Making college more affordable: the education provisions of the Taxpayer Relief Act of 1997 can help.

Thanks to the Taxpayer Relief Act of 1997, families with college-bound students (parents included), can take advantage--starting this year--of a variety of new tax benefits. These include the Hope scholarship and lifetime learning credit, the education "IRA," penalty-free individual retirement account distributions, a deduction for interest on education loans and qualified state tuition programs. As is often the case with new tax legislation, only taxpayers with adjusted gross incomes (AGIs) below certain limits can take full advantage of the benefits. Since such tax payers normally are not confronted with complex tax planning decisions, CPAs will need to make sure those clients thoroughly understand the new provisions.

Because not all of the changes are available or beneficial to every taxpayer and some can be used only at the exclusion of others, the explanation of each of the benefits below is followed by an analysis of the opportunities and limitations. In addition, the provisions' compatibility with the others also is discussed.

HOPE SCHOLARSHIP AND LIFETIME LEARNING CREDITS

The Hope scholarship is a tax credit equal to 100% of a student's first $1,000 of qualified education expenses plus 50% of the next $1,000. The maximum credit of $1,500 per student is available in each of the first two years of a postsecondary degree program. To qualify, a student must attend an eligible higher education institution on at least a half-time basis for one academic period during the year.

The lifetime learning credit is 20% of qualified education expenses paid by a taxpayer (up to $5,000 of qualified expenses before 2003 and up to $10,000 thereafter). A maximum credit of $1,000 per year ($2,000 annually after 2002) is permitted for an unlimited number of years. Unlike the Hope credit, qualified tuition expenses for the life time learning credit include the cost of instruction taken to acquire or improve existing job skills. This means the cost of continuing professional education at colleges and universities may now be a creditable expense. Taxpayers are not allowed a deduction and a credit for the same expense.

Both credits are granted for qualified education expenses of the taxpayer, the taxpayer's spouse and his or her dependents. The payor of the qualified expenses is entitled to the credit, and any education expenses a dependent pays are treated as paid by the taxpayer claiming the dependent. The credits are nonrefundable--neither credit will be refunded to the taxpayer if they exceed his or her tax liability.

Opportunities and limitations. A taxpayer cannot claim both credits simultaneously for one student in the same year. Under current rules, the Hope credit produces a larger tax benefit per student for any given expense. The Hope credit dollar limitations also apply on a per-student basis. So, for example, two eligible student's in a family can generate a maximum $3,000 Hope credit. On the other hand, the lifetime learning credit is limited to $1,000 per tax return, regardless of the number of eligible students. Although a student cannot use both credits in the same year, a taxpayer can take both Hope and lifetime learning credits in the same tax year if more than one student in the household incurs qualified expenses.

A Hope credit is available for expenses paid and academic terms beginning after December 31, 1997. Expenses prepaid in 1997 for an academic term beginning in 1998 are not eligible. Timing of payments also is important in the second and final year of Hope credit eligibility. If a taxpayer's payments during the second year exceed the annual limits, prepayment of the following year's tuition effectively wastes credits. Postponing payment until the following year qualifies the payments for the lifetime learning credit.

The lifetime learning credit is available for expenses paid and education beginning after June 30, 1998.

Example. Sally begins her freshman year in fall 1998. Her $5,000 tuition payment for the fall semester qualifies her father for the maximum Hope credit in that year. If he pays the same amount for the spring semester in January 1999 and pays $5,500 for the fall semester of her sophomore year in August 1999, he more than qualifies for the maximum Hope credit in 1999. It might be wise for the family to postpone payment for the spring 2000 semester until that year so that it qualifies for the lifetime learning credit.

Some taxpayers face another timing decision. The Hope credit cannot be claimed after the tax year in which a student completes the first two years of his or her colleGE education. Further, it can be claimed in a maximum of two tax years. For the average student who starts school in the fall term, the Hope credit is thus an option in three different tax years. (In the above example, Sally's parents could take the credit in two of three years, 1998, 1999 or 2000.) The taxpayer must select the two years that provide the maximum benefit. This depends largely on the cost of the education. If expenses are large enough to take the maximum Hope credit in year 1, the first two years make sense. Conversely, if the maximum available Hope credit in year 1 is less than $1,500, it may be wiser to claim a lifetime learning credit in year 1 and a Hope credit in years 2 and 3.

Example. Roger begins taking classes at the local community college in August 1999. His tuition expenses are $700 in 1999, $2,000 in 2000 and $1,500 in 2001. Because of his lower expenses in 1999, Roger's mother would be better off taking a $140 lifetime learning credit in that first year, a full Hope credit of $1,500 in the second year and a $1,250 Hope credit in the third year for a three-year total of $2,890. This is much better than the $2,500 that would be available if the family took the Hope credit in the first two years and a lifetime learning credit in the third year. Note: This scenario assumes an academic year begins with the fall semester and continues through the spring and any summer term.

One major impediment to a family's benefiting from these credits is the restricted scope of education expenses that qualify. Only tuition and some fees are eligible. The cost of books, equipment, supplies, room and board cannot be included. Even some expenses normally considered part of student fees--such as athletic and activity fees--do not qualify. This narrow definition limits the usefulness of these education tax credits since other nontaxable education benefits such as scholarships reduce the amount of qualified expenses otherwise available. The reduction is required even if the other benefits are not used to pay for qualified expenses.

Example. Jose begins his freshman year in September 1999. His expenses for the fall semester include $5,000 in tuition, $3,000 in room and board and $600 for books and other supplies. Jose receives two scholarships: $3,000 from the university, which is applied directly to his tuition, and a $500 check from the local Rotary Club, which he uses to pay for his books. Of Jose's $8,600 in expenses, only $5,000 is "eligible." Eligible expenses must then be reduced by $3,500 in tax-free scholarships (even though Jose used the Rotary scholarship to pay for books). The remaining $1,500 in eligible expenses means Jose's parents can take a $1,250 Hope credit in 1999.

The tax reduction from education tax credits also may be diminished by the limits that apply to nonrefundable credits in general. Tax credits generally were designed to benefit low income taxpayers. After subtracting the earned income credit, nearly any combination of the remaining credits probably substantially exceeds many low-income taxpayers' remaining tax liabilities. As a result, some low-income taxpayers with children are likely to derive little benefit from education tax credits. Exhibit 1, above, illustrates this predicament.

Exhibit 1: Making Use of Tax Credits

Kevin and Michele are married filing a joint return. They have two children, ages 12 and 19; the older child is a college student.

Adjusted gross income                                $25,000
Standard deduction(*)                                 (6,900)
Exemptions(*)                                        (10,600)
Taxable income                                       $ 7,500
Tax(*)                                               $ 1,129
Earned income credit(*)                                 (731)

Maximum amount allowable for the aggregate
of the child, Hope, lifetime learning, dependent
care and disability credits                           $ 398(+)

(*) 1997 amounts.

(+) Note: One child credit (for a child age 12) totals $500

Low income taxpayers aren't the only ones affected. Higher income taxpayers who use education credits become candidates for the alternative minimum tax. None of the newly available credits can be used to reduce the AMT. Taxpayers owe the greater of their regular tax liability (reduced by education credits) or their AMT liability. Use of various tax credits to offset the regular tax increases the likelihood the AMT liability will be higher.

EDUCATION IRA

Taxpayers now are permitted to make contributions to IRAs devoted to accumulating funds for education. The contributions are in all cases nondeductible, but the account is tax-exempt and distributions to pay qualified higher education expenses of a designated beneficiary are not included in a taxpayer's gross income. Contributions are limited to $500 per year and prohibited after the beneficiary reaches age 18. A 10% penalty is assessed on amounts distributed for purposes other than qualified education expenses. However, tax-free rollovers can be made to other education IRAs for the same beneficiary or for other beneficiaries in the original beneficiary's family.

Opportunities and limitations. Education IRAs are attractive arrangements for taxpayers with growing incomes because the AGI limitation on their use applies when contributions are made, not when distributions are taken to pay education expenses. Thus, young families can take full advantage of the accounts even if they are in higher brackets by the time their children attend college (and thus may not be eligible for the education tax credits). The law provides a penalty-free way out if a student subsequently finds even better college help. Taxpayers can take distributions without penalty to the extent a student receives scholarship or employer education assistance money to pay for school expenses.

The education IRA is also flexible because it affords taxpayers two distinct ways to capitalize on its benefits.

1. Regular distributions. Taxpayers can take a tax-free distribution of contributions and earnings to pay for qualified education expenses. Education tax credits cannot be taken in the year a tax-free distribution is made.

2. Waive income exclusion. Taxpayers also can waive the tax exclusion on earnings distributions. Parents might find this election a valuable option since it makes them eligible for education tax credits. Simultaneous use of credits and education IRA proceeds is permitted if the distribution is taxable. Under certain circumstances, this may be the optimal approach. Even though a taxpayer must include a distribution in income, the amount subject to tax is computed using the favorable annuity rules of IRC section 72, excluding a portion of each distribution. Since the tax is imposed on the individual who is taking the distribution--the student--it is taxed at his or her lower tax bracket. This makes a taxable education IRA distribution a simple way for parents to shift income to lower bracket taxpayers--their children. A relatively low tax payment by the student permits the higher bracket parents to take advantage of beneficial education tax credits.

Perhaps the biggest drawback to an education IRA is that all its advantages are predicated on the designated beneficiary eventually attending college. If the beneficiary does not do so, withdrawals can be expensive. In general, five types of distributions from an education IRA are not subject to penalty:

* Payment of qualified education expenses.

* Rollover to another education IRA.

* Distributions on account of the beneficiary's death.

* Distributions on account of the beneficiary's disability.

* Distributions to the extent the beneficiary receives excludable scholarships or employer assistance.

Otherwise, the only other way to get money out of an education IRA is to pay tax at regular income tax rates plus a 10% penalty on the accumulated income.

PENALTY-FREE IRA WITHDRAWALS

Parents also can now use regular IRAs to supply funds needed for college. To the extent IRA withdrawals do not exceed qualified education expenses, the distributions are not subject to the usual 10% penalty on premature distributions. They do, however, remain taxable income.

Example. Bob and Mary make a $5,000 withdrawal from Bob's IRA to pay for their daughter's tuition expenses. Because Bob is only 48, such a distribution ordinarily Is subject to a 10% penalty. Under the new rules, the $5,000 is taxed to Bob and Mary only in their regular bracket without penalty.

Opportunities and limitations. For many taxpayers, IRAs often represent the largest pool of liquid assets available for major expenses such as college. Because IRA distributions are subject to income tax, a taxpayer can claim an education credit for qualifying expenses paid with these funds. In some cases, the credits may offset any tax on a distribution. Penalty-free IRA withdrawals are a convenient way for taxpayers to cover education costs without earmarking money for that purpose in advance, as is required with education IRAs. If a child should elect not to attend school, funds in a regular IRA remain intact and continue to grow tax-deferred until retirement.

Taking early distributions from a Roth IRA to pay for education costs also may be a wise move since those withdrawals similarly are not penalized. The new Roth IRA allows taxpayers with AGI below certain levels to make nondeductible contributions to an account that accumulates income tax-free. A taxpayer can then take tax-free withdrawals to the extent they are "qualified distributions." While early distributions to pay for education costs are not considered qualified distributions, this does not automatically mean they are taxable. Nonqualified distributions from Roth IRAs are not taxed under the normal annuity rules. Instead, taxpayers first are entitled to recover their after tax contributions free of tax before any distribution is deemed to come out of accumulated income. Consequently, even nonqualified Roth IRA distributions can escape tax. Taxpayers first can take tax-free distributions of contributions to pay for college costs and then wait to distribute accumulated income until after retirement, when it will be tax-free. This means Roth IRAs have tax consequences similar to education IRAs without any restrictions on the use of the funds and with a higher annual contribution ($2,000 versus $500).

Example: Betty's Roth IRA has a balance of $15,650 in 2004, representing $12,000 in aftertax contributions and $3,650 in, accumulated earnings. Even though she is only age 51, Betty can withdraw up to $12,000 to pay for her son's education expenses with no penalty and without having to pay any tax on the distributed amounts.

DEDUCTIBILITY OF EDUCATION LOAN INTEREST

Interest paid on loans a taxpayer incurs to defray higher education costs is now deductible for purposes of determining his or her AGI. The loan must be obtained from an unrelated party and only the first 60 months of interest paid are deductible. The deduction cannot exceed $1,000 in 1998, $1,500 in 1999, $2,000 in 2000 and $2,500 in 2001 and thereafter. A taxpayer claimed as a dependent by another taxpayer is not eligible for the deduction. The deduction is effective for interest paid after December 31, 1997, regardless of when the loan was obtained.

Example: Cindy and Steve borrowed $10,000 from the Third National Bank of Tyler in 1996 to pay for their son Adam's college expenses. Repayment begins in 1998. The 1998 interest expense is $1,800. The couple can deduct $1,000 of this amount in 1998 as a so-called above-the-line deduction, reducing their AGI. If the loan was taken in Adam's name, no deduction would be permitted as long as he is declared a dependent on his parent's tax return.

Opportunities and limitations. CPAs can help clients avoid several potential traps. As is the case with many of the other new education benefits, dependents are specifically prevented from taking the interest deduction. Interest payments made by a dependent are not attributed to the taxpayer claiming the dependent. To preserve deductibility, parents--rather than dependent students--should borrow the money and pay the interest.

Further, a taxpayer cannot deduct interest as education interest if it is otherwise deductible under any other IRC provision. For example, if a loan for education expenses is secured by a personal residence and the interest is thus considered qualified residence interest, the taxpayer must claim the interest as an itemized deduction from AGI rather than as qualified education loan interest for purposes of determining AGI. In effect, the 1997 act now encourages taxpayers to structure loans to generate what previously would have been classified as nondeductible personal interest.

QUALIFIED STATE TUITION PROGRAMS

The 1997 act retains the concept of qualified state tuition programs. Such programs allow certain higher education costs to be prepaid to a state government, with "services" provided to a designated beneficiary at a later time. The growth of these deposits is not taxable before the beneficiary attends college, but any distribution or provision of services from the program will be included in

the student's gross income to the extent the value received exceeds the amounts contributed. Under the new law, contributions to these programs are now considered completed gifts that qualify for the annual $10,000 gift tax exclusion in the year the contribution is made. The act also expands qualifying expenses to include room and board.

Opportunities and limitations. The tax consequences of qualified state tuition programs are similar to those of education IRAs for which a taxpayer has elected a waiver of exclusion from income. An education IRA, however, is more flexible in that beneficiaries have the freedom to go to the school of their choice. In addition, taxpayers can direct how education IRA funds are invested instead of leaving them in a state's hands. A taxpayer using a state tuition program can still use the Hope and lifetime learning credits because program distributions are taxable when they are made.

LIMITED AVAILABILITY AND COVERAGE

In many cases, a taxpayer's ability to take advantage of the act's education provisions depends on his or her level of income. Exhibit 2, page 41, illustrates the education benefits available to taxpayers at various AGI levels. The income intervals displayed in the exhibit represent the ranges over which benefits are phased out.

Exhibit 2: Adjusted Gross Income Limits for Education Benefits

Provision                                AGI Phaseout Range

Hope scholarship credit              Single: $40,000 to $50,000
                                     Married filing jointly:
                                       $80,000 to $100,000

Lifetime learning credit             Single: $40,000 to $50,000
                                     Married filing jointly:
                                       $80,000 to $100,000

Education IRA                        Single: $95,000 to $110,000
                                     Married filing jointly:
                                       $150,000 to $160,000

Traditional IRA withdrawal           No limit
without penalty

Education loan interest              Single: $40,000 to $55,000
                                     Married filing jointly:
                                       $60,000 to $75,000

Qualified state tuition programs     No limit

Obtaining a tax benefit for the payment of higher education costs also depends on the nature of the expenses. The education tax benefits are not uniform in covering costs. To help CPAs and their clients sort out this confusion, exhibit 3, above, summarizes the costs covered by each benefit.

Exhibit 3: Education Costs Covered

                                       Limited         Books and
Provision                    Tuition    Fees    Fees   Supplies

Hope scholarship credit         X(*)    X(*)
Lifetime learning credit        X       X
Education IRA                   X                X        X
Traditional IRA withdrawal
without penalty                 X                X        X
Education loan interest         X                X        X
Qualified state tuition
programs                        X                X        X

                                Room and
Provision                        Board

Hope scholarship credit
Lifetime learning credit
Education IRA                    X(*)
Traditional IRA withdrawal
without penalty                  X(*)
Education loan interest          X(*)
Qualified state tuition
programs                         X(*)

(*) Student must attend at least half-time.

WHAT ONCE WAS SIMPLE NO LONGER IS

As a result of the Taxpayer Relief Act of 1997, an area of the tax law that previously was not very complex has become decidedly more so. For taxpayers seeking tax-favored methods of providing for college education, choosing among the many new alternatives can be intimidating. To further complicate matters, various phase-in rules and periodic inflation adjustments may mean the best choice will change over time. As a result, taxpayers of all types will have to employ fairly sophisticated planning techniques in an effort to maximize the potential savings found in the new education tax incentives.

RELATED ARTICLE: Baby Boomer's Top Financial Needs

1. Capital growth

2. College funding

3. Home ownership

4. Retirement planning

PULSE 1997 Survey Report, Financial Planning for Baby Boomers, American Society of CLU & ChFC, Bryn Mawr, Pennsylvania.

RELATED ARTICLE: Employer Assistance Still Tax-Free

The Taxpayer Relief Act of 1997 extended--through May 31, 2000--the exclusion from employee income of employer-provided education assistance under Internal Revenue Code section 127. The extension applies only to undergraduate courses. As a result, each year an employee can exclude from income up to $5,250 paid by an employer for the employee's education under a nondiscriminatory plan.

An employer educational assistance plan is an excellent benefit for those who are able to take advantage of it. The only problem is its limited applicability--only employees who work for employers with formal plans can take advantage of this benefit. And the exclusion does not apply to graduate-level classes.

RELATED ARTICLE: EXECUTIVE SUMMARY

* THE TAXPAYER RELIEF ACT OF 1997 includes a variety of tax benefits for college-bound students and their families. These include the Hope scholarship and lifetime learning credit, the education "IRA," penalty-free individual retirement account distributions, a deduction for interest on education loans and improvements to qualified state tuition programs.

* THE HOPE SCHOLARSHIP IS A TAX CREDIT equal to 100% of a student's first $1,000 of qualified education expenses and 50% of the next $1,000. A maximum credit of $1,500 per student is available in each of the first two years of a college degree program. The lifetime learning credit is 20% of qualified education expenses ($5,000 of expenses before 2003 and $10,000 thereafter). Both credits cannot be claimed simultaneously for one student in the same year.

* TAXPAYERS CAN MAKE $500 ANNUAL contributions to an education "IRA" to pay a designated beneficiary's qualified higher education expenses. Contributions are not tax deductible but withdrawals--including earnings--to pay qualified expenses are excluded from gross income.

* ANOTHER GOOD SOURCE OF COLLEGE funds is withdrawals from regular or Roth IRAs. In both cases, the 10% premature withdrawal penalty is waived. Because Roth IRA withdrawals are not taxed under the normal annuity rules, taxpayers can recover aftertax contributions first to pay college costs and wait to distribute earnings tax-free after retirement.

* INTEREST PAID ON LOANS A TAXPAYER incurs to pay higher education costs is deductible if certain requirements are met. The deduction cannot exceed $1,000 in 1998, $1,500 in 1999, $2,000 in 2000 and $2,500 in 2001 and thereafter.

* A TAXPAYER'S ABILITY TO TAKE full advantage of the act's education provisions depends on the amount of his or her adjusted gross income and the nature of the expenses to be paid.