;
brothers, sisters, stepbrothers, stepsisters; parents, stepparents, and grandparents; aunts and
uncles; nieces and nephews; sons-in-law, daughters-in-law, fathers-in-law, mothers-in-law,
brothers-in-law, and sisters-in-law; spouses of the aforementioned individuals; and first
cousins of the original beneficiary.

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CRS-10
Among other things, the document establishing and governing a Coverdell
Account must specify that the trustee or custodian can only accept contributions in
cash (like a 529 Program), that contributions be made before the beneficiary attains
age 18 (except for special needs beneficiaries), and that contributions to the account
will not cause total contributions per beneficiary for the year to exceed the legal limit.
Further, the account’s funds cannot be invested in life insurance contracts and cannot
be combined with other property except in a common trust fund or common
investment fund. (Other than these restrictions, contributions can be invested in any
options available through the trustee, such as stocks, bonds, mutual funds, and
certificates of deposit.) In addition, the agreement must state that any balance
remaining in an account will be distributed to the beneficiary within 30 days after the
beneficiary reaches age 30 (other than a special needs beneficiary) or dies, whichever
is earlier.
Earnings in Coverdell Accounts generally grow on a tax-deferred basis, which
as previously noted, provides greater tax savings to more affluent families because
their income is subject to higher marginal tax rates. In addition, withdrawals from
the accounts that are applied toward qualified expenses at the elementary, secondary,
and postsecondary levels are exempt from federal income tax.30 Unlike qualified
withdrawals from the 529 Program, which are tax free only through December 31,
2010, this is a permanent feature of Coverdell Account distributions used to pay the
cost of attending an eligible institution of higher education.
As information on qualified withdrawals from Coverdell Accounts does not
have to be reported on federal income tax returns, the value excluded from income
due to Coverdells is not available from the IRS. (As previously noted, this also is
true for the 529 Program during its tax-free period.) The JCT estimates that the
earnings exclusion of Coverdell Accounts could produce tax expenditures that range
from $100 million annually during FY2005-FY2007 to $200 million annually in
FY2008 and FY2009.31 Of the three education savings provisions, then, the 529
Program appears to be the most costly to the Treasury (i.e., provide the greatest
benefit to taxpayers) and the ESB Program, the least costly (i.e., provide the smallest
benefit).
Any individual taxpayer whose income is below specified levels may make
after-tax contributions to Coverdell Accounts of up to $2,000 annually per
beneficiary through December 31, 2010. The annual per-beneficiary contribution
limit — which was quadrupled in P.L. 107-16 — is not adjusted for inflation and will
revert to $500 in 2011, absent congressional action. Tax-free rollovers of funds from
one Coverdell Account to another of the same beneficiary or to certain family
30 Effective after Dec. 31, 2001 and through Dec. 31, 2010, funds invested in Coverdells
may be used toward certain expenses incurred in connection with attending public or private
elementary and secondary schools. For more information see CRS Report RL31439,
Federal Tax Benefits for Families’ K-12 Education Expenses in the Context of School
Choice, by Linda Levine and David P. Smole.
31 JCT, Estimates of Federal Tax Expenditures for Fiscal Years 2005-2009.

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CRS-11
members of a beneficiary do not count against the annual limit.32 Contributions
receive favorable gift and estate tax treatment, although not the “5-in-1-year”
provision allowed 529 Program contributors as noted above. Also unlike 529
Programs, the beneficiary must pay a 6% tax on excess contributions.
The MAGI of individual taxpayers who contribute to Coverdell Accounts must
be below $110,000 ($220,000 for joint return filers).33 The annual limit on
contributions is gradually reduced for individual taxpayers with incomes of more
than $95,000 but less than $110,000 (more than $190,000 but less than $220,000 for
joint return filers). However, parents whose incomes are above the thresholds could
give a tax-free gift of up to $2,000 to their child who could deposit the entire amount
in his/her account. The income ceilings are not adjusted for inflation and will (under
the sunset provisions of P.L. 107-16) revert to $95,000 and $150,000, respectively,
after December 31, 2010.
Contributions from corporations and tax-exempt organizations (e.g., a
foundation, charity, or union) are not contingent upon income. They thus may donate
the maximum annual contribution to accounts of children in families with incomes
in the phase-out ranges.
Like 529 college savings plans, qualified withdrawals from Coverdells may pay
for tuition, fees, books, supplies, and equipment required for enrollment or
attendance; room and board expenses for students enrolled on at least a half-time
basis; and special needs services required by a special needs beneficiary. QHEEs
also include withdrawals from a beneficiary’s Coverdell Account that are contributed
to the beneficiary’s 529 plan.
With some exceptions, the earnings portion of withdrawals that go toward
purposes other than QHEEs or that exceed them is included in the taxable income of
the distributee. These nonqualified distributions also are subject to a 10% penalty,
unless they are made to a beneficiary or to the beneficiary’s estate on or after the
beneficiary’s death, due to a beneficiary becoming disabled, or due to a beneficiary
receiving a tax-free scholarship or educational allowance. In order to determine
whether any portion of earnings withdrawn from a Coverdell Account is taxable, the
beneficiary’s QHEEs must be reduced by any tax-free educational assistance received
(e.g., Pell Grants) and be coordinated with other education tax benefits as shown in
Table 1.
32 Eligible family members are the same as those previously described for the Section 529
Program.
33 In the case of Coverdells, MAGI is equal to AGI plus the exclusions for foreign earned
income, foreign housing costs, and income from sources in U.S. territories and Puerto Rico.

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CRS-12
Table 1. Major Features of Education Savings Bonds, Section 529 or Qualified Tuition Programs,
and Coverdell Education Savings Accounts
Characteristics
Education Savings Bonds
Section 529 or Qualified Tuition Programs
Coverdell Education Savings Account
Nature of the
The bond must be a Series EE bond issued
A program that enables funds to accumulate for the
A custodial or trust account established
savings vehicle
after 1989, or a series I bond. It must be
purpose of paying the QHEEs of designated
expressly to pay the QHEEs of designated
issued in the taxpayer’s name (if sole
beneficiaries. There are two kinds of Section 529
beneficiaries. Accounts may be established
owner) or the name of the taxpayer and
Programs: prepaid tuition plans and college savings
for beneficiaries at any bank or other IRS-
spouse (if co-owners).
plans. The former, which can be sponsored by states
approved entity. Contributions can be
and higher education institutions, provides a hedge
invested in any options (except life insurance
against inflation by enabling contributors to pay tuition
contracts) available through the trustee, such
for future courses at today’s prices; contributions are
as stocks, bonds, mutual funds, and
pooled and invested by the plan sponsor. The latter,
certificates of deposit. As the beneficiaries
which can only be sponsored by states, allows
typically are minors when the accounts are
individuals to contribute to one of several investment
opened, parents or guardians generally act as
options predetermined by the plan’s sponsor.
the responsible individual who is accorded
decision-making authority according to the
trustee’s policies.
Nature of the tax
Interest may be excluded from bond
Earnings on non-deductible cash contributions to 529
Same as 529 Programs.
benefit
owner’s income if both principal and
Programs grow tax-deferred until withdrawn.
interest are used to pay QHEEs of eligible
students.
Earnings withdrawn from a state-sponsored 529
Same, except earnings withdrawn to pay
Program to pay the QHEEs of the plan’s beneficiary
QHEEs are permanently tax-exempt.
from 2003 through 2010 are tax-free.a If withdrawals
are not used to pay QHEEs or exceed their value, the
earnings portion is taxable and generally subject to a
10% additional tax penalty.
Amounts in a 529 Program can be rolled over tax-free
Same as 529 Programs.
once a year to another 529 plan of the same beneficiary
or to a 529 plan of a member of the beneficiary’s
family. The account owner can change a 529 plan’s
beneficiary without tax consequences, but the new
beneficiary must be a family member of the original
beneficiary.b

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CRS-13
Characteristics
Education Savings Bonds
Section 529 or Qualified Tuition Programs
Coverdell Education Savings Account
For whom can the
The student must be someone for whom the
Beneficiaries and contributors do not have to be family
Same as 529 Programs.
savings be used?
bond owner takes a federal income tax
members.
exemption (e.g., children, spouse, or
themselves).
The bond owner must be at least 24 years
No age limit on contributors or on beneficiaries.
Accounts can be established for persons
old before the bond’s issue date.
under age 18, or for special needs
beneficiaries regardless of age. When the
beneficiary (other than special needs
beneficiary) reaches age 30 or upon the death
of the beneficiary, the account generally must
be closed and the earnings included in the
beneficiary’s or estate’s income.
Income eligibility
Individuals whose MAGI is $76,200 or
No income eligibility limits or phase-out of the value
Through December 31, 2010, individuals
limits
more ($121,850 or more for joint filers) in
of contributions contingent on income.
may contribute if their MAGI is below
tax year 2005 cannot claim the tax benefit
$110,000 ($220,000 for those filing joint
for bonds redeemed to pay QHEEs. The
returns). The contribution amount is
amount of the benefit is gradually reduced
gradually reduced for individuals whose
for taxpayers whose MAGI is above
MAGI is between $95,000 and $110,000
$61,200 (above $91,850 for married
($190,000 and $220,000 for those filing joint
couples filing joint returns and for
returns). Contributions of organizations (e.g.,
qualifying widower(s)). The income
corporations, unions, and trusts) are not
ranges are adjusted annually for inflation.
income-limited.
Annual
The standard yearly purchase limit on
None
Contributors may make a total of $2,000 in
contribution limits
bonds applies ($30,000 face value for an
nondeductible cash contributions annually
individual and $60,000 face value for a
per beneficiary (excluding rolled over
married couple owning bonds jointly in the
amounts). The contribution limit is not
case of Series EE bonds and $30,000 face
indexed for inflation. The beneficiary must
value in the case of Series I bonds).
pay a 6% tax on excess contributions.
Level of
Any college, university, vocational school,
Same
Same
postsecondary
or other postsecondary institution eligible
education and
to participate in an ED-administered
eligible institutions
student aid program. For courses at the
undergraduate and graduate degree level.

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CRS-14
Characteristics
Education Savings Bonds
Section 529 or Qualified Tuition Programs
Coverdell Education Savings Account
Qualified expenses
Tuition and required fees. Bond proceeds
In practice, prepaid tuition plans generally are limited
Cost of attendance (see Section 529 Program
also may be rolled into Section 529
to coverage of tuition and required fees. College
column for definition). Withdrawals from
Programs and Coverdell Accounts.
savings plans can cover the cost of attendance (i.e.,
Coverdell accounts also may be used to make
tuition, fees, books, supplies, and equipment required
contributions to 529 plans on behalf of the
for enrollment; room and board for students enrolled at
Coverdell accounts’ beneficiaries.
least half-time; and expenses for special needs
beneficiaries).
These expenses must be reduced by any
Same
Same
tax-free educational assistance (e.g., Pell
Grants, scholarships, veterans’ educational
assistance, and employer-provided
educational benefits).
Coordination of
The interest exclusion cannot be taken for
Section 529 plan withdrawals will not be tax-free if
Same as 529 Programs.
benefits (i.e., no
the same QHEEs used to compute an
used to pay the same QHEEs used to compute an
double benefit
education tax credit and higher education
education tax credit and higher education deduction,
allowed)
deduction, paid with any tax-free
paid with any tax-free educational assistance, or paid
educational assistance, or paid with
with ESBs. A beneficiary may receive withdrawals
expenses used to calculate the tax-free
from a Coverdell Account and a 529 plan in the same
portion of withdrawals from a 529 Program
year, but the withdrawals will be taxable to the extent
or Coverdell Account.
they exceed adjusted QHEEs.
Source: The tax information was derived from Internal Revenue Service, Tax Benefits for Education, Publication 970; provisions of the Internal Revenue Code; and commentary.
Note: MAGI may be defined differently depending on the tax benefit. It is equal to AGI for most taxpayers.
a Until 2004, beneficiaries of 529 Programs sponsored by higher education institutions had to pay tax on earnings withdrawals for qualified expenses.
b Amounts in 529 Programs and Coverdell Accounts may be transferred to the designated beneficiary’s spouse; their son or daughter or descendant of son or daughter; stepson or
stepdaughter; brother, sister, stepbrother, or stepsister; father or mother or ancestor of either; stepfather or stepmother; son or daughter of a brother or sister; brother or sister of
father or mother; son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law; the spouse of any individual previously mentioned; and first cousin.

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CRS-15
Relationship to Eligibility for
Traditional Federal Student Aid
Higher education savings benefits and federal student aid, specifically the
federal need analysis system, are closely interrelated. A change in the treatment of
higher education savings benefits can impact the need analysis calculation, by
affecting the amount determined to be available from income and assets — also
known as the expected family contribution (EFC) — to contribute toward
postsecondary education expenses.34 To the extent that the balances in these savings
vehicles (assets) and the withdrawals from them (income) are expected to be
contributed toward postsecondary expenses, an aid recipient would be determined to
have a higher EFC and less financial need for federal student aid.
Although the relationship between higher education savings benefits and federal
student aid is interrelated, over the years the treatment of the various types of plans
in the federal need analysis calculation has differed and/or lacked clarity. The Deficit
Reduction Act of 2005 (DRA) (P.L. 109-171) attempted to clarify some of the
confusion surrounding the treatment of the different education savings benefits.
Specifically, DRA enacted the following changes:
! A qualified education benefit is defined as a qualified tuition plan
under section 529 of the IRC or other prepaid tuition plan offered by
a state, and Coverdell Accounts;
! a qualified education benefit shall not be considered an asset of the
dependent student for the purposes of determining need for federal
financial aid; and
! the value of a qualified education benefit shall be the refund value
of any tuition credits or certificates purchased for prepaid tuition
plans, and the current balance of the account for college savings
plans.
This section analyzes how education savings benefits are treated in the
calculation of the EFC, focusing specifically on the calculation for dependent
students because many of the difficult issues associated with the treatment of
education savings benefits in need analysis are likely to be experienced by dependent
students.35
34 For additional information regarding the calculation of the EFC, see CRS Report
RL33266, Federal Student Aid Need Analysis System: Background, Description, and
Legislative Action, by Charmaine Mercer.
35 There are three separate dependency classifications for individual applicants: dependent
student, independent student with dependents, and independent student without dependents.
Parental financial information is not considered if the applicant meets the statutory
definition of an independent student. To be classified as statutorily independent [Title IV,
Section 480(d)], an applicant must meet one of the following conditions: be 24 years of age
or older by Dec. 31 of the award year; married; enrolled in a graduate or professional
program; have a dependent other than a spouse; orphan or ward of the court; or a military
veteran or active duty service member.

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CRS-16
This section begins with an overview of the federal need analysis system,
including a brief description of the key steps for calculating the EFC for dependent
students. It is followed by an analysis of the EFC treatment of each of the education
savings benefits separately. It concludes with a discussion of selected issues relating
to need analysis and education savings benefits.
Federal Student Aid and the EFC
The federal need analysis system underlies the annual allocation of billions of
dollars (more than $73 billion in FY2006) in student financial aid supported by Title
IV (grants, loans, work-study) of the Higher Education Act (HEA) (P.L. 89-329, as
amended). It entails gathering financial data, which are provided by the student via
the free application for federal student aid (FAFSA); calculating the EFC; and
packaging of the applicant’s financial aid award by the postsecondary institution’s
financial aid administrator (FAA).
EFC. The EFC is the amount that the federal need analysis system determines
a family has available to contribute toward postsecondary education expenses. In
calculating the EFC, consideration is given to available income (a combination of
taxable and untaxed income and benefits), and for some families, available assets.
In addition, living expenses, retirement needs, and federal and state tax liabilities are
considered. The income contribution is calculated by determining the total income
of a student and his or her family (where applicable), and determining available
income by subtracting a series of allowances from total income; a percentage of that
available income is considered as an income contribution toward postsecondary
education costs. A contribution from assets is similarly calculated. The combination
of the available income contribution and asset contribution divided by the number of
individuals in the family enrolled in college constitutes the EFC. The EFC process
looks back a year for its income data and federal income tax liability. That is, for
award year 2006-2007,36 2005 income and federal income tax data were used.
EFC and Packaging. FAFSA data are submitted to a Central Processor (an
entity working under contract for the U.S. Department of Education) that calculates
the aid applicant’s EFC based on statutorily defined rules. From the Central
Processor, the EFC and other summary data are reported to FAAs and to the FAFSA
filer. The FAA determines the student’s need for federal student aid and other
sources of aid, based primarily upon the EFC and cost of attendance (COA). This is
true for all federal student aid programs (e.g., loans, campus-based programs) except
for the Pell Grant program. For nearly all Pell recipients, the award is calculated by
subtracting the EFC from the maximum appropriated Pell Grant for the year (i.e.,
without regard to the COA). The FAA determines need in conjunction with each
program’s award rules and puts together the financial aid award or package, which
consists of the specific sources and amounts of student aid the applicant will receive
to help pay for his or her education-related expenses.
EFC Calculation for Dependent Recipients. The EFC is influenced by
the inclusion of income and assets, such as the net worth or the distribution from an
36 The 2006-2007 award year began July 1, 2006, and ends on June 30, 2007.

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CRS-17
education savings benefit. The EFC is further impacted by the reported ownership
of the education savings benefit. The need analysis calculation assesses parental
income and assets at a lower rate than the income and assets of dependent students
(discussed below).
Parents’ income is afforded a more generous income protection allowance (IPA)
than is a dependent student’s income. For example, for the 2006-2007 award year,
the lowest parental IPA is $11,960 (this amount varies by family size and the number
of students in college), whereas the IPA for dependent students is a fixed $2,550.
Further, parental available income (total income minus various allowances including
the income protection allowance) is taxed within the EFC process on a progressive
schedule with an assessment rate ranging from 22% to 47%; in contrast, a dependent
student’s available income is assessed at a fixed 50%.
Parental assets are reduced by an education savings and asset protection
allowance (i.e., the amount of assets that is shielded from the expected family
contribution) that varies depending upon the age of the older parent; in contrast, no
portion of a dependent student’s own assets is similarly sheltered from consideration.
More critically, the discretionary net worth of parental assets (net worth minus the
education savings and asset protection allowance) is taxed within the EFC calculation
at a much lower rate than are the assets of a dependent student — not more than
5.64% for parental assets,37 and a fixed 35% for a dependent student’s assets.
As a result of these assessments, for nearly all dependent students, it is more
advantageous for the net worth of savings and income derived from those savings to
be considered those of their parents in the EFC calculation.38 To illustrate, consider
the different amounts a hypothetical dependent student will be expected to contribute
toward postsecondary expenses if $10,000 in savings is treated as a parental asset or
as his/her own. Based on the 2006-2007 rules for determining the EFC, for a
dependent student from a family of four (including two parents, the oldest parent
being 45 years of age, and a younger sibling) with total parental income (TI)39 of
37 The EFC rules provide that the discretionary net worth of parental assets is first taxed at
a 12% rate; this determines the so-called “contribution from assets.” That asset contribution
is added to parental available income yielding “adjusted available income.” Adjusted
available income is then taxed under a progressive contribution table, with 47% being the
highest tax rate in this table. As a result, the maximum possible contribution from the
discretionary net worth of parental assets is equal to 47% of 12%, or 5.64%.
38 There are two conditions under which the process described above is greatly modified,
particularly rendering differences in the treatment of assets inconsequential. Under the
simplified needs test, no assets are considered in calculating the EFC for a dependent
student if his or her parents’ AGI is less than $50,000 and the student and parents meet
certain conditions applied to their federal income tax returns. Further, there is an automatic
zero EFC applicable when the parents of a dependent student have AGI that is not greater
than $20,000 (the threshold for 2006-2007 award year) and meet the same conditions
regarding federal tax returns as apply for the simplified needs test.
39 Total income (TI) includes the adjusted gross income (taxable income from all sources)
amount that is calculated for federal tax filing purposes, income earned from work, and
untaxed income and benefits claimed for federal income tax.

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CRS-18
$50,000, student AGI of $1,000, and parental assets of $50,000,40 that includes the
$10,000, the estimated EFC is approximately $3,300.41 If, in contrast, the additional
$10,000 in savings is treated as the student’s asset, the EFC rises to an estimated
$6,800 — more than twice the EFC when treated as a parental asset. Depending
upon the student’s postsecondary expenses, this difference may have a substantial
negative effect on his/her eligibility for federal need-based aid.
EFC Treatment of Each Savings Benefit
To delineate the impact of each savings benefit on the EFC and students’
financial need, we consider the following questions for each:
! What does the HEA specify as the EFC treatment of the benefit?
! What is ED’s intended policy regarding the reporting on the FAFSA
of the benefit and its EFC treatment?
! What guidance do FAFSA filers generally have regarding how to
report the benefit on the FAFSA?
It is this last question that is perhaps the most telling. Regardless of what the
HEA requires and ED intends, it is FAFSA filers’ understanding of what they are to
do on the FAFSA that will determine for many students the impact these tax benefits
have on their EFC and financial need. As will be delineated below, it is likely that
many individuals, including even those paying close attention to the instructions they
receive in print or on the Web, will find limited or confusing guidance or, at times,
no guidance.
The text of the HEA is the source for consideration of the first question. The
2006-2007 Federal Student Aid Handbook is the primary source consulted for the
second.42 It should be noted that this publication was printed and made publically
available prior to the enactment of the DRA of 2005, which made several revisions
to the need analysis formula, including the treatment of education savings benefits
— these changes thus are not reflected in the Handbook. In addition to the
Handbook, over the years ED has issued several letters intended to provide policy
guidance on this issue for financial aid administrators. For example, on January 22,
2004, in an effort to clarify its intended treatment of Coverdell Accounts, Section 529
programs (prepaid tuition and college savings), and ESBs in calculating the EFC, ED
40 These total assets are $5,700 more than the $44,300 asset protection allowance provided
in the EFC rules to a family whose older parent is 45 years of age. Thus, a portion of the
$5,700 will be expected in contribution toward education expenses.
41 This estimate is based on the following allowances for parent’s income: only one parent
having earned income; 2005 taxable income being assessed at 15%; 5% of total income
being reserved for state and other taxes, and 7.65% of income for Social Security taxes.
42 This a multi-volume document of which the part entitled Application and Verification
Guide is the source for the citations in this CRS report. For convenience, we refer simply
to the Handbook in all subsequent references. All volumes of the 2006-2007 Federal
Student Aid Handbook can be found at [http://www.ifap.ed.gov/IFAPWebApp/
currentSFAHandbooksYearPag.jsp?p1=2006-2007&p2=c]. The discussion in this report
reflects the version of the Handbook posted on the Web as of July 13, 2006.

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CRS-19
published a Dear Colleague letter to institutions participating in the student aid
programs.43 Additionally, following the enactment of the DRA, two Dear Colleague
letters were released in April and June of 2006 to provide guidance in the calculation
of the EFC and COA adjustment.44 These two letters are important because they are
the most recent guidance that FAAs have regarding the changes enacted by the DRA.
Although Dear Colleague letters are intended to provide FAAs with ED’s
interpretation of the legislation regarding the treatment of education savings benefits
for the purposes of calculating the EFC, there is no guarantee that all FAAs will
receive and/or read the letters.
In terms of guidance for FAFSA filers, the focus is on the resources that
individuals filing the paper or Web forms are most likely to have access to. These
are the instructions accompanying the form itself for 2006-200745 — individuals
filling out either the paper or Web versions receive relatively similar instructions —
and an online set of instructions separate from the Web FAFSA that is available to
all FAFSA filers.46 The former are referred to subsequently in this report as the
“FAFSA-accompanying instructions.” The latter are referred to as the “online
instructions.” It is important to mention that the FAFSA, both the paper and Web
version, were available as early as January 1, 2006, prior to implementation of the
DRA changes. Thus, these instructions to filers did not reflect the changes enacted
by the DRA at the time the filer completed the application. While it is possible that
a filer could resubmit his/her FAFSA in light of these changes, it is unlikely that a
student would be aware of such changes.

Education Savings Bonds — Asset Treatment. HEA Section 480(f)
defines “assets” for purposes of calculating the EFC as including bonds, among other
financial resources. The HEA does not address ESBs per se. The Handbook is silent
regarding the asset treatment of ESBs. ED, in the 2004 Dear Colleague letter,
identifies ESBs as assets of the bond owner.
43 The letter is identified as DCL ID: GEN-04-02, and referred to subsequently in this report
as the 2004 Dear Colleague letter. The letter is available at [http://ifap.ed.gov/dpcletters/
GEN0402.html].
44 The April 2006 letter is identified as DCL ID: GEN-06-05, and is referred to subsequently
in this report as the April Dear Colleague letter. The June 2006 letter is identified as DCL
ID: GEN-06-10, and is referred to subsequently in this report as the June Dear Colleague
letter. The April 2006 letter is available at [http://www.ifap.ed.gov/dpcletters/
attachments/GEN0605.pdf]. The June 2006 letter is available at [http://www.ifap.ed.gov/
dpcletters/attachments/GEN0610.pdf].
45 The 2006-2007 paper form and instructions can be accessed at [http://www.ifap.ed.gov/
fafsa/attachments/0607FAFSAApplication(eng)100605.pdf].
46 The separate online instructions for 2006-2007 can be found at [http://www.studentaid.ed.
gov/students/publications/completing_fafsa/2006_2007/ques2.html]. The discussion in this
report reflects the version of these online instructions posted on the Web as of July 13, 2006.
The Handbook is available on the Web as well, but because FAFSA filers are not directed
to it, it is likely that very few filers would consult the Handbook as they complete their
application.

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CRS-20
FAFSA filers are informed through all of the sets of instructions that
investments to be reported include bonds, though ESBs are not identified specifically.
In fact, there is no guidance as to whose asset the bonds should be considered. If
filers understand “bonds” to include ESBs, their inclusion among assets may increase
the EFC. Filers reporting ESBs as assets are likely to report them as their parents’
since the bonds, to be used toward tuition and fees, must be in the taxpayers’
(typically, the parents’) names. As described earlier, a much smaller portion of
parental assets are expected to be contributed compared to student assets.
Education Savings Bonds — Income Treatment. HEA Section
480(a)(1) provides that total income for purposes of determining the EFC includes
“untaxed income.” Untaxed income is defined in Section 480(b)(5) as including
“interest on tax-free bonds” but there is no reference to ESBs. The Handbook
provides no guidance regarding treatment of ESB untaxed income.
The FAFSA-accompanying instructions are silent regarding whether and how
aid filers are to report untaxed ESB income specifically. Worksheet B, one of three
worksheets that filers complete in order to calculate amounts of income, assets, or tax
benefits to be reported on the FAFSA, is used to determine the amount of untaxed
income and benefits to be included in determining total income. While not asking
about ESB interest directly, it does include two questions which may lead to the
inclusion of untaxed ESB income in the EFC calculation. Worksheet B asks filers
to report any tax-exempt interest income which they have reported on line 8b of their
1040 or 1040A federal income tax return. Line 8b is used to report any “tax-exempt
interest” received (untaxed ESB income is not explicitly identified for inclusion by
the instructions for the federal income tax return). In addition, Worksheet B has an
open-ended request that filers provide the amount of “Other untaxed income not
reported elsewhere on Worksheets A and B.” All of the instructions list a number of
examples of untaxed income and benefits, such as workers’ compensation benefits,
without mentioning ESBs. For this question, all instructions also direct the filer not
to include student aid.
Thus, it is unclear whether most FAFSA filers with untaxed ESB income would
report it on their aid application. It would appear to depend in part on whether they
report ESB interest on line 8b of either the 1040 or 1040A federal income tax
return.47 As to whom the income should be credited, none of the instructions offer
guidance, although, similar to the ESB asset treatment, it is likely filers would
assume this is the parents’ income.
Section 529 Prepaid Tuition Plans — Asset Treatment. The HEA, as
amended by the DRA, delineates how Section 529 prepaid tuition plans are to be
treated in determining a student’s eligibility for federal student aid. Previously, the
asset value of prepaid tuition plans did not have an impact on the calculation of the
EFC and was not reported on the FAFSA. Rather, payment of qualified expenses
from a prepaid tuition plan reduced a student’s cost of attendance on a
47 Tax filers calculate the exclusion of interest from ESBs on IRS form 8815 and report the
“excludable interest” on Schedule B. Instructions for these forms do not direct the tax filer
to also include this interest income on line 8b.

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dollar-for-dollar basis. As a consequence, a student’s financial need for federal
need-based aid was decreased by the amount of any qualified withdrawal made from
a prepaid tuition plan — effectively applying a 100% tax rate to the distribution when
determining financial need. The DRA amended this provision so that prepaid tuition
plans are considered assets in calculating the EFC. Section 480(f) now states, “A
qualified education benefit shall not be considered an asset of a student for purposes
of Section 475 [EFC calculation for dependent students].” The HEA also now
specifies that the value of these plans are to be determined by ascertaining the refund
value of any tuition credits of certificates purchased. ED’s April and June 2006 Dear
Colleague letters state further that the plan’s value shall be included in the EFC
calculation only if the account is owned by the parent.
However, the FAFSA-accompanying instructions, released in January 2006,
state that prepaid tuition plans are not to be reported as an asset. It states, “The value
of a pre-paid tuition plan is not counted as an asset.” The online instructions reiterate
that admonition and also state that “The annual value of the tuition prepayment will
be taken into account when the school packages your aid and will reduce your
financial need.” The Handbook also offers a similar interpretation.
Section 529 Prepaid Tuition Plans — Income Treatment. As has been
described, withdrawals from Section 529 plans (both prepaid tuition plans and states’
college savings plans) to pay QHEEs are excluded from income for federal tax
purposes. The HEA does not explicitly address the treatment of income from these
plans, though Section 480(b)(14) describes the untaxed income to be considered in
determining the EFC as including “any other untaxed income and benefits....” The
Handbook similarly states that “the IRS does not tax distributions from plans used
for higher education purposes.”
The FAFSA-accompanying instructions and the online instructions are silent
with regard to the treatment of qualified withdrawals from Section 529 prepaid
tuition plans. As noted, FAFSA Worksheet B does ask for information on “other
untaxed income and benefits,” although the second sentence in the instructions for
this open-ended question (“Don’t include student aid,...”) may suggest that they not
report withdrawn earnings.
Section 529 College Savings Plans — Asset Treatment. Section
480(f) of the HEA defines assets for purposes of the EFC calculation as including
such savings vehicles as stocks and mutual funds, which suggests that Section 529
college savings plans should be considered as assets included in the EFC calculation.
The Handbook not only states that college savings plans are to be included as assets,
but also that “The value of a college saving plan should be treated as an asset of the
owner (not the beneficiary [i.e., the dependent student] because the owner can change
the beneficiary at any time) and will be reported on the FAFSA if the owner’s assets
are reported.” College savings plans are, according to ED’s guidance, to be treated
as parental assets only if the parents are the owners. Because there are instances

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whereby a dependent student can be an owner of a college savings plan, the plan’s
assets in those cases would not be reflected in the EFC calculation.48
The FAFSA-accompanying instructions, while clearly stating that college
savings plans are to be included as assets, do not provide any direction as to whose
assets they are. At the same time, the online instructions list college saving plans as
assets in the instructions for a question posed to the student regarding his or her
assets, but not in the instructions for a similar question for the student’s parents. As
a result of this lack of clarity across all sets of instructions, it is uncertain the extent
to which filers will follow ED’s interpretation of the DRA stating that college
savings plans owned by parents be treated as parental assets.
Section 529 College Savings Plans — Income Treatment. The HEA
does not address the treatment of untaxed income from college savings plans, though,
as noted previously, it has a broad requirement that other untaxed income is to be
included in total income. The Handbook categorically states that qualified
withdrawals from college saving plans “should not be treated as untaxed income or
as resources.” Similarly, the 2004 Dear Colleague letter declares that untaxed 529
distributions, “are not counted as parent or student income.”
All sets of FAFSA instructions are silent regarding this treatment. As was
described for the Section 529 prepaid tuition plans (see above), filers could include
this income among “any other untaxed income and benefits” called for by Worksheet
B, or may be dissuaded by the caution in the Worksheet B instructions that this
untaxed income is not to include student aid.
Coverdell Education Savings Accounts — Asset Treatment. Prior
to the enactment of the DRA, the HEA did not address Coverdell Accounts directly.
Coverdell Education Savings Accounts are now defined as a qualified education
benefit for the purposes of Title IV. Thus, as in the case of 529 prepaid and college
savings plans, the HEA now specifies that they are not considered an asset of the
dependent student when calculating the EFC. All three Dear Colleague letters
declare that Coverdells shall be included as parental assets in the EFC calculation if
the parent is the account owner. In the Handbook, ED also states that these assets are
to be included and, further, that “[t]heir value should be reported on the FAFSA as
an asset of the account owner.” “Account owner” is apparently intended to refer to
a dependent student’s parents or guardians, but the term in the context of Coverdells
is ambiguous.
The FAFSA-accompanying instructions require the inclusion of Coverdell
Accounts as investments but are silent as to whose they are to be considered. In
contrast, the online instructions, call on students to report as their own assets any
Coverdell Accounts “in your name.” Further, they state, “The money in an Education
IRA is an asset for the student beneficiary because an Education IRA is not a
48 Not only do four states allow dependent students to be account owners, according to the
College Savings Plan Network, but also if Uniform Gift to Minors Act and Uniform
Transfer to Minors Act accounts are liquidated and reinvested in college savings plans, their
assets continue to belong to the student.

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retirement account. It is essentially a savings account to be used for the student’s
education expenses. Therefore, if you own the account, you must report the amount
in your Coverdell Education Savings Account with your investments.” As a result,
none of the instructions provided to FAFSA filers for the 2006-2007 award year,
reflect ED’s interpretation of the DRA’s amendments to the HEA regarding the
treatment of Coverdell assets.
Coverdell Education Savings Accounts — Income Treatment . The
HEA does not address the treatment of untaxed Coverdell withdrawals beyond the
language already described suggesting a broad reach to the definition of untaxed
income and benefits. The Handbook stipulates that untaxed Coverdell interest
income is to be included among “other untaxed income and benefits” on Worksheet
B. In direct conflict, the 2004 Dear Colleague letter states that such income is not
to be included as parental or student income in calculating the EFC.
FAFSA filers do not receive this message about what ED appears to intend
because the FAFSA-accompanying instructions and the online instructions are silent
as to the treatment of the untaxed income. Filers may report withdrawals from the
accounts in response to Worksheet B’s open-ended question regarding “other untaxed
income and benefits” or consider them to be student aid excluded from that question.
Concluding Issues
There are two major issues that can be identified from the preceding analysis.
First, FAFSA filers often do not receive clear or timely guidance, either through the
FAFSA-accompanying instructions or the online instructions, about whether and how
the asset value of these tax-favored savings or the untaxed income derived from them
are to be reported. Consequently, families with similar financial and other
characteristics can be treated in very different ways depending upon how they
interpret the instructions they do receive, or how they act in the absence of guidance.
Second, the DRA addressed the different treatment in the need analysis system
accorded to 529 prepaid plans versus college savings plans. But the issue of account
ownership remains unclear. Although the HEA was amended to clarify that a
qualified education benefit shall not be considered an asset of a dependent student
when calculating the EFC, this action assumed that a dependent student would not
be the owner of the benefit. This assumption is further evidenced by ED’s
justification of 529 college savings plans: in the Handbook, it states that the plans
are considered parental assets because the owner can change the beneficiary
(dependent student). However, the 2004 Dear Colleague letter called for equal asset
treatment of both Coverdells and 529 college savings plans, despite the Coverdell
“account owner” not always being able to change beneficiaries. In any event, there
are some instances in which dependent students can be owners of qualified education
benefits. The DRA and ED’s April and June 2006 Dear Colleague letters effectively
mean that in cases where a dependent student owns a qualified education benefit, the
assets escape consideration in the EFC calculation. Furthermore, because qualified
education benefits can be opened by persons other than a parent or guardian (e.g.,
grandparents), the asset or income levels from such investments have never reflected
in the EFC calculation.
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