Tax-Favored Higher Education Savings Benefits and Their Relationship to Traditional Federal Student Aid

Tax-Favored Higher Education Savings Benefits and Their Relationship to Traditional Federal Student Aid

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Pr
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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, Higher Education Tax Credits and Deduction: An Overview
of the Benefits and Their Relationship to Traditional Student Aid.
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
College Cost Reduction and Access Act of 2007. This report will be updated as warranted.

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Introduction ..................................................................................................................................... 1
Tax-Advantaged Higher Education Savings Provisions.................................................................. 2
Education Savings Bonds.......................................................................................................... 2
Section 529 or Qualified Tuition Programs............................................................................... 5
Coverdell Education Savings Accounts .................................................................................... 7
Relationship to Eligibility for Traditional Federal Student Aid..................................................... 13
Federal Student Aid and the EFC ............................................................................................ 14
EFC ................................................................................................................................... 14
EFC Treatment of Each Savings Benefit................................................................................. 16
Education Savings Bonds: Asset Treatment...................................................................... 17
Education Savings Bonds: Income Treatment .................................................................. 17
Section 529 Prepaid Tuition Plans: Asset Treatment ........................................................ 18
Section 529 Prepaid Tuition Plans: Income Treatment ..................................................... 18
Section 529 College Savings Plans: Asset Treatment ....................................................... 19
Section 529 College Savings Plans: Income Treatment.................................................... 19
Coverdell Education Savings Accounts: Asset Treatment ................................................ 20
Coverdell Education Savings Accounts: Income Treatment ............................................. 20
Concluding Issues ................................................................................................................... 20

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Table 1. Major Features of Education Savings Bonds, Section 529 or Qualified Tuition
Programs, and Coverdell Education Savings Accounts ............................................................. 10

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Author Contact Information .......................................................................................................... 20

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olicymakers 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
P 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 process of determining student eligibility for traditional federal financial aid,
consisting of grants, loans, or work-study income.
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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. 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

1 For more information see CRS Report RL34224, College Costs and Prices: Issues for Reauthorization of the Higher
Education Act, by Rebecca R. Skinner and Blake Alan Naughton.
2 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. The IRA’s owner must be the student, their spouse, or either of their children or grandchildren.
3 These accounts are irrevocable gifts to minors. Parents typically act as custodians of the accounts. The custodians
control the accounts until minors reach age 18 or 21, depending upon the state. The beneficiaries then can use the funds
for any purpose. Custodial accounts, which are subject to taxation annually, allow families to minimize their tax bills.
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 Linda Levine and Charmaine Mercer.
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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ŗȱ

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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).
Although 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 Labor Committee in the House and
the Health, Education, Labor, and Pensions Committee in the Senate have jurisdiction over
education issues. The 110th Congress continues to work on the reauthorization of the Higher
Education Act (HEA, P.L. 89-329, as amended by P.L. 105-244). During the first session of the
110th Congress, two major HEA reauthorization proposals were introduced: Higher Education
Amendments of 2007 (S. 1642) and the College Opportunity and Affordability Act of 2007 (H.R.
4137). Neither of the two proposals contain provisions that would affect college savings plans.
This is in part because reauthorization of the HEA is heavily intertwined with the budget
reconciliation process. The passage of the College Cost Reduction and Access Act (CCRAA) of
2007 (P.L. 110-84) on September 27, 2007, made significant changes to the student loan
programs, the Pell Grant program, and the federal need analysis formula. Notably, the CCRAA
included provisions that will change how disbursements from the education savings plans are
treated in the need analysis formula and clarified the issue of ownership of these accounts,
specifically for dependent students. These changes have been viewed as important particularly in
an era of heightened concern about the ability of families to afford postsecondary education in the
face of rising college prices.
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The first college savings tax benefit Congress enacted is the Education Savings Bond (ESB). 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 the 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) when the bond is redeemed, while a family in the 25% tax
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bracket would pay $125 (0.25 x $500).5 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.6 Bond owners also must have reached age 24 before the issue
date of the bonds,7 which limits the utility of the program to students under 29 years old who file
tax returns separately from their parents.8 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 QHEEs 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 to claim the tax benefit. Persons whose modified adjusted gross income (MAGI) is
$80,600 or more ($128,400 or more for filers of joint returns) in tax year 2007 may not take the
exclusion.9 The amount that can be subtracted from income is gradually reduced for taxpayers
whose MAGI is above $65,600 ($98,400 for married couples filing jointly).10 These income
levels are adjusted annually for inflation. If a family at the time of bond purchase underestimates
their future income, 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.11 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.)

5 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.
6 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.
7 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.
8 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.
9 MAGI usually 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.
10 Married couples who own bonds must file joint returns to take the exclusion.
11 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.
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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. 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, assume that (1) a dependent child attends a college
charging the 2007-2008 average tuition and fees of $6,185 at four-year public institutions,12 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 $4,000, including $2,000 in interest, is redeemed. Under these circumstances,
the taxpayer could exclude 67% of the bond’s interest or $1,340 from income ($2,685 in adjusted
QHEEs—$6,185 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, the composition of any aid received (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.
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.

12 The College Board, Trends in College Pricing 2007.
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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.13 The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, 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. Subsequently, the Pension Protection Act
of 2006 (P.L. 109-280) made EGTRRA’s changes to Section 529 plans permanent. Due in part to
the program enhancements, 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.14 As of December 31, 2006, there were 9.3 million accounts;15 their total asset value was
$105.7 billion.16
If projections of assets totaling in the hundreds of billions of dollars by the end of the decade
prove correct,17 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, the JCT estimates that the income exclusion
could produce tax expenditures that double between FY2007 and FY2011, from $600 million to
$1.2 billion.18
The two types of 529 Programs are the following:
• 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

13 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 grow on a tax-deferred basis.
14 Peter Schmidt, “Prepaid-Tuition Plans Feel the Pinch,” Chronicle of Higher Education, September 12, 2003.
(Hereafter cited as Schmidt, Prepaid-Tuition Plans Feel the Pinch.)
15 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.
16 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.
17 Schmidt, Prepaid-Tuition Plans Feel the Pinch.
18 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2007-2011, JCS-3-07,
September 24, 2007. (Hereafter cited as JCT, Estimates of Federal Tax Expenditures for Fiscal Years 2007-2011.)
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the account owner may change subject to certain limitations.19 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).
The majority of 529 Program assets were in prepaid tuition plans through 2000.20 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.
There is no annual limit on contributions to a beneficiary’s 529 plan(s).21 Although contributions
are not deductible from income for federal tax purposes, many states offer a deduction for state
tax purposes.22 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. Both the deferral and exemption confer greater tax savings on more
affluent families because of their higher marginal income tax rates.
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 $12,000 in 2007 as a tax-free gift per beneficiary, with the amount
adjusted annually for inflation. Taxpayers with substantial resources who want to assist students
can gain from a special gifting provision that allows them to donate up to $60,000 per beneficiary
in a single year (or $120,000 in the case of two grandparents, for example) by treating the
payment as if it were made over five years.

19 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 such as one with different investment
strategies.
20 Schmidt, Prepaid-Tuition Plans Feel the Pinch.
21 Programs have set high and varying limits on the total value that a college savings account can reach.
22 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.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
Ŝȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
Like the two other higher education savings provisions, 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.
˜ŸŽ›?Ž••ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŒŒ˜ž—?œȱ
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.23
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.) The agreement also must state that any balance in the account will be distributed to the

23 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.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
ŝȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
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.24
Because information on qualified withdrawals from Coverdell Accounts does not have to be
reported on federal income tax returns, the value excluded from income is not available from the
IRS. (As previously noted, this also is true for the 529 Program.) The JCT estimates that the
earnings exclusion of Coverdell Accounts could produce tax expenditures of $100 million
annually during FY2007-FY2011.25 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 members of a beneficiary do not count against the annual limit.26 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 the 529 Program, the beneficiary must pay a
6% tax on excess contributions.
The MAGI of individual taxpayers who contribute to Coverdell Accounts in tax year 2007 must
be below $110,000 ($220,000 for joint return filers).27 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

24 Effective after December 31, 2001 and through December 31, 2010, funds invested in Coverdells may be used
toward certain expenses incurred in connection with attending public or private elementary and secondary schools.
25 JCT, Estimates of Federal Tax Expenditures for Fiscal Years 2007-2011.
26 Eligible family members are the same as those previously described for the Section 529 Program.
27 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.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
Şȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
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
and be coordinated with other education tax benefits as shown in Table 1.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
şȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
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
A custodial or trust account established
savings vehicle
after 1989, or a series I bond. It must be
the purpose of paying the QHEEs of designated
expressly to pay the QHEEs of designated
issued in the taxpayer’s name (if sole owner)
beneficiaries. There are two kinds of Section 529 beneficiaries. Accounts may be established for
or the name of the taxpayer and spouse (if co- Programs: prepaid tuition plans and college savings beneficiaries at any bank or other IRS-approved
owners).
plans. The former, which can be sponsored by
entity. Contributions can be invested in any
states and higher education institutions, provides
options (except life insurance contracts) available
a hedge against inflation by enabling contributors
through the trustee, such as stocks, bonds,
to pay tuition for future courses at today’s prices; mutual funds, and certificates of deposit. As the
contributions are pooled and invested by the plan beneficiaries typically are minors when the
sponsor. The latter, which can only be sponsored accounts are opened, parents or guardians
by states, allows individuals to contribute to one
generally act as the responsible individual who is
of several investment options predetermined by
accorded decision-making authority according to
the plan’s sponsor.
the trustee’s policies.
Nature of the tax
Interest may be excluded from bond owner’s
Earnings on non-deductible cash contributions to Same as 529 Programs.
benefit
income if both principal and interest are used 529 Programs grow tax-deferred until withdrawn.
to pay QHEEs of eligible students.

Earnings withdrawn from a state-sponsored 529
Same as 529 Programs.
Program to pay the QHEEs of the plan’s
beneficiary are tax-free. 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- Same as 529 Programs.
free 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.a
For whom can the
The student must be someone for whom the
Beneficiaries and contributors do not have to be
Same as 529 Programs.
savings be used?
bond owner takes a federal income tax
family members.
exemption (e.g., children, spouse, or
themselves).
ȬŗŖȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
Characteristics
Education Savings Bonds
Section 529 or Qualified Tuition Programs
Coverdell Education Savings Account
The bond owner must be at least 24 years old No age limit on contributors or on beneficiaries.
Accounts can be established for persons under
before the bond’s issue date.
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 $80,600 or more
No income eligibility limits or phase-out of the
Through December 31, 2010, individuals may
limits
($128,400 or more for joint filers) in tax year value of contributions contingent on income.
contribute if their MAGI is below $110,000
2007 cannot claim the tax benefit for bonds
($220,000 for those filing joint returns). The
redeemed to pay QHEEs. The amount of the
contribution amount is gradually reduced for
benefit is gradually reduced for taxpayers
individuals whose MAGI is between $95,000 and
whose MAGI is above $65,600 (above $98,400
$110,000 ($190,000 and $220,000 for those filing
for married couples filing joint returns and for
joint returns). Contributions of organizations
qualifying widower(s)). The income ranges are
(e.g., corporations, unions, and trusts) are not
adjusted annually for inflation.
income-limited.
Annual contribution The standard yearly purchase limit on bonds
None
Contributors may make a total of $2,000 in
limits
applies ($30,000 face value for an individual
nondeductible cash contributions annually per
and $60,000 face value for a married couple
beneficiary (excluding rolled over amounts)
owning bonds jointly in the case of Series EE
through December 31, 2010. The contribution
bonds and $30,000 face value in the case of
limit is not indexed for inflation. The beneficiary
Series I bonds).
must pay a 6% tax on excess contributions.
Level of
Any college, university, vocational school, or
Same Same
postsecondary
other postsecondary institution eligible to
education and
participate in an ED-administered student aid
eligible institutions
program. For courses at the undergraduate
and graduate degree level.
Qualified expenses
Tuition and required fees. Bond proceeds also In practice, prepaid tuition plans generally are
Cost of attendance (see Section 529 Program
may be rolled into Section 529 Programs and
limited to coverage of tuition and required fees.
column for definition). Withdrawals from
Coverdell Accounts.
College savings plans can cover the cost of
Coverdell accounts also may be used to make
attendance (i.e., tuition, fees, books, supplies, and contributions to 529 plans on behalf of the
equipment required for enrollment; room and
Coverdell accounts’ beneficiaries.
board for students enrolled at least half-time; and
expenses for special needs beneficiaries).
These expenses must be reduced by any tax-
Same Same
free educational assistance (e.g., Pell Grants,
scholarships, veterans’ educational assistance,
and employer-provided educational benefits).
Ȭŗŗȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
Characteristics
Education Savings Bonds
Section 529 or Qualified Tuition Programs
Coverdell Education Savings Account
Coordination of
The interest exclusion cannot be taken for the Section 529 plan withdrawals will not be tax-free Same as 529 Programs.
benefits (i.e., no
same QHEEs used to compute an education
if used to pay the same QHEEs used to compute
double benefit
tax credit and higher education deduction,
an education tax credit and higher education
allowed)
paid with any tax-free educational assistance,
deduction, paid with any tax-free educational
or paid with expenses used to calculate the
assistance, or paid with ESBs. A beneficiary may
tax-free portion of withdrawals from a 529
receive withdrawals from a Coverdell Account
Program or Coverdell Account.
and a 529 plan in the same year, but the
withdrawals will be taxable to the extent 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. 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.
ȬŗŘȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
Ž•Š?’˜—œ‘’™ȱ?˜ȱ•’?’‹’•’?¢ȱ?˜›ȱ›Š?’?’˜—Š•ȱŽ?Ž›Š•ȱ
?ž?Ž—?ȱ’?ȱ
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.28 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 or lacked clarity. Both the Deficit Reduction Act of 2005 (DRA) (P.L.
109-171) and the College Cost Reduction and Access Act of 2007 (CCRAA) (P.L. 110-84)
attempted to clarify some of the confusion surrounding the treatment of the different education
savings benefits. Specifically, the 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.
Additionally, the following provisions enacted by the CCRAA will become effective July 1, 2009:
• individuals who were in foster care at age 13 or older will be considered
independent students for the purpose of applying for and receiving federal
student aid;29
• distributions from the education savings benefits will not be considered as
income in the need analysis formula; and

28 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.
29 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 December 31 of
the award year; married; enrolled in a graduate or professional program; have a dependent other than a spouse; be an
orphan or ward of the court; or be a military veteran or active duty service member.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
ŗřȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
• qualified education benefits were further clarified as being considered the asset
of the student in the case of independent students and the asset of the parent in
the case of dependent students, no matter who the account owner is.
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.
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.
Ž?Ž›Š•ȱ?ž?Ž—?ȱ’?ȱŠ—?ȱ?‘Žȱȱ
The federal need analysis system underlies the annual allocation of billions of dollars (more than
$94 billion in 2005-2006) 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).
ȱ
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 2007-2008,30 2006 income and federal income tax data were used.
ȱŠ—?ȱŠŒ”Š?’—?ȱ
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

30 The 2007-2008 award year began July 1, 2007, and ends on June 30, 2008.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
ŗŚȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
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.
ȱŠ•Œž•Š?’˜—ȱ?˜›ȱŽ™Ž—?Ž—?ȱŽŒ’™’Ž—?œȱ
The EFC is influenced by the inclusion of income and assets, such as the net worth or the
distribution from an 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 2007-2008 award year, the lowest parental IPA
is $12,430 (this amount varies by family size and the number of students in college), whereas the
IPA for dependent students is a fixed $3,000. 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,31 and a fixed 20% 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.32 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 2007-2008 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)33 of

31 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%.
32 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 2007-2008 award
year) and meet the same conditions regarding federal tax returns as apply for the simplified needs test.
33 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.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
ŗśȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
$50,000, student AGI of $1,000, and parental assets of $50,000,34 that includes the $10,000
education savings benefit, the estimated EFC is approximately $3,000.35 If, in contrast, the
additional $10,000 in savings is treated as the student’s asset, the EFC rises to an estimated
$5,000. Depending upon the student’s postsecondary expenses, this difference may have a
substantial negative effect on his/her eligibility for federal need-based aid.
ȱ›ŽŠ?–Ž—?ȱ˜?ȱŠŒ‘ȱŠŸ’—?œȱŽ—Ž?’?ȱ
To delineate the impact of each savings benefit on the EFC and students’ financial need, CRS
considered 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 2007-2008 Federal
Student Aid Handbook is the primary source consulted for the second.36 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 published a Dear Colleague letter to institutions
participating in the student aid programs.37 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.38 It should be noted that Dear Colleague letters are

34 These total assets are $6,900 more than the $43,100 asset protection allowance provided in the EFC rules to a family
whose older parent is 45 years of age. Thus, a portion of the $6,900 will be expected to be contributed toward education
expenses.
35 This estimate is based on the following allowances for parent’s income: only one parent having earned income; 2006
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.
36 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, CRS refers simply to the Handbook in all subsequent references. All
volumes of the 2007-2008 Federal Student Aid Handbook can be found at http://www.ifap.ed.gov/IFAPWebApp/
currentSFAHandbooksYearPag.jsp?p1=2007-2008&p2=c. The discussion in this report reflects the version of the
Handbook posted on the Web as of January 14, 2008.
37 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.
38 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/
(continued...)
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
ŗŜȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
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, although there is no guarantee
that all FAAs will receive 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 2007-200839—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.40 The former are referred to subsequently in this report as the
“FAFSA-accompanying instructions.” The latter are referred to as the “online instructions.”
?žŒŠ?’˜—ȱŠŸ’—?œȱ˜—?œǱȱœœŽ?ȱ›ŽŠ?–Ž—?ȱ
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.
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.
?žŒŠ?’˜—ȱŠŸ’—?œȱ˜—?œǱȱ —Œ˜–Žȱ›ŽŠ?–Ž—?ȱ
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.

(...continued)
attachments/GEN0605.pdf. The June 2006 letter is available at http://www.ifap.ed.gov/dpcletters/attachments/
GEN0610.pdf.
39 The 2007-2008 paper form and instructions can be accessed at http://www.ifap.ed.gov/fafsa/attachments/
0708FAFSAFinal.pdf.
40 The separate online instructions for 2007-2008 can be found at http://www.ifap.ed.gov/fafsa/attachments/
0708FOTWWorksheetColor.pdf. The discussion in this report reflects the version of these online instructions posted on
the Web as of January 14, 2008. 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.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
ŗŝȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
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.41 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.
ŽŒ?’˜—ȱśŘşȱ›Ž™Š’?ȱž’?’˜—ȱ•Š—œǱȱœœŽ?ȱ›ŽŠ?–Ž—?ȱ
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 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. Furthermore, the HEA specifies that the value of these
plans is to be determined by ascertaining the refund value of any tuition credits of certificates
purchased.
HEA Section 480(f)(3) states, “A qualified education benefit shall not be considered an asset of a
student for purposes of Section 475 [EFC calculation for dependent students].” In addition, the
FAFSA-accompanying instructions, released in January 2007, state that prepaid tuition plans
should be reported as an asset of the parent if the account is owned by the parent. ED’s April and
June 2006 Dear Colleague letters state that the plan’s value shall be included in the EFC
calculation only if the account is owned by the parent. The Handbook further maintains that if the
account is owned by the dependent student, the value of the account is to be excluded from both
the student’s and parent’s assets.
ŽŒ?’˜—ȱśŘşȱ›Ž™Š’?ȱž’?’˜—ȱ•Š—œǱȱ —Œ˜–Žȱ›ŽŠ?–Ž—?ȱ
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....”

41 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.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
ŗŞȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
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.
Effective July 1, 2009, withdrawals from prepaid tuition plans to pay QHEEs will no longer be
considered income for the purposes of determining need for federal student aid.42
ŽŒ?’˜—ȱśŘşȱ˜••Ž?ŽȱŠŸ’—?œȱ•Š—œǱȱœœŽ?ȱ›ŽŠ?–Ž—?ȱ
Section 480(f) of the HEA defines assets for purposes of the EFC calculation as including such
savings vehicles as stocks, mutual funds, and qualified education benefits. The Handbook not
only states that college savings plans are to be included as assets, but also that “The value of the
account is considered an asset of the owner of the account, unless the owner is a dependent
student.” Both Section 529 college savings plans and prepaid tuition plans are, according to ED’s
guidance, to be treated as parental assets only if the parents are the owners. Because there are
several instances whereby a dependent student can be an owner of a college savings plan or
prepaid tuition plan, the plan’s assets in those cases would not be reflected in the EFC
calculation.43 Both sets of FAFSA instructions similarly state that the college savings plans are to
be treated as assets of the parents when the parent owns the account.
The CCRAA subsequently clarified that the value of the account shall be treated as an asset of the
parent when calculating the EFC for dependents students, no matter who the account owner.
However, this provision will not become effective until July 1, 2009.
ŽŒ?’˜—ȱśŘşȱ˜••Ž?ŽȱŠŸ’—?œȱ•Š—œǱȱ —Œ˜–Žȱ›ŽŠ?–Ž—?ȱ
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 the distribution from the account “should not be
treated as estimated financial assistance.” 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.44

42 Provision enacted by the College Cost Reduction and Access Act of 2007, P.L. 110-84.
43 According to the College Savings Plan Network, several states allow minors to be owners of prepaid tuition and
college savings plans, but depending upon the age of the minor, a state may require that an individual be named to
manage the account on the minor’s behalf. In addition, if Uniform Gift to Minors Act and Uniform Transfer to Minors
Act accounts are liquidated and reinvested in Section 529 plans, their assets continue to belong to the student.
44 The changes enacted by the CCRAA regarding the treatment of withdrawals to pay QHEEs for prepaid tuition plans
will also apply to college savings plans. Similarly, the provision will not be effective until July 1, 2009.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
ŗşȱ

Š¡ȬŠŸ˜›Ž?ȱ ’?‘Ž›ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŽ—Ž?’?œȱŠ—?ȱ‘Ž’›ȱŽ•Š?’˜—œ‘’™ȱ?˜ȱ›Š?’?’˜—Š•ȱ
ȱ
˜ŸŽ›?Ž••ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŒŒ˜ž—?œǱȱœœŽ?ȱ›ŽŠ?–Ž—?ȱ
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 unless the owner of the accounts is a dependent student.”
˜ŸŽ›?Ž••ȱ?žŒŠ?’˜—ȱŠŸ’—?œȱŒŒ˜ž—?œǱȱ —Œ˜–Žȱ›ŽŠ?–Ž—?ȱ
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
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.
˜—Œ•ž?’—?ȱ œœžŽœȱ
Although the DRA clarified the different treatment accorded prepaid tuition plans and college
savings plans in the need analysis formula, and the CCRAA addressed the issue of account
ownership and treatment of withdrawals as income in the need analysis formula, one thing that
remains clear is that FAFSA filers 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.

ž?‘˜›ȱ˜—?ŠŒ?ȱ —?˜›–Š?’˜—ȱ

Linda Levine
Charmaine Mercer
Specialist in Labor Economics

llevine@crs.loc.gov, 7-7756

˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
ŘŖȱ