The TRA '97 offers a multitude of education incentives.

In an effort to encourage taxpayers to pursue higher education, Congress enacted a host of incentives in the Taxpayer Relief Act of 1997. Available for the first time are Hope Scholarship and Lifetime Learning Credits, education individual retirement accounts and an above-the-line deduction for student loan interest; extended/expanded provisions include qualified state tuition programs and employer-provided education assistance.

The Taxpayer Relief Act of 1997 (TRA '97) significantly expanded the tax benefits associated with higher education expenses. The law now includes a plethora of provisions granting a variety of benefits to taxpayers, including tax credits, deductions, exclusions, and tax-favored methods of financing and saving for higher education costs. Not only did the TRA '97 expand the types of education-related tax benefits afforded to taxpayers, it also provided tax benefits to groups of taxpayers largely ignored under prior law, including both the traditional student and certain nontraditional students whose higher education expenses are not deductible under Sec. 162. The education tax incentives are summarized in Table 1 on page 246.

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The 10-year revenue cost for the TRA '97 education benefits is estimated at almost $99 billion, $76 billion of which is attributable to two tax credits available in 1998 and beyond, the Hope Scholarship Credit (Hope Credit) and the Lifetime Learning Credit (Learning Credit).(1) The Education individual retirement account (IRA), a new savings-oriented provision, can be established in 1998, but the actual tax benefits may take some time to realize. Changes to the tax treatment of qualified state tuition programs (QSTPs), including a provision to include room and board expenses as qualified higher education expenses (QHEEs), are also effective in 1998. Interest expense on qualifying student loans is deductible beginning in 1998. Finally, the employer-provided education assistance exclusion under Sec. 127 has been extended to courses beginning before June 1, 2000, making qualified assistance benefits paid to employees during 1997 excludable. Consistent with many other Code provisions, most of the new tax benefits are subject to phaseouts based on the taxpayer's adjusted gross income (AGI).

The phaseouts vary substantially among die different education provisions. The coordination of the phaseouts is but one of several considerations that must be made in attempting to maximize tax benefits for a given taxpayer. The definition of higher education expenses that qualify also differs. Some of the education provisions are intended to be long-term in nature, while others provide only a short-term benefit. In many cases, multiple provisions cannot be used in a single tax year; planning is needed to maximize tax savings over eligible periods. This article examines the education benefits created by the TRA '97, the changes made to existing education provisions and the coordination of the new and amended provisions with existing law.

Education Credits

The traditional student (typically aged between 18 and 24 and pursuing a first academic degree), as well as certain nontraditional students, have historically found no tax benefit associated with education costs due to Regs. Sec. 1.162-5(b)(2) and (3), which denies deductions when the education prepares a taxpayer to enter a new trade or business, to gain entry into a business or to meet the minimum standards required therein. These students may benefit from the Hope and Learning Credits.

General Provisions

The Hope and Learning Credits are provided under new Sec. 25A, added by TRA '97 Section 201, for certain qualified tuition and related expenses (QTREs). The key provisions, definitions, phaseouts and effective dates of the two credits are summarized in Table 2 on page 248. QTREs are defined as tuition and fees, excluding books, room and board, equipment, meals, lodging, transportation and excludable assistance/scholarships. Taxpayers can claim a nonrefundable Hope Credit up to $1,500 per eligible student for QTREs paid during the year on the student's behalf. Under Sec. 25A(b)(1), the credit is 100% of the first $1,000 of QTREs and 50% of the next $1,000 of QTREs. Sec. 25A(b)(2) specifies that the Hope Credit is allowed for only the first two years of a student's postsecondary education.

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Taxpayers can claim a nonrefundable Learning Credit of 20% of QTREs, up to a maximum of $5,000 ($10,000 in 2003 and thereafter) paid during the tax year on behalf of one or more eligible students. In contrast to the Hope Credit, the Learning Credit may be claimed for an unlimited number of years; the amount that may be claimed is not affected by the number of eligible students. The maximum annual Learning Credit of $1,000 ($2,000 for 2003 and beyond) will not be adjusted for inflation.

Clearly, the Hope Credit is designed to benefit taxpayers funding the education costs of the traditional student, while the Learning Credit will benefit a broader range of taxpayers, including both traditional and nontraditional students. According to Sec. 25A(c)(2)(A), these elective credits are mutually exclusive with respect to an eligible student; thus, they present a choice if the QTREs qualify the taxpayer for either credit. In addition, Sec. 25A(e)(2) specifies that the Education IRA tax-free withdrawal provisions (discussed below) cannot be used for a tax year in which either credit is elected. For the traditional student, the Hope Credit is generally more beneficial through 2002 for education expenses incurred in the first two years of postsecondary education. The Learning Credit may be more beneficial beginning in 2003, depending on the amount of QTREs incurred during the tax year and the inflation adjustments made.

Example 1: J incurs and pays $11,000 in QTREs on behalf of his son, A, an eligible student, in 1999. J can take a Hope Credit of $1,500 (100% of $1,000 + 50% of $1,000); alternatively, J can take a Learning Credit of $1,000 (20% of $5,000). For 1999, J should elect the higher, the $1,500 Hope Credit.

Example 2: The facts are the same as in Example 1, except that it is 2003 and the Hope Credit has been indexed for inflation to $1,650. J can take a $1,650 Hope Credit or a $2,000 Learning Credit (20% of $10,000). J should claim the Learning Credit.

Because the Hope Credit is a per-eligible-student computation and the Learning Credit is a per-return computation, the presence of more than one eligible student also favors taking the Hope Credit over the Learning Credit.

Example 3: J incurs and pays $7,000 in QTREs on behalf of each of his triplets, all freshmen and eligible students, during 1999. J is entitled to a Hope Credit of $4,500 (3 X $1,500) or a Learning Credit of $1,000 (20% of $5,000). J should elect the Hope Credit.

Planning opportunities: The Hope Credit's two-year rule produces important planning opportunities, because academic and tax years often do not coincide. Taxpayers may not be able to claim the Hope Credit for the entire first two years of postsecondary education because they are typically spread over three tax years. This situation has little or no effect at higher levels of QTREs (i.e., above $2,000 per year through 2001), but at lower levels, some of the tax benefit may be lost without proper planning.

Example 4: M graduates from high school in Spring 1998 and attends State U. full-time beginning in Fall 1998. Her QTREs for her freshman and sophomore years, paid at the beginning of each term, are as follows:

Fall 1998     $4,000
Spring 1999    4,000
Fall 1999      4,000
Spring 2000    4,000

M's parents can take a $1,500 Hope Credit for each of 1998 and 1999; if they do so, they cannot also take a Hope Credit for the education expenses associated with the Spring 2000 term. They can take a Learning Credit in 2000.

Example 5: The facts are the same as in Example 4, except that M's eligible education expenses are as follows:

Fall 1998     $1,200
Spring 1999    1,200
Fall 1999      1,200
Spring 2000    1,200

M's parents' Hope Credit is $1,100 (100% of $1,000 + 50% of $200) for 1998 and $1,500 for 1999. Because 1998 tuition is less than $2,000, $400 of the maximum allowable credit is left unused.

This underuse may be avoided by prepaying spring term tuition at the end of the fall term. Many educational institutions impose December deadlines for spring term tuition and fees. Under Sec. 25A(g)(4), if QTREs are paid during a tax year for an academic period beginning during the first three months of the following tax year, such period is treated as beginning in the earlier tax year. However, because the Hope Credit applies only to QTREs paid after 1997, tuition paid in 1997 to cover 1998 academic periods does not qualify.

Example 6: The facts are the same as in Example 5, but Spring 1999 and 2000 tuition is prepaid in December 1998 and 1999, respectively. Thus, $2,400 is paid in both Fall 1998 and 1999; the maximum Hope Credit of $1,900 can be elected for each year.

According to Sec. 25A(b)(2)(C), the determination of whether the student has completed the first two years of education is made at the beginning of the tax year. Many students will not have completed their second year of postsecondary education at the beginning of the tax year in which the spring term of their sophomore year occurs, providing taxpayers with some flexibility as to years in which the Hope Credit may be elected. At a minimum, taxpayers in such situations can elect the credit in two of three tax years.(2) The AGI phaseout should be considered in timing the election for maximum benefit.

Example 7: The facts are the same as in Example 4. The maximum credit of $1,500 can be elected by M's parents for any two of 1998,1999 or 2000. If they expect relatively higher AGI in 1999 to preclude any tax benefit from a Hope Credit election in that year, they should elect the credit for 1998 and 2000.

Eligible Students

Students eligible for the credits are shown in Table 2 on page 248. According to Sec. 25A(g)(3), if a parent claims a child as a dependent, only the parent may claim either credit as to such child; any qualified expenses paid by the child are deemed to be paid by the parent. Thus, students claimed as dependents may not claim either the Hope or the Learning Credit on their own return. Part-time students over age 18 generally do not qualify as dependents, under Regs. Sec. 1.151-3(b); such students may be eligible to elect either credit, but many are unlikely to have sufficient taxable income to realize a benefit therefrom.

Example 8: P and M pay the QTREs of their son, H; H is age 20 and enrolled half-time at State U. during 1998 and earns $5,000 that year. Under Sec. 151, H is not a dependent of his parents; thus, P and M are not entitled to either the Hope or Learning Credit for the QTREs. If H pays his own QTREs, he will reap no benefit, because his taxable income is zero, and the credits are nonrefundable.

In addition, under Sec. 25A(b)(2)(D), the Hope Credit is not available for QTREs for any academic period for which die student has been convicted of a Federal or state felony offense for possession of a controlled substance before die end of die tax year with or within which the academic period ends.

QTREs

The definition of QTREs for the Hope and Learning Credits is shown in Table 2. on page 248. The definition of QTREs for the Learning Credit at Sec. 25A(c)(2)(B) includes qualified tuition and fees for any course of instruction at an eligible educational institution to acquire or improve job skills of the qualifying individual. Thus, the Learning Credit benefits many taxpayers not previously entitled to a deduction under Sec. 162, in two ways. First, the standard of "acquiring or improving" job skills under Sec. 25A is a broader standard than that in Regs. Sec. 1.162-5, which allows deductions only for expenses that maintain or improve existing skills. QTREs for graduate, professional degree and vocational education courses are more likely to meet this more liberal standard. Second, the Regs. Sec. 1.162-5(b)(2) and (3) tests do not apply in determining eligibility for the Learning Credit.

Example 9: B, age 26, is a graduate of State U. and an engineer. B incurs and pays QTREs associated with her pursuit of a law degree at night. Such education would not be deductible under Sec. 162, because the law degree qualifies B for a new trade or business.(3) While these expenses do not qualify for the Hope Credit, they do qualify for a Learning Credit.

A taxpayer's ability to take advantage of the Hope and Learning Credits is affected by die academic status of a student as full-time, half-time or less than half-time. To qualify as an eligible student for the Hope Credit, under Sec. 25A(b)(2)(B) and (b)(3)(B), a student must carry at least one-half of the normal full-time work load for at least one academic period that begins during the year. This restriction does not apply to the Learning Credit.

Example 10: C, classified as a half-time student by State U., completes two undergraduate courses in his first term, Spring 1999. C incurs and pays the education expenses for the courses. He is entitled to a Hope Credit for 1999.

Example 11: R completes two undergraduate courses at State U. during 1999, one course in each of the Spring and Fall terms. R is not entitled to a Hope Credit because she was less than a half-time student; however, her expenses are likely to qualifying for the Learning Credit.

Finally, the phaseouts indicated in Table 2 should be scrutinized. Higher-income taxpayers may find the Hope and Learning Credits to be of little benefit. Taxpayers approaching the phaseout range for the credits may wish to plan the recognition of discretionary income so that credit eligibility is maintained.

Example 12: H and W, married filing jointly, expect to pay $7,000 in QTREs for their daughter, C, a freshman and eligible student in 2000. AGI on H's and W's 1994-1997 tax returns was in the $120,000-$140,000 range. H and W will reap no benefit from either the Hope or Learning Credit if their AGI continues to stay in that range in 2000; their AGI will exceed the upper limit of the phaseout range ($100,000) for the two credits.

Example 13: The facts are the same as in Example 12, except that H's and W's AGI on their 1994-1997 tax returns ranges from $70,000-$75,000. H and W should avoid recognizing discretionary income during 2000, because the phaseout range for the credits begins at $80,000.

As discussed below under "Investment Provisions," taxpayers whose AGI exceeds the phaseout ranges established for the Hope and Learning Credits may be able to establish an Education IRA. The phaseout for Education IRAs ($150,000-$160,000 if married filing jointly) is somewhat more generous than that applicable to the education credits, although the associated tax benefit may also be smaller.

Summary

These two credits represent a fundamental change in education incentives available to taxpayers. The Hope Credit is a windfall to many families with traditional students, especially those with students at any number of relatively inexpensive qualifying higher educational institutions (e.g., community colleges); the credit may actually offset most of the tuition costs at those institutions. The Learning Credit extends a tax benefit to taxpayers who previously had none under Sec. 162. For taxpayers who otherwise qualify for a deduction under Sec. 162,(4) the Learning Credit provides an alternative tax benefit. The credit avoids the 2%-of-AGI floor imposed on Sec. 162 deductions by employees, but may not be as beneficial to self-employed taxpayers whose education expense deductions reduce both income and FICA taxes.

Investment Provisions

The education investment provisions outlined in Table 1 on page 246 include the new Education IRA, QSTPs (which were substantially modified by the Small Business Job Protection Act of 1996 and the TRA '97) and Series EE U.S. savings bonds.(5) The Education IRA provides for an exclusion of earnings by the beneficiary; Sec. 135 provides for an exclusion of interest earned on Series EE bonds by the investor. QSTPs create tax benefits through the deferral of income; however, inflation protection is the primary financial benefits, While the Hope and Learning Credits provide immediate tax benefits, the tax-favored investment vehicles discussed below are likely to be of greater benefit in long-term planning for higher education costs. The investment provisions refer to QHEEs rather than QTREs. The definitions, phaseouts and effective dates for these provisions are summarized in Table 3 on page 250.

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Education IRAs

TRA '97 Section 213(a), adding Sec. 530, provided an income exclusion for amounts distributed from an Education IRA, a trust or a custodial account created exclusively to pay the account beneficiary's QHEEs. For this purpose, QHEEs are defined in Secs. 529(e)(3) and 25A(g)(2) as postsecondary tuition, fees, books, supplies and equipment for the enrollment or attendance of a designated beneficiary at an eligible educational institution, less scholarships and other tax-free educational assistance. Only cash contributions to the account are allowed, up to $500 per student per year; indexing is not provided. As shown in Table 3, the opportunity to make contributions to an Education IPA is phased out ratably under Sec. 530(c) for taxpayers based on modified AGI (i.e., AGI plus amounts excluded under Secs. 911, 931 and 933). Sec. 530(b)(1)(A) specifies that contributions are nondeductible and cannot be made after the beneficiary reaches age 18.

Only the earnings portion of the Education IRA is potentially subject to tax, not the contributions portion. Under Sec. 530(d)(2)(A), withdrawals are tax-free to the extent of the beneficiary's QHEEs; if the withdrawal exceeds QHEEs, the earnings includable in the beneficiary's gross income, calculated under Secs. 530(d)(2)(B) and 72(b), is reduced based on the ratio of QHEEs to aggregate distributions. Sec. 530(d)(4)(a) imposes a 10% penalty on the taxable part of a distribution.

Example 14: G receives a $15,000 distribution from an Education IRA during 2008; his QHEEEs are $17,000 for the same period. The $15,000 is excludable from his gross income.

Example 15: C receives a $9,000 distribution from an Education IRA with a $10,000 balance during 2008; $4,000 of the balance is from contributions and $6,000 from earnings. C's QHEEs are $8,000. Under Sec. 72(b), $5,333 ($8,000/$9,000 X $6,000) is attributable to QHEEs. The $667 ($6,000 - $5,333) balance is taxable income and subject to the 10% penalty.

Under Sec. 530 (b)(2)(B), the definition of QHEEs for Education IRA purposes includes contributions to a QSTP. An Education IRA may be established currently and the funds used at a later date to allow participation in a QSTP.

Example 16: G and S establish an Education IRA in 1998 for their daughter, L. L expects to enroll in college in 15 years. G and S make the maximum $500 contribution annually through 2004. In 2005, the state in which they reside establishes a QSTP. If G and S wish to participate in the QSTP, funds from the Education IRA may be distributed tax-free and reinvested in the QSTP.

All amounts in an Education IRA must be distributed to the beneficiary before age 30.(6) This age limit provides some flexibility for students considering delaying school or expecting to pursue graduate studies. The TRA '97 allowed tax-free, penalty-free transfers and rollovers of account balances from an Education IRA (as well as redesignations of the named beneficiary), if the new beneficiary is a member of the former beneficiary's family and the transfer or rollover occurs before the former beneficiary reaches age 30. Sec. 530(b)(1)(e) provides that the value of the beneficiary's account is includable in his taxable estate on death.

A broad class of taxpayers can establish and contribute to an Education IRA. Grandparents who meet the modified AGI limit, for example, may wish to establish such accounts for grandchildren.(7) Under Sec. 530(d)(3), contributions are gifts eligible for the $10,000 annual gift tax exclusion.

No Hope or Learning Credit may be taken in a tax year in which any portion of a distribution from an Education IRA is excluded from gross income, under Sec. 25A(e)(2). Whether a Hope Credit, Learning Credit or income exclusion from an Education IRA will be most advantageous depends on a variety of factors, including the amount of the distribution from the Education IRA, the educational expenses incurred during the tax year, the parents' tax rate versus the eligible student's tax rate, inflation adjustments to the Hope Credit, and the expected time of enrollment.

Example 17: D and C are married filing jointly. They contribute $500 per year for 15 years ($7,500 overall), to an Education IRA for the benefit of their dependent daughter, R. In the first year R attends college, 2012, the total value of the Education IRA is $22,500 ($7,500 of contributions and $15,000 of earnings). The Hope Credit has been indexed to $2,400 and the Learning Credit is $2,000. A distribution of $10,000 from the Education IRA to R pays for her $10,000 of QHEEs. Of the $10,000 distribution, $6,667 ($15,000/$22,500 x $10,000) is attributable to untaxed earnings and potentially taxable to R. If the Hope or Learning Credit is not claimed by D and C, the full $10,000 distribution may be excluded from R's taxable income. If D and C claim either credit based on R's QTREs in the year of the distribution, she win not be eligible for the exclusion, and must include the $6,667 in income.

Example 18: T, an eligible student in 2010, takes a distribution from an Education IRA to pay his QHEEs for the year. If T waives the available income exclusion, his taxable income will be $7,500. His parents are otherwise eligible to elect the Hope Credit, which has been indexed to $2,250. If T's marginal tax rate is 15%, he will owe $1,875, which includes the 10% penalty. The family's net tax savings is $375 ($2,250 - $1,875) if the credit is elected. If T's parents 'tax liability before the Hope Credit is less than $1,875, electing the credit win result in a net tax increase to the family for the year. Because the Hope Credit is nonrefundable, T's $1,875 tax will no longer be offset by his parents' tax savings therefrom.

The preceding examples assume that the Hope and Learning Credits will be available 15 years from now. Given the Hope Credit's two-year cap, it may be advisable to avoid using Education IRA distributions to pay for qualified expenses while the credits are available.

QSTPs

TRA '97 Section 211 expanded Sec. 529, which provides for deferral of tax on earnings of QSTPs. These programs permit individuals to either purchase tuition credits or make contributions to accounts established to meet the education expenses of a designated beneficiary. Distributions from these accounts are included either in the beneficiary's gross income to the extent they exceed total contributions made on his behalf, or in the contributor's gross income if a refund is received that exceeds the total contributions. Under Sec. 529(c)(3)(a), amounts distributed from QSTPs generally are included in income under Sec. 72 in the same manner as are distributions from annuities. If QSTP distributions are used to pay QHEEs, the distributee or other eligible taxpayer (e.g., parent) may also claim the Hope or Learning Credit, if otherwise eligible.(8)

Example 19: Y, the dependent beneficiary of a QSTP established by her parents, receives a $10,000 distribution in 1998 and uses it to pay $10,000 of QHEEs. Her parents contributed $30,000 to the account; earnings were $10,000. If the other requirements are met, Y's parents are entitled to either the Hope or Learning Credit, while Y may exclude $7,500 ($30,000/$40,000 X $10,000) of the $10,000 distribution from gross income.

TRA '97 Section 211 (a) made several changes to the QSTP provisions, including broadening the definition of QHEEs under Sec. 529(e)(3), shown in Table 3, to include room and board expenses for students enrolled at least half-time. Sec. 529(e)(5) expands the definition of eligible educational institution so that state authorities may include a broader set of institutions under their QSTPs.

The new law also changed the estate and gift tax consequences of these programs to participants and contributors. Under Sec. 529(c)(2), contributions to QSTPs are now treated as gifts eligible for the $10,000 annual gift tax exclusion. If a contribution exceeds $10,000 in a single year, the donor may elect to treat it as if made ratably over a five-year period, under Sec. 529(c)(2)(b). This enables taxpayers to avoid gift tax consequences if they establish a QSTP over a short period of time or make relatively large, single payments.

Example 20: F transfers $25,000 to a QSTP maintained by State U. for the benefit of her daughter, S, in 1998. The transfer is a gift to S by F that qualifies for the $10,000 annual gift tax exclusion. No other gifts to S are made by F in 1998. Without an election, the taxable gift is $15,000 ($25,000 - $10,000 annual exclusion). Instead, F may elect to treat the contribution as a gift made over five years. If the election is made, F is treated as making $5,000 gifts to S in 1998-2002. If no other gifts are made by F to S in 1998-2002, the $5,000 gifts are offset by the annual exclusion, and no gift tax will be due in any of those years.

Under Sec. 529(c)(3)(C), changes in designated beneficiaries or rollovers within 60 days of receipt of a QSTP distribution from the distributee to another are allowed if the new and former beneficiaries are members of the same family.(9) Sec. 529(c)(5)(B) specifies that gift tax rules apply to such transactions only if the new beneficiary is a generation below that of the former beneficiary.

Although QSTP characteristics and benefits differ across the states that have implemented such programs, one attractive feature of the programs is inflation protection against the rising costs of education; this may offset any tax costs associated with distributions from these programs. While only 15 states currently have such programs, 12 more are about to launch programs, three are waiting to have a plan signed into law, and nine states have legislation pending.(10) A careful examination of program details is recommended for all taxpayers considering the use of a QSTP to finance a higher education.

Series EE U.S. Savings Bonds

TRA '97 Section 211 (c) expanded the definition of QHEEs under Sec. 135(c)(2)(C) to include contributions to a QSTR. Taxpayers who currently hold Series EE savings bonds can redeem the bonds, exclude the interest income thereon and reinvest in QSTPs, provided the other provisions of Sec. 135 are met. This may be beneficial to taxpayers concerned that the Sec. 135 AGI limits will reduce their future Series EE bond exclusion benefit if they continue to hold the bonds. Interest excluded under Sec. 135 as a contribution to a QSTP does not increase the investment in the contract for purposes of determining the taxable portion of a QSTP distribution.

Example 21: M and B purchased Series EE bonds in 1990 for $12,000, intending to redeem them beginning in 2005 to pay college expenses for their daughter, J. B returned to work after J started college. M and B expect their 1998 AGI to be $75,000 and to increase over the next few years. The Series EE phaseout start at $78,350 if married filing jointly in 1998.(11) The bonds can be redeemed for $18,000 in 1998. If M and B redeem the bonds in 1998 and contribute the $18,000 to a QSTP, the $6,000 in accrued interest will be excludable.

According to Sec. 135(d)(2), as amended by TRA '97 Section 201(d), the QHEEs eligible for the bond redemption proceeds exclusion must be reduced by QTREs used to compute the Hope or Learning Credit.

Comparison of Investment Provision Features

The three investment provisions enable taxpayers to save for higher education costs in a variety of ways. Important differences in the availability, features and limits of each of the investments should be considered to implement a plan for higher education savings and to minimize taxes.

The definition of QHEEs, listed in Table 3, is more generous for Education IRAs and QSTPs than for Series EE bond redemption, in two ways. First, QHEEs include not only tuition and fees, but also books, supplies and equipment. Second, room and board is a QHEE when the student is at least half-time. The change in QSTP rules to cover room and board costs is significant, because the inflation-protection feature of QSTPs now extends to these costs, which may well exceed other higher education costs. QHEEs for Education IRAs and Series EE bonds include contributions to QSTPs; therefore, taxpayers have the flexibility to shift these funds to a QSTP in the future. QHEEs are reduced for certain benefits under all three provisions.

For taxpayers in jurisdictions with QSTPs, the features of such programs should be compared with Education IRA benefits and restrictions, because contributions to both are not allowed in any one tax year.(12) Any amount contributed to an Education IRA in excess of $500 is considered an excess contribution under Sec. 4973(e)(1)(B) (enacted by TRA '97 Section 213(d)(2)) subject to the 6% excise tax if any amount is contributed during the year to a QSTP.

There are substantial differences in the amount of savings that can be achieved under the three forms of investment. Because the Education IRA contribution is capped at $500 per beneficiary per year, it may take some time to create sufficient funds in the account to meet the escalating costs of higher education. On the other hand, QSTPs can be used to accumulate the full amount of QHEEs. Similarly, sufficient investments in Series EE bonds can finance all eligible QHEEs.

The Series EE bond investments offer flexibility in planning for education costs, because there is no requirement that the bonds be designated to pay for education costs at the time of purchase. Instead, the tax benefits occur at redemption; the bonds can be redeemed at any time. The Education IRA designation occurs at the time the account is established, with the potential drawbacks that the funds (1) are not readily available to the contributor in emergencies and (2) will eventually be distributed to the beneficiary even if he does not pursue a higher education. This loss of control over the funds must be weighed against the potential tax benefits. QSTPs have provisions that permit the contributor access to the account funds; however, penalties in the form of reduced rates of return may be incurred.

QSTPs have no AGI restrictions, which make them more attractive to higher-AGI taxpayers, although the AGI limits on Education IRAs are generous versus those for Series EE bonds. Education IRAAGI limits are imposed when contributions are made to the account, rather than when amounts are withdrawn. In contrast, the Series EE bond AGI limits are imposed at redemption; thus, a taxpayer is not assured of being eligible for the interest income exclusion then the bonds are redeemed. The Education IRA permits more flexibility in investment choices and, therefore, a potentially higher rate of return than may be available on Series EE bonds or through QSTPs. Taxpayers who find the Series EE bond provisions attractive may simply wish to divert $500 to an Education IRA and continue purchasing or holding of the bonds with remaining funds.

Finally, QSTPs are largely designed for traditional students, and the programs' benefits are likely to be most attractive when relatively long-term planning horizons are involved. Similarly, tax savings from Education IRAs and Series EE bonds are enhanced when education costs are expected to be incurred in the future, because the deferral benefit increases as time passes. Nontraditional students currently (or soon-to-be) enrolled are likely to find that the investment provisions are not very effective in achieving tax benefits, due to the immediate need to pay education costs. Instead, tax benefits to these nontraditional students are likely to occur through the new credits or other provisions.

Expense Provisions

Student Loan Interest Deduction

TRA '97 Section 202(a) provided in new Sec. 221(a) an above-the-line deduction for interest paid on qualified education loans during the first 60 months in which interest payments are required. Interest payments due and paid after 1997 on any qualified education loan are deductible, but cannot exceed the following annual limits:

                    Interest
Tax Year                 Cap

1998                  $1,000
1999                  $1,500
2000                  $2,000
2001 and thereafter   $2,500

The interest cap will not be indexed for inflation. For existing loans, Sec. 221(e) provides that payments are deductible to the extent the 60-month period has not vet expired. Under Sec. 221(d), a loan and any refinancings therefore treated as one loan.

Example 22: J graduated from Private U. in August 1905. She had taken out a qualified education loan required to be repaid over 10 years. J delayed the start of her monthly qualified education loan repayments for six months, to March 1, 1996. As of Dec. 31, 1997. J had made all 22 required loan payments. If she continues to make loan repayments on schedule, J may deduct the interest on the next 38 payments (12 payments in 1998, 12 in 1999, 12 in 2000 and two in 2001), up to the annual interest cap.

Sec. 221(c) specifies that a taxpayer may not claim the interest deduction in a year in which he is claimed as a dependent. Under Sec. 221(f)(2), married taxpayers must file jointly to claim the deduction; under Sec. 221(f)(1), the interest is not deductible under Sec. 221 if it is deductible under another Code provision.

Example 23: M and I borrow money using a qualified borne-equity loan to help finance the education of their daughter, E. M and I may not deduct any of the associated interest as student loan interest; rather, the interest is deductible as home-equity interest on Schedule A.

A "qualified education loan" is defined by Sec. 221(e)(1) as debt incurred to pay the QHEEs of the taxpayer, spouse, or any dependent in attending postsecondary educational institutions, certain vocational institutions or other institutions conducting internship or residency programs. Under Sec. 221(e)(1)(c), loans between related parties do not qualify. QHEEs include tuition, fees, room and board and related expenses, reduced by educational benefits excludable from gross income under Secs. 117, 127, 135, as veterans or military benefits or as distributions from an Education IRA. Under Sec. 221(e)(1)(B), the expenses must be paid or incurred within a reasonable period before or after the debt is incurred, and must be attributable to a period when the student attends at least half-time. Under Sec. 221(b)(2)(B), the interest deduction is phased out ratably for individual taxpayers with modified AGI (as defined in Sec. 221(b)(2)(C)) of $40,000-$55,000 ($60,000-$75,000 for joint returns). Under Sec. 221 (g), these amounts win be indexed for inflation after 2002.

Exclusion Provisions

The TRA '97 did not change the exclusion provisions identified in Table 1, with the exception of the Sec. 127 employer-provided education assistance exclusion. The exclusion of up to $5,250 of employer-provided provided undergraduate educational assistance was extended by TRA '97 Section 221's amendment to Sec. 127(d) to cover courses beginning before June 1,2000. The effective date of the extension is Jan. 1, 1997, which makes all qualified assistance paid in 1997 excludable. The coordination of this and other tax provisions creates increased complexity in maximizing the tax benefits associated with funding higher education.

Other Education Incentives

The TRA '97 created other education incentive provisions, including expansion of the forgiveness of student loan debt by tax-exempt charitable organizations under Sec. 108(f) (TRA '97 Section 223(a)) and the allowance of penalty-free withdrawals from IRAs for education expenses (Sec. 72(t), as amended by TRA '97 Section 203). TRA '97 Section 222 repealed the Sec. 145(b)(1) limit on qualified Sec. 501(c)(3) bonds other than hospital bonds; TRA '97 Section 223(a) increased the Sec. 148(f)(4)(D)(vii) arbitrage rebate exception for governmental bonds used to finance education facilities; and TRA '97 Section 226(a) created additional incentives under new Sec. 1397L for education zones.

TRA '97 Section 203(a) created Sec. 72(t)(2)(E), which provides that the 10% penalty on most early withdrawals from traditional IRAs does not apply if the taxpayer uses the amounts to pay QHEEs of the taxpayer, the taxpayer's spouse, or any child or grandchild of the taxpayer or taxpayer's spouse. The provision is effective for distributions made, expenses paid and academic periods beginning after 1997. Many financial planners consider IPA withdrawals to be a last resort for paying education expenses, because income tax is imposed at ordinary rates and the deferral benefits of the IRA are lost.(13) Borrowing may be wiser, especially if the loan can generate deductible interest.

Conclusion

Taxpayers have many new opportunities to reduce the cost of a higher education. Interactions among provisions, timing choices, AGI limitations and provisions of any available QSTP should all be considered to maximize the potential tax and financial savings. Some provisions (e.g., the Hope and Learning Credits) provide fun savings this year, while the potential tax benefits of the savings provisions increase over time. Taxpayers who receive the benefit of existing education tax incentives should examine the new provisions to determine whether more tax-advantageous arrangements can be made. With proper planning, taxpayers can lower the cost of a variety of educational pursuits. Notice 97-60(14) provides additional information on many of the provisions discussed herein.

(1) Joint Committee on Taxation, Estimated Budget Effects of the Conference Agreement on the Revenue Provisions of H.R. 2014, "The Taxpayer Relief Act of 1997" (JCX-39-97), cited in 76 Tax Notes (8/4/97), pp. 592, 593.

(2) The maximum flexibility depends on the term "two years of postsecondary education," the definition of which may require future guidance. If this term is defined as higher institutions commonly denote classification as freshman, sophomore, etc. (i.e., in terms of credit hours earned), a student consistently enrolled on a half-time basis could take several years to complete two years of postsecondary education. In contrast, a student who earns college credits in advance of enrollment (e.g., by advanced placement testing) may reach sophomore status in less than two years and, accordingly, be ineligible for the credit.

(3) See Regs. Sec. 1.162-5(b)(3)(iii), Example 1.

(4) Sec. 25A(g)(5) denies both a credit and a Sec. 162 deduction, however.

(5) For a discussion, of the relative merits of QSTPs and Serie, EE U.S. savings bonds, see Swayze and Zimmerman, "Practical Tax Planning for Higher Education costs," 27 The Tax Adviser 692 (Nov. 1996).

(6) See The Taxpayer Relief Act of 1997, Statement of the Managers (8/1/97), p. 41.

(7) Gift tax and generation-skipping transfer tax considerations (if applicable) should be weighed.

(8) See note 6.

(9) Sec. 529(c)(2), as expanded by TRA '97 Section 211(b)(1), defines "member of the family" to include all the family relationships specified in Sec. 152, as well as spouses of said family members.

(10) Asinof, "State-Run College-Savings Programs Win Tax Break, as New York. Others Sign On." The Wall Street Journal (8/8/97), p C1.

(11) Rev. Proc. 96-59, 1996-2 CB 393. Section 3.08.

(12) The excess contributions tax does not apply to contributions to a QSTP described in Sec. 531)(b)(2)(B).

(13) Donato, "Using IRAs for College Gets Low Grades," The Wall Street Journal (8/19/97), p. C1.

(14) Notice 97-60, IRB 1997-46, 8; for a discussion, see Tax Clinic," IRS Issues Guidance on Education Tax incentives," 29 The Tax Adviser 88 (Feb. 1998).