Who's paying for your child's education? A summary of education incentives.

The Taxpayer Relief Act of 1997 added several new tax advantages for those incurring higher education expenses and tinkered with some of the existing ones. With a handful of opportunities available, it is important to understand each of these options, as well as how they work together.

Tax Credits

The most dramatic change is the introduction of credits for qualified education expenses. Two types of credits are available, the Hope scholarship credit and the lifetime learning credit. Exhibit 1, on page 540, presents a comparison of the credits' calculations and rules.

Exhibit 1: Hope and Lifetime Learning Credit Comparision

                       Hope credit

Eligible students      Enrolled in a degree, certificate or
                       other program leading to a recognized
                       educational credential at an
                       eligible educational institution and
                       carrying at least one-half the normal
                       full-time work load

Academic years         First two years of post-secondary
                       education

Eligibility            Only if credit has not been claimed
                       for any two prior tax years

Effective date         For expenses paid after Jan. 1,
                       1998, for academic periods starting
                       after that date

Credit calculation     All of the first $1,000 of qualified
                       expenses and 50% of the next
                       $1,000 of qualified expenses

Aggregate limit        One credit for each of the taxpayer's
                       eligible students plus one credit
                       for the taxpayer, plus one credit for
                       the taxpayer's spouse
Other restrictions     Not available to a person convicted
                       of a drug-related felony

                       Lifetime learning credit

Eligible students      Enrolled in a degree, certificate or
                       other program leading to a recognized
                       educational credential at an
                       eligible educational institution

Academic years         All academic years

Eligibility            Anytime

Effective date         For expenses paid after June 30,
                       1998, for academic periods starting
                       after that date

Credit calculation     20% of up to $5,000 of qualified
                       expenses

Aggregate limit        Qualified expenses of the taxpayer,
                       spouse and dependents are
                       combined and only one credit can
                       be taken per family

Other restrictions     None

Taxpayers will receive credits for qualified expenses that the taxpayer, spouse and dependents incur. A taxpayer may only claim a credit for himself if he is not eligible to be claimed as a dependent on another person's tax return. However, a taxpayer may include expenses paid directly by a dependent when calculating the credit.

Expenses eligible for the credit include tuition and fees required for the enrollment or attendance at an eligible educational institution. The definition is expanded for the lifetime learning credit to include tuition and related expenses for any course of instruction at an eligible educational institution to acquire or improve job skills. Qualified expenses do not include expenses for courses involving sports, games or hobbies, unless they are part of the individual's degree program. Also excluded are books, student activity fees, athletic fees, insurance expenses or other expenses (including meal and lodging expenses, transportation and similar personal, living or family expenses) unrelated to an individual's academic course of instruction.

Eligible educational institutions are accredited postsecondary educational institutions offering credit toward a bachelor's degree, an associate's degree or another recognized postsecondary credential. Certain proprietary institutions and postsecondary vocational institutions are also eligible. The institute must be eligible to participate in the Department of Education student aid programs.

Total expenses eligible for the credit are the total expenses incurred, less certain amounts paid for the student's benefit. Reductions must be made for a scholarship or grant excludable under Sec. 117, veterans' and reservists' educational assistance or a payment of educational expenses (other than a gift, bequest, devise or inheritance)' excludable from gross income. This would include employer-provided educational benefits deductible under Sec. 162.

The timing of the payments also affects the credit calculation. If payment is made in one tax year for an academic period that begins during the first three months of the subsequent year, the credit is claimed in the year the payment is made. The exception is for payments made prior to the credit's effective date.

The credits are phased out for taxpayers filing a joint return with modified adjusted gross income (MAGI) of $80,000 to $100,000 ($40,000 to $50,000 for single filers). MAGI is AGI increased by any amount excluded from AGI by Sec. 911 (the foreign income exclusion), Sec. 93t (the exclusions of income from certain U.S. possessions) and Sec. 933 (Puerto Rico income exclusion).

Saving Plans

Beginning in 1998, education individual retirement accounts (IRAs) are available as a vehicle for saving for higher education expenses. Nondeductible contributions of up to $500 can be made to an education IRA designated as such. Any individual with MAGI of less than $150,000 on a joint return or $95,000 individually may fund an education IRA for the benefit of any person under age 18. However, the total that can be contributed on behalf of any beneficiary is limited to $500 per year, even if more than one individual makes contributions for the benefit of the child. Contributions in excess of $500 must be withdrawn (as well as any earnings attributable to them) by the due date of the return for that year, or a 6% excise tax will be imposed. Under the technical correction provisions of the IRS Restructuring and Reform Bill of 1998, the excise tax will be imposed each year the excess contribution exists.

Education IRA earnings are not subject to tax; distributions are not taxed to the extent of higher education expenses incurred during the distribution year. Higher education expenses are the same expenses that qualify for the credits discussed earlier, except that room and board expenses for a student enrolled on at least a half-time or greater basis may also be included. Room and board expenses are generally the school's posted room and board expenses, or $2,500 for students living off campus and away from home. Distributions may also be used to purchase tuition credits or to make contributions under a qualified state tuition program for the beneficiary. Distributions taken for other purposes will be subject to income tax as well as a 10% excise tax, unless they were made either after the designated beneficiary's death or disability or to the extent education expenses were paid with a tax-free scholarship. The tax and the excise tax are calculated only on the pro rata portion of the distribution that represents earnings.

If the designated beneficiary does not use the funds in an education IRA for education expenses, the balance of the account may be rolled into the education IRA of another family member. "Family" for this purpose is broadly defined as children, stepchildren, grandchildren, parent, stepparent, sibling, nephew or niece, aunt or uncle, brother- or sister-in-law, mother- or father-in-law or the spouse of any listed relative. An amount received via a rollover does not affect the $500 contribution limit for that year.

Another change effective for 1998 is that funds in traditional or Roth IRAs may be used to pay for the same education expenses that qualify under the education IRA rules, without the 10% excise tax for early withdrawals that generally applies to distributions made before age 59 1/2. There are no tracing rules applied to these distributions. The amount that can be taken free from the excise tax is equal to the amount expended for qualified education expenses by the taxpayer or the dependent student, reduced by any tax-free scholarships, grants or distributions from education IRAs.

Clients may be tempted by the idea that they could absorb potentially large college expenses for their children without affecting their everyday budget by dipping into their IRAs. The waiver of the penalty alone does not make this a preferred method of funding an education. The effect on overall retirement planning, whether non-IRA funds are available and the long-term cost of forfeiting future tax-deferred earnings, etc., must be considered before deciding to withdraw these expenses from IRAs.

Another savings vehicle is the state-sponsored tuition credit purchase program. Under these programs, a person can purchase tuition credits on behalf of a designated beneficiary or make contributions to an account established to meet a designated beneficiary's qualified higher education expenses. These plans are now tax-exempt. Distributions from these programs are taxed to the extent they represent earnings. The earnings portion is calculated under the annuity taxation rules.

To qualify, a state tuition program must meet a number of requirements:

1. Contributions must be made only in cash;

2. Penalties must be imposed on any refund of earnings not used for higher education expenses;

3. Contributors may not direct the investment of any contribution or earning;

4. Interest may not be used to secure a loan;

5. Safeguards must exist to prevent contributions in excess of those necessary for the beneficiary's qualified higher education expenses.

Student Loan Interest Deduction

Also new for 1998 is an above-the-line deduction for qualified student loan interest paid during the tax year. Subject to limits based on MAGI, the maximum deduction is $1,000 for 1998, and increases $500 each year until reaching $2,500 in 2001.

The deduction phases out for taxpayers with $60,000 to $75,000 of MAGI on a joint return and $40,000 to $55,000 of MAGI on an individual return. Taxpayers that can be claimed as dependents on another return are not eligible for the deduction.

The only interest eligible for the deduction is interest paid on a qualified loan during the first 60 months that interest payments are required; months during which the loan is in deferral or forebearance do not count. A qualified loan is a debt incurred to pay qualified higher education expenses incurred by the taxpayer, his spouse or dependent as of the time the loan was taken. These expenses must have been paid or incurred within a reasonable time before or after the loan was originated, and must be attributable to education furnished when the recipient was enrolled on at least a half-time basis. Advisers should note that a loan does not have to be a traditional "student loan" (which is customarily Federally guaranteed or subsidized) to be a qualified loan. However, interest on the loan is deductible only by the person or persons obligated on the loan and paying the interest. Qualified expenses are judged by the same criteria as for the educational IRAs.

Planning for Education Expenses

Understanding how the tax-favored rules work together is essential to maximizing the tax advantages available for higher education. The first choice is how to save for future college expenses. The education IRA offers tax-free growth, but contributions are limited to $500 per year. If a qualified state tuition program is available, it offers the ability to fund the full present value of an education, but the earnings are tax-deferred, not tax-free. Because a contribution to a state program subjects any contributions to an education IRA to a 6% excess funding excise tax, a choice must be made as to which vehicle to use. Both vehicles offer the ability to roll over unused amounts to family members. However, use of the state programs limits the choice of institutions to those designated by the program.

The education IRA rules have income limits on the contributor, but this seems generally inconsequential, because a person can fund his own education IRA even if he has no earned income. Therefore, a high-income parent can gift $500 to a child, who can then make the contribution directly.

Other factors to consider are the years remaining until the beneficiary attends college, the amount available to invest, the expected rates of return and the importance of directing the investments. Simple projections should show which options yield the most after-tax dollars at the time the student attends college.

Decisions also need to be made as the funds are spent on qualified expenses. The credits are not available in years in which the taxpayer elects to treat distributions from education IRAs as nontaxable. For the next several years, it is unlikely that accumulated earnings in an education IRA will be so large that tax-free treatment will produce a greater benefit than either credit. Therefore, the taxpayer must be careful to report the distribution as taxable. Better planning may be not to take a distribution from the education IRA in a year that the taxpayer will qualify for the credit, if it is anticipated that the taxpayer will not qualify for the credit in a future year.

It may be possible to qualify for both credits in the same year; however, both credits may not be claimed for the same student in the same year. Claiming the Hope credit for one dependent will not prevent a taxpayer from claiming the lifetime learning credit for another dependent. Also, the decision is an annual one; claiming the Hope credit for the first two years of college does not preclude claiming the lifetime learning credit in future years.

Expenses eligible for the credit or payable from a tax-advantaged account must be coordinated with expenses from other tax-free sources. As a general rule, amounts received tax-free and used to pay educational expenses (e.g., Pell Grants, scholarships and amounts received from employers) must be subtracted from the total qualified expenses (see Exhibit 2 above). If distributions are made from both education and other IRAs during the year, the amount distributed from the education IRA must be subtracted to determine the amount that can be withdrawn from a regular or Roth IRA without imposition of the 10% penalty. The total remaining is the amount of qualified educational expenses to be used to calculate the allowed credit or distribution. (The unanswered question is whether classes taken to understand these credits qualify for the credit.)

Exhibit 2: Qualified Education Expenses Available

                                        Lifetime         Hope
                                     learning credit    credit

Tuition                                    Yes           Yes(*)
Course-related fees                        Yes           Yes(*)
Olher fees                                 No            No
Books                                      No            No
Supplies and equipment                     No            No
Roam and board                             No            No
Purchase of education credits              No            No

                                    Education          State
                                       IRA        tuition programs

Tuition                                Yes              Yes
Course-related fees                    Yes              Yes
Olher fees                             Yes              Yes
Books                                  Yes              Yes
Supplies and equipment                 Yes              Yes
Roam and board                         Yes(*)           Yes(*)
Purchase of education credits          Yes              N/A

                                     Regular or
                                     Roth IRAs

Tuition                                Yes
Course-related fees                    Yes
Olher fees                             Yes
Books                                  Yes
Supplies and equipment                 Yes
Roam and board                         Yes(*)
Purchase of education credits          Yes

(*) Must be enrolled at least half-time to qualify.