How Policy Changes and Tax Strategies Affect College Expenses

A recent survey shows the most common ways of paying for college include family savings, federal student loans, as well as scholarships and grants. Families and individuals may also use a combination of these financial resources to cover college expenses. The federal government provides tax benefits on many payment methods to help taxpayers finance higher education costs. This issue brief reviews several of the most frequently used funding methods and their tax treatments. In addition, it discusses recent and forthcoming policy changes associated with these instruments from a tax perspective. 

Federal Student Loans and Tax Treatments

Over 70% of families with college or college-bound students complete the federal student loan application form every year through the mechanism, formally known as the Free Application for Federal Student Aid (FAFSA). Federal student loans and the FAFSA have had a large presence in policy discussions and have undergone several major changes, both in the repayment and application processes. 

Student Loan Forgiveness: Policy Proposals and Challenges

After the Supreme Court struct down the Biden administration’s student loan forgiveness plan in August 2023, the administration used a variety of alternative mechanisms to cancel student loans. For example, it proposed the modified Saving on a Valuable Education (SAVE) Plan to expediate loan balance forgiveness and reduce monthly payments. Most recently, in mid-April, the Department of Education (ED) released proposed regulations for additional student loan cancellation — mirroring a plan announced by the Biden administration earlier the same month. 

Generally, the proposed regulations consist of the following: 

1. Eliminating accumulated interest for borrowers with balances higher than what they originally borrowed. 
2. Automatically canceling loans for people who have been repaying undergraduate loans for 20 years and graduate loans for 25 years. 
3. Automatically canceling loans for borrowers who would be eligible for forgiveness but did not apply.
4. Canceling loans for borrowers who went to institutions that provided low financial value.

There is a fifth element listed in the administration’s drafted provisions but is not in the proposed regulations: Automatically forgiving student loans for borrowers who are facing hardship for paying back their loans or showing high risks of future default. The ED indicates it will release regulations for this provision in the coming months. 

Several elements of the ED’s proposed regulations are connected with the Biden administration’s SAVE Plan. As such, more comprehensive cost estimates should reflect provisions under both plans. Because of the expanded eligibility and more generous benefits in these provisions, an increased number of current and perspective borrowers may transfer to or enroll in these plans. These plans would also incentivize more borrowing.

Available estimates, albeit preliminary, show the combined costs of the SAVE Plan and the ED’s proposed regulations are in the $560 to $750 billion range. Given the unsustainable level of $34 trillion national debt – currently at 123% of GDP – continuing with the same broken college loan system will further exacerbate the problem. Eventually the solutions will be either to increase taxes, cut spending, or a combination of both. 

The Biden administration indicates that it plans to implement certain elements of the ED’s proposed regulations as soon as this fall. Although the administration is confident that these provisions are robust from a legal perspective, its post-Supreme Court administrative actions have been experiencing legal challenges. Numerous states have also challenged the administration’s SAVE Plan and indicated they plan to initiate lawsuits against the most recent proposed regulations. 

Before the proposed regulations are finalized, borrowers can follow current policies to carry on their repayment plans.

Income-Driven Repayment Plans: Impacts From the Pandemic

The income-driven repayment (IDR) plans have become increasingly popular even before the COVID-19 pandemic. The IDR plans calculate monthly payments as a share of the borrower’s discretionary income, which makes repayment affordable given other financial obligations. IDR programs forgive the remaining loan balances after a certain number of years, typically between 20 and 25 years. The IRS considers the forgiven balances as taxable income; therefore, borrowers must pay taxes on that amount. An exception to this tax provision is the Public Service Loan Forgiveness (PSLF), which permits loan forgiveness after 10 years of repayment while working in public service for the same span of years. The forgiven loan balance for PSLFs is not considered taxable income.

The American Rescue Plan Act of 2021 temporarily exempted forgiven student loan balances from federal income taxes for loans canceled between Jan. 1, 2021, and Dec. 31, 2025. As such, loans canceled under the proposed regulations would not be subject to tax if forgiven before the end of 2025. However, certain states may consider such canceled loans as income for state tax purposes. 

During the pandemic, federal student loan borrowers’ payments were suspended, and the interest rate was set at 0% in March 2020. In late 2023, the payment pause ended, and borrowers’ loans have now resumed repayment and interest accrual. However, a tax benefit that has not been altered by the pandemic-era policies is that taxpayers can deduct up to $2,500 of student loan interest paid during the year on their federal income tax returns, subject to income limits.

FAFSA Applications: Delays and Additions

On the application front, the delayed release of the FAFSA application form from October 2023 to January 2024 has many advocates concerned that financially constrained families would change their college selections, or not attend college at all. Some colleges postponed their traditional May 1 decision deadline, whereas others decided to stay with the same deadline. 

Because the FAFSA application is an annual process, students need to fill out the form every academic year to ascertain coverage. The IRS recently reminded student athletes that any income from using their name, image, and likeness (NIL) is taxable and should be reported on their FAFSA form. This may have implications on the amount of student athletes’ eligible financial aid. The NIL income comes from a range of activities, such as receiving endorsements, selling apparel, or acting as influencers on social media. Other forms of income can also be derived from noncash payments, including gifts and transactions involving non-fungible tokens (NFTs), which are treated as property for federal income tax purposes.

529 Plans and Tax Benefits

Formally known as qualified tuition programs (QTPs), 529 plans provide tax benefits that help families pay for education expenses.[1] Contributions to 529 accounts are after-tax, meaning that they are not tax deductible. However, distributions from these accounts are tax-free if they are used to pay for qualified higher education expenses. In other words, the contributions grow tax-free without being subject to annual taxation until funds are distributed. If the funds are used to pay for nonqualified expenses, a 10% tax penalty and normal income tax rate are applied to the earning portion of the withdrawal. This instrument has grown in popularity in recent years: As of September 2023, there were 94 savings plans with total assets of $409 billion. 

Generally, each 529 plan has an overall lifetime limit on the amount that can be contributed to the account, which ranges from $235,000 to $550,000 and varies by state. On an annual basis, there are certain considerations from a gift and estate tax perspective. In 2024 the annual gift tax exclusion amount is $18,000. This means that each parent can contribute up to $18,000 to each of their children’s 529 accounts without triggering gift tax issues. However, the tax code has an exception that allows contributors to make five-year contributions in one single year, but they are not allowed to contribute until five years later. This means a married couple can allocate $360,000 to 529 accounts for their two children in 2024 without being subject to gift tax. The accelerated contribution option has two major benefits: 

1. Earlier contribution allows assets more time to grow in the account.
2. Funds placed into 529 accounts are not considered part of the contributor’s estate for tax purposes. 

Practitioners report that 529 accounts are treated more favorably than other types of savings when it comes to determining eligibility of federal student loans. For instance, distributions from 529 plans are not considered income for FAFSA purposes. In addition, the Securing a Strong Retirement Act of 2022 (informally known as SECURE Act 2.0) further modified treatment of grandparent-owned or other nonparent relative-owned 529 plans. As a result, distributions from these grandparent-owned plans are no longer treated as student income for FAFSA purposes. Some say this change has turned the traditional grandparent “trap” into a “grandparent loophole.” 

Another major change from the SECURE Act 2.0 is that beginning in 2024, taxpayers can make tax- and penalty-free rollovers from 529 accounts to Roth IRAs for up to $35,000 over the course of a beneficiary’s lifetime. Because some beneficiaries may ultimately decide to pursue careers that do not require a college degree, this option provides an alternative to making nonqualified withdrawals for funds trapped in 529 accounts. However, there are some limitations to prevent abuse: 

• The 529 plan must be held by the designated beneficiary for at least 15 years.
• The rollover amount must come from contributions made to the 529 account at least five years prior to the transfer date.
• The annual rollover amount is subject to the annual Roth IRA contribution limit, which is $7,000 in 2024. 

Additional Education Tax Benefits

Tax Credits

The American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit (LLC) are two major tax credits for education expenses. Both credits are means-tested with annual limits of $2,500 per student and $2,000 per return, respectively. The policy goal of these credits is to provide federal financial assistance to students from middle-income families, who may not qualify for benefits, such as Pell Grants, for financially disadvantaged families. The federal government spent approximately $16 billion annually on these credits.  

In principle, there is no double dipping across various education tax benefits for the same expenses. For expenses incurred by a particular student, only one type of credit — either the AOTC or LLC — applies. When it comes to interactions with 529 accounts, expenses used to claim these tax credits need to be deducted from qualified education expenses under 529 account withdrawals to determine if any of the 529 distributions are taxable. 

Scholarships and Grants

Scholarships and grants are another common source of financing college education. Generally, if these funds are used to pay for qualified expenses — e.g., tuition, fees, and books — they are excluded from income. If the scholarship is used to cover room and board or optional items, they are taxable. Additionally, work-based scholarships are generally taxable because they constitute payment for services. 

Another component of federal grants is the Pell Grant program, which is the largest federal grant aid supporting higher education. In fiscal year 2021, the program provided $26 billion in grants to 6.1 million students for the academic year 2020–21. The vast majority of recipients — over 97% — had a total family income below $60,000. For the academic year 2024–25, the amount awarded to Pell Grant recipients ranges from $740 to $7,395. Eligible students apply for the grants through the FAFSA. Similar to other grants, Pell Grants are not taxable as long as students use them for qualified expenses. 

Conclusion

Paying for college is a major financial decision for many American families and individuals. Many tax-favored instruments are available to help taxpayers finance costs of higher education. As the era of COVID-19 relief programs come to an end, future policy changes will continue to shape how Americans finance higher education expenses — some modifications will be quite nuanced, whereas others will likely be more comprehensive. The coming final regulations for student loan forgiveness and potential legal challenges, the November election, and the impending expiration of the Tax Cuts and Jobs Act provisions may all bring changes to the dynamics of affording college.  

Notes

[1] This issue brief focuses on 529 saving plans instead of 529 prepaid plans at the college level. Prepaid plans allow contributors to purchase a certain number of academic periods, essentially prepaying for future tuition at current costs. They are most commonly used to pay for public in-state universities. In 2023, out of $432 billion assets in 529 plans, 95% ($409 billion) were held in saving plans, while the remaining 5% ($23 billion) were in prepaid plans. The tax treatments of these two types of plans are identical. In addition, using 529 plans to cover K–12 expenses is not discussed in this issue brief. 

This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy. The views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.