How an obscure college aid fix could help millions of low-income students

The tax filing season is upon us, which means college students and their parents will be getting big refunds. Since 2009 they’ve been able to qualify for up to a $2,500 tax credit for tuition expenses under President Obama’s American Opportunity Tax Credit. And lawmakers recently made that benefit a permanent part of the tax code. Combined, tuition tax credits will provide over $20 billion to students and families in 2016, but there is a big flaw in this popular and growing form of financial aid. Our research shows that nearly 40 percent of undergraduates cannot benefit, most of whom are from low-income families.

That is mainly because need-based grants cover all of their tuition (usually federal Pell Grants), so they have no eligible expenses with which to claim a tax benefit. Many of these families incur housing and food expenses on par with, or even greater than, tuition, but only tuition expenses qualify for tax benefits. Critically, families can receive the American Opportunity Tax Credit even if they don’t owe federal income tax, but that is often an empty benefit: the low-income families that feature is meant to help are the same ones who receive Pell Grants that already cover their tuition. It’s a classic case of Washington policymakers failing to coordinate an ever expanding list of federal programs.

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Obama’s latest budget includes a smart fix for this issue that could let families treat a Pell Grant as if it were tuition they had paid with their own money for the purposes of claiming tuition tax benefits. A family that used a Pell Grant to pay a $1,000 tuition bill, could treat that amount as an out-of-pocket payment and then claim a $1,000 tax credit. They receive the grant and the tax benefit, helping make higher education more attainable for exactly the students who need the most aid. Some might think that is double dipping, but as long as the student incurred living expenses of at least that amount, it’s not. More on that in a minute.

While this might sound like a minor accounting technicality, the effects for students are anything but. Our analysis shows that the share of undergraduates eligible for a tax benefit jumps from about 62 percent today to over 77 percent under the proposal. That is about 3 million additional students. Furthermore, the students who today claim reduced tax benefits because their Pell Grants partially cover tuition would be able to claim larger credits, helping them offset living expenses while in school. The administration estimates students would pick up $2 billion a year in additional tax credits -- but it could be much more if every eligible student claims his benefit.

Such a change almost exclusively affects students at community colleges and public four-year schools. Pell Grants are more likely to cover much or all of the tuition at these schools, compared with higher cost private nonprofit or for-profits schools. Today just 50 percent of community college students can claim a tax credit. That would increase to over 75 percent. At public four-year schools tax benefit eligibility jumps from 62 percent of students to about 79 percent. Few additional students at private nonprofit and for-profit schools gain eligibility from the change, since most already qualify. In a way, this would put students at low-cost public schools on equal footing with other students when it comes to tax credits.

The IRS says families can effectively do what the Obama administration is proposing on their own, but it is a cumbersome workaround that might leave them worse off. They have to tell their school to apply Pell Grants to living expenses and then pay tuition out-of-pocket, rather than the other way around. The money is fungible so it is mostly a matter of accounting. The catch is that Pell Grants become taxable income under that approach (only aid used to cover tuition is tax-free). If they or their parents earn enough other income, they might owe taxes on the grant, creating a paperwork nightmare and complicated financial tradeoffs.  

If Pell Grants were tax-free regardless of whether students applied them to tuition or living expenses, as the Obama administration proposes, there would be no reason not to make that workaround the automatic setting in financial aid offices and on tax forms. Families would maximize their grants and tax benefits without having to take special steps. This does, however, require Congress to pass legislation. Given the widespread support among lawmakers for both Pell Grants and tuition tax benefits, it’s time they coordinate these two large sources of federal aid.

Delisle is the director of the Federal Education Budget Project at New America, a Washington, DC think tank. Dancy is a policy analyst at New America.

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