Tax planning for college education expenses.

Tax Planning for College Education Expenses

One major aspect of financial planning is to set aside funds for children's education expenses. As the costs of providing a college education continue to escalate, it has become even more important to carefully plan for these future expenses.

Many of the provisions of the Technical and Miscellaneous Revenue Act of 1988 were designed to close loopholes left by the Tax Reform Act of 1986. However, one significant provision has important implications for parents who wish to plan for their children's college education. The Technical and Miscellaneous Revenue Act of 1988 states that interest income from United States savings bonds may now be excluded from gross income if the proceeds from redemption of the bonds are used to pay higher education tuition expenses.

In the past, it has been suggested that parents purchase U.S. savings bonds in a child's name and allow the interest to accrue until the bonds are redeemed. This method was beneficial because the child was taxed on the interest income at a lower bracket than the parents. The Tax Reform Act of 1986 has made this alternative unattractive since the unearned income over $1,000 of a child under the age of 14 is now taxed at the parent's bracket. The new provision enacted in the Technical and Miscellaneous Revenue Act contains a major benefit to parents who wish to set aside funds for future college education costs.

A number of stipulations are attached to the new provision. The redeemed bonds must have been issued after December 31, 1989 and the individual purchasing the bonds must be at least 24 years old before the date of issuance. Also, the provision does not apply to bonds acquired by gift. The proceeds must be used to pay qualified educational expenses for enrollment or attendance at an institution of higher learning. The proceeds must be spent on qualified higher educational expenses in the same tax year that the bonds are redeemed. The payment may be for the benefit of the taxpayer, the taxpayer's spouse or for any qualified dependent of the taxpayer.

A limitation applies if the proceeds from the redemption of the bonds exceed the taxpayer's higher education expenses for the year. In this situation, the excludible amount of interest is based upon a fraction which must be applied to the total interest income. The numerator in the fraction is the amount of qualified education expenses paid for the year. The denominator is the total proceeds from the redemption of the savings bonds.

Example 1: Assume that a couple filing jointly pays $3,000 of qualified higher education expenses for a dependent child. Also assume that the couple redeems a total of $4,500 in U.S. savings bonds during the year. Assume that the $4,500 includes $3,000 of principal and $1,500 of interest. The amount of interest which may be excluded would be computed according to the following formula:

Excludible Interest = Total Interest income X Qualified Educational Expenses/Total Redemption Proceeds.

The amount of excludible interest in this example would be $1,000 ($1,500 X $3,000/$4,500).

Modified AGI Limitation

Another limitation in the provision relates to the taxpayer's modified adjusted gross income. If modified AGI exceeds $40,000 (or $60,000 on a joint return), a fairly complicated phase-out ratio must be used to compute the exclusion.

Modified adjusted gross income is defined as adjusted gross income including:

1. The taxable portion of Social

Security benefits and railroad

retirement benefits, if any, 2. The effect of the limitation

of passive activity losses and

credits, and 3. Adjustments for contributions

made to IRAs and other

qualified retirement plans, and

excluding:

a. Income earned abroad, b. Income derived from sources

within certain specified

possessions of the United States,

and c. Income derived from sources

within Puerto Rico.

The procedure used to apply the modified adjusted gross income limitations is as follows:

1. The amount of the total

interest which would

ordinarily be excludible is first

determined. For example, if

the total redemption proceeds

exceeds the higher education

expenses, the fraction used

above would be applied first

to determine the amount of

interest ordinarily excludible. 2. The interest ordinarily

excludible is then reduced by a

phase-out computation which

is based on modified adjusted

gross income. The fraction

which is used to multiply by

the excludible interest has as

a numerator the difference

between the taxpayer's

modified AGI and $40,000

($60,000 if filing jointly).

The fraction's denominator is

$15,000 for a single taxpayer

and $30,000 if filing jointly.

The fraction obtained in this

manner is then multiplied by

the ordinarily excludible

interest, and the result is

subtracted from the

ordinarily excludible amount.

The following examples illustrate the operation of the above rules.

Example 2: Assume a taxpayer is single and has a modified adjusted gross income of $50,000. Also assume that he received $2,000 from the redemption of U.S. savings bonds ($1,400 principal and $600 interest). Further assume that the taxpayer paid $2,400 in qualified higher education expenses. In this illustration, the proceeds of the bond redemption do not exceed the total expenses for higher education. Therefore, the limitation discussed in Example 1 does not apply. Ordinarily, the full $600 in interest received from the bonds would be excluded. However, the modified adjusted gross income limitation would require the $600 to be reduced by two-thirds. The manner of obtaining the reduction fraction is shown as follows: {(Modified AGI - $40,000)/$15,000} = {($50,000 - $40,000)/$15,000} = 2/3.

In this example, the taxpayer would only be able to exclude $200 of the interest ($600 - 2/3 of $600) because his modified adjusted income was above $40,000.

Example 3: Assume a taxpayer is married and has a modi fixed adjusted gross income of $75,000. Also assume that the couple received $10,000 from the redemption of U.S. savings bonds ($7,500 principal and $2,500 interest). Further assume that the taxpayer paid $2,000 in qualified higher educational expenses. In this example, two limitations will apply. First, since the bond redemption proceeds exceed the educational expenses, the limitation illustrated in Example 1 must be applied. This computation would be as follows: Excludible Interest = $2,500 Total Interest X $2,000 Qualified Educational Expenses/$10,000 Proceeds. Excludible Interest = $500.

This amount of interest which would ordinarily be excludible would have to be further reduced because the modified adjusted gross income exceeds $60,000. In this example, the $500 would have to be reduced by one-half. The computation of the fraction is as follows: Modified AGI - $60,000/$30,000 = $75,000 - $60,000/$30,000 = 1/2.

As can be observed from the above examples, when a single taxpayer's modified AGI reaches $55,000, no interest exclusion is available. Also, when the modified AGI of a married couple filing jointly reaches $90,000, the interest exclusion is completely phased out.

A few other special rules are applicable with the new provision. The amount of qualified higher education expenses paid must be reduced by amounts received for certain scholarships and veteran's benefits. Also, no exclusion is allowed for married individuals filing separate returns.

Conclusion

Prudent taxpayers should always be concerned with ways to minimize the tax liability. There are now very few provisions in the Internal Revenue Code that permit income to be permanently excluded from taxation. Most provisions that favor the taxpayer simply defer the recognition of taxable income. Furthermore, with the curtailment of the tax benefit of shifting income to children under the age of 14, the introduction of this provision regarding the exemption of interest on qualified U.S. savings bonds can be very significant for the taxpayer. Taxpayers can obtain maximum benefit from this provision by carefully planning investments in qualified U.S. savings bonds in light of their expectations of future higher education costs. As a result, the cost of higher education, which is constantly escalating, can be significantly subsidized by the federal government through the use of tax-free interest income.

John Leavins, PhD, CPA, is associate professor of accounting at the University of Houston-Downtown. Marvin Williams, JD, CPA, is assistant professor of accounting at the University of Houston-Downtown.