Education credit tax planning.

On a dollar-for-dollar basis, the Hope and Lifetime Learning Credits can offset taxes owed. The basis for both credits is the qualified education expenses paid to qualified educational institutions. Generally, there are few tax planning opportunities associated with these credits. However, in certain situations, taxpayers may obtain a full benefit, when one might assume no benefit is available.

The maximum Hope Credit is 100% of the first $1,000 and 50% of the second $1,000 of qualified expenditures. It applies to the first two years of post-secondary education. The Lifetime Learning Credit is 20% of qualified tuition and related expenses up to $5,000. Expenses qualifying for the Lifetime Learning Credit are not limited to the first two years of post-secondary education. The Lifetime Learning Credit applies to a wide array of qualifying education expenditures, including expenses for undergraduate- or graduate-level and professional degree courses, as well as expenses for any course of instruction at an eligible educational institution a student takes to acquire or improve job skills, even if it is not part of a degree program. Both credits are elective and nonrefundable. The excess of a taxpayer's adjusted gross income (AGI) over $40,000 ($80,000 in the case of a joint filer) will reduce both credits. If a taxpayer claims the Hope Credit in one year, he may not claim the Lifetime Learning Credit in that year for the same individual.

Taxpayers often do not realize that these credits need not be lost if their income is too high. Planning to maximize the tax benefit of the Hope and Lifetime Learning Credits may yield a higher tax benefit. Certain strategies may permit the "family unit" to receive the benefit of one or both of these credits, even though a parent's income is too high. Taxpayers with children have the best planning opportunity.

One solution to take advantage of the credit(s) when the parent's income is too high would be to have the student claim the credit(s) on his own return. Regulations issued earlier in the year allow the student to claim the credit even if someone else pays the expenses.

Example: In 2001, parents B and K have AGI of $400,000. They have two children, M and J. Both M and J attend college at a qualified educational institution, with annual qualified educational expenses for each daughter in excess of $5,000. B and K are funding these expenses. M is in her first ye,ar of college while J is in her third year.

In B and K's case, both credits would be completely phased out because of their AGI. Also, because of their AGI, B and K do not receive any benefit from claiming the children as their dependents. However, if B and K forgo claiming the children as dependents on their return, the children may claim the qualifying expenses that B and K (or any one else) paid, as long as the expenses are paid directly to the-educational institution.

Since M is in her first year of college, she qualifies for the Hope Credit, which is larger than the Lifetime Learning Credit. The tax savings to M could be as much as $1,500 per year in 2001 and 2002. In 2003, when M begins her third year, she would be eligible for the Lifetime Learning Credit, which at that time could result in a benefit of $2,000 per year on her return (in 2003, the maximum qualified expense will increase to $10,000, creating a potential $2,000 benefit). For 2001 or 2002, J could claim the Lifetime Learning Credit of $1,000 (20% of $5,000 qualifying expenses) on her return during each of those years, which could increase to $2,000 a year if she continues her education.

In most instances, the tax benefit of the credits outweighs the loss of the exemption. Further, a beneficiary is no longer required to waive the tax-free treatment for distributions from an Education IRA to claim the education credits. Careful planning can ensure that clients realize the maximum benefit from one or both of these credits.

FROM DEREK A. DODD, CPA, AIDMAN PISER & COMPANY, PA, TAMPA, FL