College education funding: maximizing family tax savings and financial aid.
With the average cost of a college education at public and private institutions estimated to rise to $60,000 and $200,000, respectively, by the year 2007, the need for financial planning for college is more critical than ever. While changes and additions to the Internal Revenue Code have fulfilled Congress' intention to "maximize tax benefits for education and provide greater choices for taxpayers in determining which tax benefits are most appropriate for them" (H.R. Conference Report), "the mere number and perplexing intricacies of these benefits make it extremely difficult for taxpayers to choose and interpret the ideal option" (June 2004 testimony of former IRS Commissioner Fred Goldberg).
Further complicating the overall planning process is the impact of various funding alternatives and tax incentives on eligibility for federal financial aid. Last year a record $90 billion in financial aid, an increase of more than 11.5 percent from the prior year, was awarded to students at both private and public institutions. Thus, a basic understanding of the financial aid process is an essential component to effective planning for the college years. All of the pieces of this complex puzzle will be explored in the paragraphs that follow.
Despite the ever-growing cost of a college education, finaid.org reports that although families are saving for college, they aren't saving enough. Specifically, between two-thirds and three-fourths of families say they are currently saving for their children's college education. However, of those, one-third have saved less that $5,000. Further, these savings tend to be in taxable accounts, especially low-risk (but also low-yield) investments. Savings accounts are the most popular savings vehicle with three-fifths of families using them, a quarter using CDs, and half using stocks and mutual funds. About a quarter of families use UGMA (Uniform Gift to Minors Act) accounts, a third use savings bonds, a sixth using Coverdell education savings accounts, and a sixth are using section 529 accounts.
In the current climate of ever-increasing college costs and ever-decreasing federal income tax rates, most financial planners agree that the starting point for evaluating all college funding alternatives is the effect that the financing alternative will have on available financial aid. Generally, those who qualify for federal financial aid (grants, loans, and work-study programs) should attempt to maximize those benefits first, while those that don't qualify will have a more simple plan--to maximize tax benefits. As a basic rule of thumb, those who earn less than $70,000 and up to $120,000 to $125,000 a year will probably qualify for aid with chances increasing with more than one child in college. Because tuition is growing at a faster rate than income (about three to four times the yearly inflation rate), those who qualify now for financial aid will probably continue to qualify in the future.
BASICS OF FINANCIAL AID
To fully understand the impact of financial aid on tax incentives, a basic understanding of the financial aid process is necessary. Two formulas are used to determine a student's eligibility for financial aid-the Federal Methodology Formula (FM), established by Congress and used by every accredited college in the United States, and the Institutional Methodology (IM) used by many colleges and private scholarship programs. Although the specific items considered in each formula may vary, both formulas measure a particular family's ability to pay against other families' ability to pay. The information used for FM analysis is collected on the Free Application for Federal Student Aid (FAFSA) which may be found at www.fafsa.edu.gov while the IM information is collected on the CSS/Financial Aid PROFILE in addition to the FAFSA. It is possible to estimate eligibility for financial aid with financial aid calculators which may be found at www.finaid.org and www.collegeboard.com.
A student's "adjusted financial need" or eligibility for financial aid is determined by the Financial Aid Formula Needs Analysis as illustrated in Table One. The computation begins with the "Cost of Attendance" (COA) which includes tuition, fees, room and board, books and supplies, personal expenses including clothing and entertainment, transportation to and from college, and other needs such as a computer. The COA is furnished by each college and may be adjusted by the financial aid counselor for special circumstances. The student's "Expected Family Contribution" (EFC), the most complex component of the financial needs analysis, is then subtracted from the COA to determine the "Basic Financial Need." Because funding for a college education is expected to come from both parent and student sources (unless the student is considered independent), the EFC is the sum of the parents' contribution from income, the parents' contribution from "assessable" assets, the student's contribution from income, and the student's contribution from "assessable" assets. Currently, the federal formulas for financial aid are constructed on the premise that parents are expected to contribute from 22 to 47 percent (the percentage is based on the amount of income) of their "discretionary income" and up to about 5.64 percent of their discretionary assets to cover college costs. Students are expected to contribute 50 percent of their available income and 35 percent of their assessable assets to funding their education. In planning, it is important to determine from the FAFSA and other supplemental data which assets are "assessable" or includible in the list of assets and which ones are not. For example, in most cases, life insurance, annuities, retirement accounts including IRAs, and the family home are not considered assessable. Finally, the "Student Resources" (scholarships/grants; VA benefits; cash gifts paid directly to the college for tuition; payments from prepaid tuition plans; payments from employer-provided education assistance plans) are subtracted from the Basic Financial Need to get the "Adjusted Financial Need."
It is apparent, then, that financial aid eligibility is maximized by keeping both the EFC and Student Resources as low as possible. It should be noted that there is evidence that Congress may change the treatment of assets in the Federal Needs Analysis Methodology in the next Reauthorization of the Higher Education Act of 1965 expected in late 2004. Specifically, a proposed formula would stop distinguishing between financial aid student and parental assets and replace that with a uniform treatment of family assets, a change that most certainly would have a significant impact on the computation, and as will be seen later, on tax planning.
TAX PROVISIONS AND THEIR IMPACT ON THE FINANCIAL AID FORMULA
Included in the Internal Revenue Code (the Code) are education provisions that may be categorized in two ways--(1) those that encourage taxpayers to save for future higher education expenses and (2) those that are intended to help taxpayers meet current higher education expenses. The first group, intended for long-term funding includes two major savings vehicles-qualified tuition programs or QTPs (section 529) and Coverdell Education Savings Accounts or ESAs (section 530) as well as other more traditional provisions such as custodial accounts and education savings bonds. The second group includes strategies that may be divided into three main categories--exclusions which allow taxpayers to exclude amounts from taxable income such as scholarships (section 117) and employer-provided education assistance (section 127), deductions including those that allow for "above the line" or "for adjusted gross income (For AGI)" deductions such as the student loan interest deduction (section 221) and the deduction for qualified education expenses (section 222), and credits which are dollar for dollar reductions in the tax liability including the Hope and Lifetime Learning credits (section 25A). The major provisions of each education incentive, including the impact on financial aid, will be discussed in the paragraphs that follow.
SECTION 529 PLANS
Section 529 of the Code establishes guidelines which allow parents to prepay higher education tuition costs for their children or themselves by making transfers to one of two types of state or institution-sponsored QTPs-college savings accounts, which are similar to mutual funds, and prepaid tuition plans, which are intended as hedges against inflation. While most of the older plans were prepaid tuition plans because of the obvious benefit of locking in current tuition costs, college savings accounts or plans have become more popular because they are more flexible and less costly administer. Institution-sponsored plans are new. One of the first of these, the Independent 529 Plan (www.independent529.com) will offer tuition certificates redeemable toward tuition at any of 300 plus member colleges and universities (Hurley).
In a college savings account, the account owner contributes cash to a plan account for a beneficiary, the contribution is invested according to the terms of the plan, and funds may be withdrawn and used for qualifying purposes at any college. Distributions are generally tax-free if used for broadly defined qualifying expenses. In a prepaid tuition plan, an account owner contributes cash to a plan account, in essence purchasing tuition credits and locking them in at current rates. When the beneficiary attends a college participating in the program, the tuition credits are used to pay for tuition and other college expenses, and the distribution is considered tax free. The tuition credits may be redeemed for cash and used to pay tuition and other expenses with the same tax-free consequences even if the beneficiary attends a nonparticipating college.
According to a recent Congressional Research Service Report, by June 30, 2003, more than five million accounts were in existence (a 50 percent increase from 2002) with the total value of savings in the program about $35 billion (a 60 percent increase from 2002). The tax and non tax advantages of QTPs listed below have contributed to the huge growth of these funds:
Federal income tax exemption. Earnings on invested funds accumulate tax free, and withdrawals are tax free if used to fund qualified higher education expenses or if made upon the death or disability of the beneficiary.
Conversion of other savings vehicles. The account owner may roll over money in U.S. Savings Bonds and Coverdell Education Savings Accounts to fund a 529 plan without incurring income tax on the distributions. There can be gift tax consequences, however.
Coordination with Hope and Lifetime Learning credits. A taxpayer may use other education incentives including the Hope or Lifetime Learning credit for a taxable year and exclude from income amounts distributed from QTPs on behalf of the same student as long as the distribution is not used for the same qualifying expenses.
Estate planning benefits including annual gift tax and generation skipping tax exclusions. Contributions to QTPs, which are entitled to the $11,000 annual exclusion, are considered a gift of a present interest thereby removing the assets from the estate as long as the donor is listed as the owner. Further, a special provision allows contributions of up to $55,000 in one year prorated over five years. The $55,000 (or an amount up to $55,000) does not reduce the donor's unified credit and immediately removes all future appreciation of the initial contribution from the contributor's taxable estate. If the contributor dies within the five-year gift tax period, his or her contributed funds will be treated as part of his or her estate on a prorated basis. In addition, the generation skipping tax is not applicable to transfers under a section 529 plan.
State income tax incentives. Many states conform to federal rules in terms of deferral/exemption of tax on interest/withdrawals. In addition, thirty-two states (and the District of Columbia) grant a full or partial tax deduction for contributions to the plan. Finally, several more states provide low and moderate income families with matching contributions or scholarships through their 529 plans
Exemption from creditors' claims. More than one quarter of the states explicitly shield section 529 plan assets from creditor claims.
Control and flexibility. Rollover rules allow one change in beneficiary per 12 month period (be careful if more than one person has created an account for the same beneficiary) to a family member including son/daughter or descendent of either; stepson or stepdaughter; brother, sister, stepbrother or stepsister; father or mother or ancestor of either, stepfather or stepmother, niece or nephew, uncle or aunt, cousin (which allows grandparents to transfer among grandchildren), in-laws, spouse of the beneficiary or any of the above. The account owner also retains the right to specify the amount, timing, and recipient of any distribution. Withdrawals may escape taxation and penalty if rolled over within 60 days to a QTP account for a family member of the beneficiary or if the withdrawal or distribution resulted from the death or disability of the beneficiary or as a result of the beneficiary receiving a scholarship. Importantly, withdrawals are not limited to higher education expenses. Of course, if funds are withdrawn for nonqualified purposes, the withdrawal is subject to both ordinary income tax rates plus a 10 percent penalty.
Broad definition of qualified expenses. While the Hope and Lifetime Learning credit definition of qualified education expenses is restricted to tuition and fees, the definition for QTPs also includes books and other expenses for vocational schools, two-year and four-year colleges as well as graduate and professional education; room and board if the beneficiary attends school at least half-time; and expenses of a special needs beneficiary that are necessary in connection with his/her enrollment or attendance at eligible educational institutions. In practice, however, due to their nature, PTPs only cover tuition and fees.
No federal contribution limits. Unlike Coverdell education savings accounts and other incentives, there is no federal limit on contributions to 529 plans regardless of the income level of the account owner. Congress did not impose a requirement on the use of section 529 accounts but rather left it to each state to establish adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the qualified higher education expenses of the beneficiary. Most states do impose a limit based on an estimate of the amount of money that will be required to provide seven years of post secondary education with the current median limit $235,000 and the high $250,000.
As attractive as 529 plans are from a tax perspective, there are several tax and non-tax pitfalls of which taxpayers should be aware including the following:
Penalties on withdrawal. Two types of penalties may be imposed on withdrawals-federal penalties and plan penalties. Section 529(c)(6) imposes a 10 percent penalty on the income portion of any distributions in excess of qualified higher education expenses computed using the annuity exclusion ratio. In addition, some plans impose penalties on "disqualified use" of funds which may include expending funds on education at a college or university that is not a member of the group, nor a "partner" (Auster, 2003). For example, Florida's plan, the largest in the country, imposes a 100% penalty on income, which means that only original contributions are returned.
Taxable earnings taxed at ordinary income rates. The lower five and 15 percent tax rates on capital gains do not apply to the taxable portions of distributions from 529 plans.
Losses on investments in 529 plans do not result in capital loss deductions. In order to recognize any losses at all, the account owner must close the 529 account (and then, of course, to prevent the withdrawal penalty roll over the account within the required 60-day period). Any loss on the sale is treated as a miscellaneous itemized deduction subject to the two percent limitation. Further, the loss is not deductible for alternative minimum tax purposes.
Adverse impact on medicaid. Since Prop. Reg. 1.529-1[C]) allows the account owner to withdraw funds, there is a possibility that the state Medicaid agency could require that the 529 accounts first be used to pay for medical and long-term care expenses before Medicaid payments can begin.
Complexity of interaction of 529 plans and other education incentives. As discussed later in this paper, the value of a section 529 plan is diminished by every tax benefit that would otherwise be available for the same education expense but that cannot be claimed when the expenses are paid with funds from a section 529 plan (Auster, 2003).
Hefty fees. Management fees on the accounts vary from one to 1.5 percent of the account balance depending on the fund.
Limited control over investments. Investment selection is limited because, by statute, the plan administrator must, for the most part, develop investment strategies, although there are some limited choices allowed to account owners.
Possible loss of favorable tax status in 2011. Although experts feel that it is unlikely that Congress will fail to extend the tax-free status of qualified distributions, the current provisions do expire in 2011 making the income portion of all distributions taxable.
Contributions in cash. Contributions to section 529 plans (and section 530 accounts as well) can only be made in cash. Thus, this method of transferring wealth from one generation to another uses the unified transfer credit dollar for dollar while alternative methods may be accomplished with a valuation discount for transfer tax purposes (e.g., interests in family limited partnerships and limited liability companies, or shares in closely-held corporations). A 25 percent valuation discount, for example, allows one-third more assets to be transferred free of transfer taxes (Auster, 2003).
Adverse impact on financial aid eligibility. The treatment of both qualified tuition plans and college savings accounts in the federal financial aid formula may significantly decrease the eligibility for financial aid. Specifically, both the assets held in the plans as well as the withdrawals from the plans may be detrimental to financial aid eligibility. In general, the impact of these plans on financial aid eligibility is dependent on two factors-the type of QTP and the identity of the account owner. College savings accounts have a low impact on need-based financial aid eligibility. In the FM, a college savings account (plan) is classified as an asset which will reduce financial need by a percentage of the account value, 5.64 percent if the parent is the account owner and 35 percent if the student is the account owner. It should be noted, however, that some private colleges using the IM count all 529 accounts as 35 percent assets regardless of the owner. If neither the parent nor the student is the account owner, generally the plan is not considered in the financial aid formula. For this reason, grandparents, and most recently, employers are increasingly the owners of these accounts. Further, the IM treats sibling 529 plans as an asset of the parent if parent is the owner thus reducing aid by 5.64 percent of the balance. While the Higher Education Act does not comment on whether a distribution from a college savings plan, or at least the earnings portion, is treated as student income which reduces aid by 50 cents on the dollar, the Application Verification Guide (the Handbook) indicates that it is not. The same is true for the earnings on prepaid tuition plans.
Prepaid tuition plans have a high negative impact on financial aid eligibility in that distributions reduce the beneficiary's need dollar for dollar either by reducing the COA or by being classified as a Student Resource. However, the balances of prepaid tuition plans are not considered assets for purposes of the FM (under the IM, the plan is considered a parental asset which reduces aid by 5.64 percent of the balance). According to FinAid, efforts are underway (with support from states and the American Council on Education) to get Congress, through the renewal of the Reauthorization of the Higher Education Act of 1965, to change the financial aid treatment of prepaid tuition plans to that similar to college savings accounts (i.e., asset of account owner and hence a low impact on financial aid). Until that time, if the QTP will not be sufficient to cover expenses of the beneficiary's entire degree program, there may be benefit to taking full advantage of financial aid for earlier years while saving QTP funds for the later years of the beneficiary's education.
Table Two summarizes both the tax advantages of QTPs and their current treatment in the Financial Aid Needs Analysis.
COVERDELL EDUCATION SAVINGS ACCOUNTS
Section 530 allows qualified taxpayers to make nondeductible annual contributions into an education savings account (a trust or custodian account administered by a bank or IRS-approved entity) totaling $2,000 per year from all sources in behalf of any individual under age 18 (a special needs beneficiary of any age qualifies). Earnings accumulate tax free, and distributions, if made for qualified education expenses, are totally or partially excluded from income based on a computation similar to the annuity exclusion. The Economic Growth and Tax Relief Reconciliation Act of 2001 broadened the definition of qualified expenses beyond those for post secondary education to include tuition for public, private, and religious schools including grades K-12 as well as the cost of tutoring, computer equipment including software that is primarily educational in nature, room and board with no limits, uniforms and extended day program costs. Withdrawn funds must be used before the beneficiary reaches age 30 or rolled over to another family member under age 30 to avoid the 10 percent penalty. However, the penalty is waived if the nonqualifying distribution is due to a beneficiary's death, disability, or receipt of a scholarship.
Unlike QTPs, not all taxpayers are eligible to make contributions to section 530 Coverdell educational savings accounts. The provisions include an AGI phase out between $95,000 and $110,000 for single taxpayers and $190,000 and $220,000 for married filing jointly taxpayers. Of course, taxpayers above these limits can make a gift of $2,000 to their child who may then make the contribution. Further, there are no AGI limits for corporate or tax-exempt organizations who may also make contributions. Taxpayers are able to claim a Hope credit or Lifetime Learning credit and exclude from gross income amounts distributed (both the contributions and earnings portions) from an ESA on behalf of the same student as long as the distribution is not used for the same educational expenses for which a credit was claimed. An ordering system, to be explained in the final section of this article, applies with funds first going toward education credits and then deemed to come from ESA distributions.
In terms of the financial aid formula, financial planners suggest that ESAs are the worst place to have college savings because of the negative impact on financial aid eligibility. As illustrated in Table Three, in the FM, the ESA is considered a student asset which reduces aid by 35 percent of the balance and distributions of both principal and earnings (according to the Handbook, although the HEA is silent) are treated as student income reducing aid 50 cents on the dollar. Under the IM, the ESA is considered a parental asset if the account is in the parent's name or the parent is custodian and, as such, reduces aid 5.64 percent of the balance each year. In addition, some private institutions consider ESA accounts of the student's siblings assessable assets decreasing aid by 5.64 percent of their balance.
While sections 529 and 530 provide tax incentives for long-term college funding alternatives, several code sections offer current tax savings opportunities through exclusions, deductions, and credits. The major provisions of these sections are discussed in the sections that follow and are summarized in Tables Four and Five.
EXCLUSIONS FROM INCOME
Section 117 allows for the exclusion from income of amounts received by a degree-seeking undergraduate student in the form of a scholarship to the extent the funds are used to pay for tuition, books, and fees. While these scholarship payments do not affect income or assets in the financial aid formula, they are considered a "student resource" which reduces financial aid dollar for dollar. Similarly, section 127 allows employees to exclude from income employer-provided educational assistance of up to $5,250 for the payment or reimbursement of qualified educational expenses including tuition, fees, books, supplies and equipment for both undergraduate and graduate courses. In the financial aid formula, the exclusion is considered "nonassessable income" and does not affect either parental or student income. However, like the scholarship exclusion, the assistance itself is considered a "student resource" reducing financial aid dollar for dollar.
STUDENT LOAN INTEREST DEDUCTION
The section 221 deduction, which allows taxpayers who are not claimed as dependents by another to deduct "For AGI" or "above the line" up to $2,500 of interest on qualified education loans for college or vocational school expenses (debt for which the taxpayer is legally liable), has no impact on the financial aid formula. Section 221 defines qualified education expenses as those for tuition, fees, room and board, books, equipment, and transportation reduced by nontaxable education benefits. Eligible institutions include colleges, vocational schools, or other post secondary institutions, and eligible students are required to take at least a half-time load in a degree, certificate, or other qualified program. A qualified education loan includes any indebtedness incurred by the taxpayer solely to pay qualified higher education expenses incurred on behalf of the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer as of the time the indebtedness was incurred; attributable to education furnished during a period during which the recipient was an eligible student as defined in Section 25A(b)(3), i.e., a degree candidate carrying at least half the normal full-time workload; and paid or incurred within a reasonable period of time before or after the indebtedness is incurred. The Regulations (1.221-1(e)(3)(ii)(A) and (B) and 1.221-1(f)(3)(ii)(A) and (B)) provide a 90-day safe harbor rule.
It is important to note that the loan must be incurred solely to pay qualified educational expenses; interest on mixed use loans does not qualify for the deduction. Further, loan amounts must be reduced by nontaxable education benefits including the section 127 employer-provided educational assistance, nontaxable distributions from section 530 Coverdell ESAs, distributions subject to the Series EE bonds interest education exclusion, and veteran's educational benefits. The allowable deduction phases out for single taxpayers with AGIs between $50,000 through $65,000 and married filing jointly taxpayers with AGIs between $100,000 through $130,000.
The requirements make tax planning in advance of making the loan, specifically determining in whose name the debt should be incurred, critical. Because of the AGI (adjusted gross income) phase-outs discussed earlier, it may be advantageous for the student who generally has a lower AGI in the years during which the loan is repaid to incur the indebtedness. However, to preserve a later deduction, the student who is a dependent should avoid making interest payments while still claimed as a dependent. On the other hand, if parents will be making the loan repayments and wish to protect deductibility of the qualified education loan interest for themselves, the indebtedness should be in their name.
Of course, once the student is no longer a dependent, he or she is allowed a deduction for interest on a loan in his or her name even if someone else makes a payment. For example, if a third party such as a parent, grandparent, or employer, who is not legally obligated to make interest payments does so in behalf of a taxpayer who is legally obligated to make the payment, the taxpayer is treated as receiving the payment from the third party and, in turn, paying the interest which is deductible if otherwise qualified. This treatment is similar to that of third party payments of tuition for purposes of the Hope and Lifetime Learning credits in Reg. 1.25A-5(b)(1).
Regulations issued in May 2004 are intended to "ensure that students obtain the maximum deduction permitted under the law." The Regulations clarify several issues including the treatment of capitalized interest and certain loan origination fees (they are deductible), interest paid by third parties in behalf of the taxpayer (as mentioned earlier, treated as paid by the taxpayer), and the definitions of qualified education loan and eligible educational institution discussed earlier.
DEDUCTION FOR QUALIFIED HIGHER EDUCATION EXPENSES
Section 222 allows an above-the-line or "For AGI" deduction of $4,000 for 2004 and 2005 for taxpayers with AGIs not exceeding $65,000 ($130,00 for married filing jointly) for qualified higher education expenses paid by the taxpayer and not otherwise deductible or excludible under other provisions. For the same time period, taxpayers with AGIs above those limits but not exceeding $80,000 ($160,000 in the case of married filing jointly) are entitled to a maximum deduction of $2,000. The deduction is scheduled to expire after tax year 2005. As is the case for the Hope and Lifetime Learning credits, qualified expenses include tuition and fees for the taxpayer, taxpayer's spouse, or a dependent of the taxpayer paid to an eligible education institution (accredited college, university, vocational school, or other accredited post secondary educational institution) for courses of instruction.
Individuals claimed as a dependent by another and married taxpayers filing separate returns are not entitled to the deduction. An important restriction allows the deduction only to the taxpayer who pays the qualifying expenses. Therefore, in order for a parent to take the deduction for expenses of a dependent child, the parents must pay the expenses. Expenses paid by a dependent or a third party other than parents do not qualify for the deduction. Unlike distributions from ESAs and QTPs, the deduction may not be taken in the same year as Hope or Lifetime Learning credits for the same student. Further, while the entire tax-free distribution from an ESA reduces the deduction, only the earnings portion of a tax-free distribution from a 529 plan reduces the deduction. It is unclear how this deduction might affect financial aid as there is currently no language in the Higher Education Act governing the interaction between the new tax deduction and Title IV assistance.
HOPE AND LIFETIME LEARNING CREDITS
The section 25A Hope credit provides for a nonrefundable (cannot exceed tax liability) credit of up to $1,500 per student (100 percent of first $1,000 and 50 percent of next $1,000) for qualified education expenses paid during the year on behalf of a student (taxpayer, taxpayer's spouse, taxpayer's dependents) enrolled at least half-time in a degree program during the first two calendar years of post secondary education (college or vocational). Qualified education expenses generally include tuition and fees only, unless additional fees (such as athletic fees, computer fees, books and equipment fees) are required for enrollment in the institution and the amounts are paid directly to the institution. Expenses related to noncredit courses or courses associated with hobbies, games, or sports are usually not eligible for the credit unless they are part of the student's degree program. In addition, expenses paid with non-taxable income (excluded scholarships, distributions from ESAs) do not qualify unless the scholarship amount or ESA distribution is included in taxable income.
The credit, which is phased out for single taxpayers with AGIs beginning at $42,000 and married filing jointly taxpayers with AGIs beginning at $85,000, may not be claimed on a married filing separate return or on a return of an individual claimed as a dependent of another. Although the dependent may not claim the credit, expenses paid by a dependent are treated as paid by the parent, thus allowing the parent to claim the credit. Also, in a recent Letter Ruling (LTR 200236001) and consistent with final regulations, the IRS allowed the Hope credit to a student whose parents could have, but did not, claim him as a dependent. Observers note that this interpretation clearly favors the wealthy in that parents whose income level is such that credits and dependency exemptions are lost due to AGI limits may forgo the exemption and allow the student to claim the credit. Finally, unlike the treatment of the section 222 deduction, the Regulations also specify that payments made by third party directly to the institution are treated as student payments.
While the section 25A Hope scholarship credit was introduced to help ensure middle income students have universal access to the first two years of post secondary education, the Lifetime Learning credit was designed to offer continued support to a broader audience--traditional undergraduate students, graduate students, and "lifetime learners" who are not necessarily enrolled in a degree program. With the same AGI phase outs as the Hope credit, the section 25A Lifetime Learning credit provides for a 20 percent nonrefundable credit computed on the first $10,000 of expenses paid per taxpayer. Thus, the Lifetime Learning credit has a maximum per family unit; the Hope credit has a maximum per student. While the Hope and Lifetime Learning credits may not be taken in the same year for the same student, it is possible to switch from one credit to the other from year to year.
In terms of the impact of tax credits on financial aid, by statute, the receipt of the tax credits is to have no effect on a student's eligibility for, or level of, federal student aid. For calculation of the EFC under the Higher Education Act, HEA Section 480(a)(2) states that the tax credits cannot be considered income or assets for purposes of that calculation. Also, HEA Section 480(j)(3) provides that "the determination of need for HEA Title IV aid programs--student's cost of attendance minus the EFC and non-Title IV assistance--is not to include the credits as non-Title IV assistance. Any non-Title IV assistance included in this calculation reduces a student's need and hence, his or her eligibility and level of assistance under need-based Title IV aid" (Stoll).
COORDINATION OF TAX INCENTIVES
Recent changes in tax law have made planning for education both more flexible and more complex. In addition to recognizing the interaction with financial aid goals, the use of all tax benefits must be carefully planned and coordinated. When calculating current tax benefits for qualifying education payments, an ordering process is required. For taxpayers qualifying for the Hope or Lifetime Learning credits, qualified education expenses are first applied to the scholarship exclusion, then to credits, and finally to QTP or ESA distributions. If, on the other hand, the qualified higher education deduction is to be used, expenses are first applied to the scholarship exclusion, then to the QTP or ESA distributions, and finally to the deduction.
It should be noted that distributions from QTPs get more favorable treatment than those from ESAs in that only the excluded earnings portion reduces qualifying expenses available for the higher education deduction while the entire amount (earnings and contribution portions) excluded from an ESA is deemed to reduce the qualifying expenses. For example, assume tuition of $5,000. If the taxpayer makes a qualifying withdrawal from a QTP of $5,000 ($1,000 earnings and $4,000 original contribution) in order to pay the tuition, the expenses eligible for a credit or deduction are reduced only by the $1,000 earnings portion. Therefore, the other $4,000 would qualify for the credit or deduction. On the other hand, if the $5,000 withdrawal is used to pay tuition from an ESA ($1,000 earnings and $4,000 original investment), the expenses eligible for a credit or deduction are reduced by the entire $5,000 distribution.
Tables Six and Seven illustrate the coordination, in relatively simple examples, of various education incentives. From a tax planning perspective, note that tax free distributions from ESAs, QTPs, scholarships, or employer-provided education plans should be used to pay for expenses that do not qualify for the Hope or Lifetime Learning credit such as room and board, books, equipment or supplies as illustrated in Tables Six and Seven. Further, to maximize tax savings, qualified expenses should be paid with QTP distributions rather than ESA distributions due to the more favorable treatment of QTPs. To accomplish this, funds currently in an ESA may be rolled over tax free into a QTP (keeping in mind the gift tax consequences of transfers to QTPs).
With the cost of a college education increasing at more than twice the rate of inflation and three times the growth of the average family income, early planning to fund a college education is more critical than ever. Most financial planners agree that the first step in the complex area of college funding is the determination of whether or not a student will qualify for financial aid. The plan for those who may qualify is to incorporate many of the strategies discussed in this paper in terms of ownership of assets and timing of expenditures aimed at maximizing aid eligibility. Those taxpayers should use tax savings vehicles with the lowest impact on financial aid. On the other hand, those who will not qualify for financial aid will look to more tax-favored strategies to maximize family tax savings. In both cases, a thorough understanding of the various short-term and long-term tax savings provisions included in the Internal Revenue Code, their coordination with each other, and their interaction with the financial aid process should be part of every family's overall financial planning strategy.
Financial planners will be closely monitoring activities in Washington both before and after the election. Simplifying the "appalling array of education-related incentives" placed number two on a list of short-term priorities in former IRS Commissioner Fred T. Goldberg, Jr.'s June 15, 2004, testimony before the Subcommittee on Oversight of the House Committee on Ways and Means. In calling for action in this area, he endorsed Congress' and the Administration's recent proposals to consolidate benefits, simplify rules for expenses, increase the number of qualifying taxpayers, and standardize definitions.
Specifically, the President's 2005 Budget lists several simplifying provisions including a proposed new Lifetime Learning credit that would cover student loan interest up to $2,500, would apply the credit on a per-student rather than a per-taxpayer basis, would increase the AGI phase-out limits, and would index dollar limits. Bills by Congressman Amo Houghton would create an "Education Credit" that combines the Hope and Lifetime Leaning Credits and offers a tax credit for one-half of the first $3,000 of post secondary education expenses. The credit would be on a per child basis and would not be limited to the first two years of post secondary education. Senate Finance Committee Chairman Charles E. Grassley's Anticipatory Initiatives for Matriculation (AIM) Bill would make permanent several education incentives enacted in EGTRRA and remove the limitation on the deductibility of student loan interest. As the President and the 108th Congress continue to concentrate in the education incentive area with a number of bills currently at various stages in the legislation process, family tax planning for a college education will only become more complex.
Auster, R. (2003). Qualified tuition programs: The often-overlooked downside. Practical Tax Strategies, 70, 336-340.
H.R. Conf. Rep No. 107-84.
Internal Revenue Code of 1986.
P.L. 107-16. The Economic Growth and Tax Relief Reconciliation Act of 2001.
Hurley, J. (2003). The Best way to save for college: A complete guide to 529 plans. Pittsford, NY: Savingforcollege.com, LLC. 125 The Entrepreneurial Executive, Volume 9, 2004
Levine, L. & J. Stedman (2003). Tax-favored higher education savings benefits and their relationship to traditional federal student aid. RL 32155 CRS Report, December 18, 2003.
Stoll, A. & J. Stedman (2002). Higher education tax credits and deductions: An overview of the benefits and their relationship to traditional student aid. RL 31129 CRS Report, updated March 7, 2002.
Testimony of former IRS Commissioner Fred T. Goldberg, Jr. (1989-1992) before the Subcommittee on Oversight of the House Committee on Ways and Means on June 15, 2004.
Ellen D. Cook, University of Louisiana at Lafayette
Table 1: Financial Aid Formula Needs Analysis Cost of Attendance Set by and provided by the college--tuition, (COA) fees, room & board, books & supplies, personal expenses such as clothing and entertainment, cost of computer, transportation to and from the university --Expected Family Computed by using family financial data Contribution (EFC) submitted on financial aid application forms: Parents' contribution from income (if divorced, custodial for greatest part of year is listed and other parent's contribution is treated as a resource) + parents' contribution from assets + student's contribution from income + student's contribution from assets = Basic Financial Need = Student Resources Scholarships/grants; VA benefits; cash gifts paid directly to the college for tuition; payments from prepaid tuition plan; payments from employer-provided education assistance plan; sources other than family income and assets = Adjusted Financial Need Adapted from material in "Tax & Financial Planning for College Expenses after the 2001 Tax Act: What Every CPA Needs to Know," presented for Louisiana Society of CPAs, May 15, 2002, Rick Darvis, College Funding, Inc. Table 2: The Impact of Section 529 Qualified Tuition Plans on Financial Aid College Savings Account Tax Benefits Account owner contributes cash to a plan account for a beneficiary. The contribution is invested according to the terms of the plan. Contributions qualify for the annual gift tax exclusion; no federal deduction although some 25 states offer deduction. Funds may be withdrawn tax free if used for qualifying purposes at any college. Qualifying expenses include tuition & fees, books & other expenses for vocational schools, 2-year & 4-year colleges as well as graduate & professional education; room & board if the beneficiary attends school at least half-time; expenses of special needs beneficiary necessary in for his/her enrollment at eligible educational institutions. No AGI phase-outs or federal contribution limits. Impact on Balance: An asset of parent which reduces aid by Financial Aid 5.64% of balance. For the IM, sibling 529 plans are If Owned by also treated as asset of the parent if parent is the Parent owner; reduces aid by 5.64% of balance. Distribution: While the Higher Education Act does not comment on treatment, the Handbook indicates that it is not. The same is true for the earnings on prepaid tuition plans. 529 plan for the student is not assessed if owned by a person other than the parent or student. Impact on Balance: An asset of student if owned by custodial Financial Aid account or student; reduces aid by 35%. If Owned by Student Distribution: While the Higher Education Act does not comment on treatment, the handbook indicates that it is not. The same is true for the earnings on prepaid tuition plans. 529 plan for the student is not assessed if owned by a person other than the parent or student. Prepaid Tuition Plans Tax Benefits Account owner contributes cash to a plan account and the contribution purchases tuition credits or credit hours based on then-current tuition rates. Contributions qualify for the annual gift tax exclusion; no federal deduction although some 25 states offer deduction. Funds may be withdrawn tax free if used for qualifying purposes at any college. Definition of qualifying expenses is the same as for College Savings Plans. No AGI phase-outs or federal contribution limits. Impact on Balance: Under FM, not an assessable asset. Under IM, Financial Aid a parental asset which reduces aid by 5.64% of the If Owned by balance. Parents Distribution: Under FM, a "resource" that will reduce aid dollar for dollar. Financial aid treatment may change to "asset of account owner" during the next reauthorization of the Higher Education Act of 1965. Impact on Balance: Under FM, not an assessable asset. Under IM, Financial Aid a parental asset which reduces aid by 5.64% of the If Owned by balance. Students Distribution: Under FM, a "resource" that will reduce aid dollar for dollar. Table 3: The Impact of Section 530 Coverdell Education Savings Accounts on Financial Aid Tax Benefits Non-deductible contribution of up to $2,000 per year for a beneficiary under age 18. Except for special needs beneficiaries, contributions must end at age 18 and assets must be withdrawn by age 30. Distributions non-taxable to extent funds used for qualified education expenses--tuition, books, fees, tutoring, computer equipment and software, uniforms for both higher education and elementary and secondary education at public, private, and religious schools. Taxpayer may claim a HOPE credit or Lifetime Learning credits and exclude from gross income amounts distributed (both the contributions and earnings portions) from an ESA on behalf of the same student as long as the distribution is not used for the same educational expenses for which a credit was claimed. An ordering system will apply with funds first going toward education credits and then deemed to come from ESA Impact on Balance: Under FM, a student asset which reduces aid Financial Aid 35% of balance. If Owned by Parent Distributions: Both principal & earnings treated as student income reducing aid 50 cents on the dollar. Under IM, considered a parental asset if parent is custodian; reduces aid 5.64% each year. If the student's siblings have ESA accounts and the student is required to file the PROFILE application form, the value of the siblings' ESAs is assessed at the parents' 5.64% rate. Impact on Balance: Under FM, a student asset which reduces aid Financial Aid 35% of balance. If Owned by Student Distributions: Both principal & earnings treated as student income reducing aid 50 cents on the dollar. Under IM, considered a student asset if anyone other than the parent is custodian; reduces aid 35% each year. Table 4: Tax Planning for Education-Current Tax Savings-Exclusions and Deductions Qualified Education Expenses Effect on Provision Summary Defined Financial Aid [section] 117 Excludes from Tuition, books "Nonassessable Exclusion for income supplies, income" that Scholarships scholarships to equipment but does not affect extent covers not room and either parental qualified board. or student education income. expenses for However, degree-seeking assistance is undergrad considered a student. No AGI "student phase-outs. resource" & will reduce aid dollar for dollar. [section] 127 Employee Tuition and "Nonassessable Exclusion for excludes from fees for income" that Employer- income up to undergrad and does not affect provided $5,250 of graduate parental or education employer- courses; books, student income. provided supplies, However, qualified equipment. assistance is education Doesn't have to considered a expenses. No be work-related "student AGI phase-outs. courses. resource" & will reduce aid dollar for dollar. [section] 221 For AGI Tuition, fees, No impact on Student Loan deduction of books, financial aid. Interest $2,500 for supplies, Deduction interest paid equipment; room on qualifying & board, student loan. transportation, Phase-outs: other necessary Single: expenses. $50,000-$65,000 AGI; MFJ: $100,000- $130,000 AGI [section] 222 "For AGI" Tuition, fees Unclear how Deduction for deduction for deduction might Qualified payment of affect Higher qualified financial aid Education education as there is no Expenses expense. language in the S: AGI not > Higher $65,000 & Education Act $130,000 MFJ. governing the $2,000 $4,000 in deduction for 2004-2005 for Single AGI interaction between $65,000 between the new & $80,000 and tax deduction MFJ $130,000 and Title IV & $160,000. assistance. Table 5: Tax Planning for Education-Current Tax Savings-Education Credits Qualified Education Expenses Effect on Provision Summary Defined As Financial Aid [section] 25A Credit of up to Tuition, fees, Section 480(a) Hope Credit $1,500 per during first two (2) states that student. 100% of years of post tax credits first $1,000; secondary cannot be 50% of next education. considered $1,000. Must be Courses must be income or enrolled associated with assets for half-time. A degree program. purposes of non-refundable Athletic fees, calculation. elective credit. insurance, Section 480(j) If parent pays activity fees, (3) provides the expenses, books are not that must be able to eligible unless determination claim exemption required as a of need for HEA for student on condition of Title IV aid tax return. enrollment and programs-- Regulations paid directly to student's cost explain who gets the institution. of attendance credit in minus the EFC special and non-Title circumstances. IV assistance- AGI phase-outs: is not to S: $42,000- include the $52,000; credits as MFJ: $85,000- non-Title IV $105,000 assistance. Limited evidence suggests that financial aid officers are far from uniform in how to consider the tax benefits when packaging aid [section] 25A Credit of up to Tuition, fees, Same as Hope Lifetime $2,000 per including grad Credit Learning family; 20% on courses/ Credit up to $10,000. A continuing ed. nonrefundable Available for elective credit all post If parent pays secondary the expenses, education--not must be able to necessarily claim exemption associated with for student on degree. tax return. New Regulations explain who gets credit in special circumstances. AGI phase-outs: S: $42,000- $52,000; MFJ: $85,000- $105,000.00 Table 6: Coordination of Tax Incentives-Scholarships, Credits, Coverdell ESA Assume that the following expenditures were made: Tuition and fees $15,000 Books, supplies, equipment 4,000 University-provided room & board 6,000 Total expenses $25,000 Sources of funds were: Scholarship $5,000 Coverdell ESA 15,000 ($10,000 earnings/$5,000 principal) Total funds $20,000 Scenario One--Take the Lifetime Learning Credit Apply the scholarship exclusion, which applies to tuition and fees and books, etc. first. For maximum results, apply against books, equipment, supplies first as the Hope/Lifetime Learning credits only apply to tuition/fees. Thus, the $5,000 scholarship is totally excluded from income. Remaining qualifying expenses are: Tuition and fees $14,000 ($15,000-$1,000) Books, etc. 0 ($4,000-$4,000) Room & board 6,000 Total $20,000 Compute the Hope or Lifetime Learning credit next. Hope credit = $1,500 (100% of first $1,000 of expenditures and 50% of next $1,000) OR Lifetime Learning credit = $2,000 (20% of up to $10,000 in expenses). Thus, use the Lifetime Learning credit. Remaining qualifying expenses are: Tuition and fees $ 4,000 ($14,000-$10,000) Books, etc. 0 Room & board 6,000 Total $10,000 The distribution from the Coverdell ESA was $15,000. Since the qualifying expenses are LESS than the distribution, part of the distribution is taxable. Qualifying Expenses 10000 = 67% Distribution $15,000 Thus, 67% of $10,000 earnings or $6,700 of the distribution is NOT taxable. The remaining $3,300 is taxable. Summary: $5,000 scholarship exclusion; $11,700 ($5,000 principal and $6,700 earnings) distribution exclusion; $2,000 credit. $3,300 is taxable. Scenario Two--Take the Hope Credit Apply the scholarship exclusion, which applies to tuition and fees and books, etc. first. Thus, the $5,000 scholarship is totally excluded from income. Remaining qualifying expenses are: Tuition and fees $14,000 ($15,000-$1,000) Books, etc. 0 ($4,000-$4,000) Room & board 6,000 Total $20,000 Compute the Hope or Lifetime Learning credit next as was done in the previous scenario but use the Hope Credit of $1,500 rather than the Lifetime Learning credit of $2,000 because it "consumes" less of the qualifying expenses. Remaining qualifying expenses are: Tuition and fees $12,000 ($14,000-$2,000) Books, etc. 0 Room & board 6,000 Total $18,000 The distribution from the Coverdell ESA was $15,000. Since the qualifying expenses are MORE than the distribution, none of the distribution is taxable. Summary: $5,000 scholarship exclusion; $15,000 distribution exclusion; $1,500 credit. Additional credit in scenario one better if tax bracket is 15% or less. Table 7: Coordination of Tax Incentives--Scholarships, QTP or ESA, Education Deduction Assume that the following expenditures were made: Tuition and fees $15,000 Books, supplies, equipment 4,000 University-provided room & board 6,000 Total expenses 25,000 Sources of funds were: Scholarship $5,000 QTP or ESA 15,000 ($10,000 earnings/$5,000 principal) Total funds $20,000 Scenario One--Distribution from a QTP Apply the scholarship exclusion, which applies to tuition and fees and books, etc. first. For maximum results, apply against books, equipment, supplies first as the Hope/Lifetime Learning credit only apply to tuition/fees. Thus, the $5,000 scholarship is totally excluded from income. Remaining qualifying expenses are: Tuition and fees $14,000 ($15,000-$1,000) Books, etc. 0 ($4,000-$4,000) Room & board 6,000 Total 20,000 The distribution from the QTP was $15,000. Since the qualifying expenses are MORE than the distribution, none of the distribution is taxable and there are remaining expenses for the FOR AGI deduction for qualifying education expenses. Be sure to apply the room & board to the QTP exclusion since that is not a qualifying expense for the QEE deduction. The remaining qualifying expenses are: Tuition and fees $10,000 ($14,000-4,000 *) Books, etc. 0 Room & board 0 ($6,000-6,000) Total $10,000 * Note only the excluded earnings of $10,000 reduce the qualifying expenses. The remaining qualifying expenses of $10,000 may be used for the deduction which is limited to $4,000 in 2004 and 2005. Summary: $5,000 scholarship exclusion; $15,000 nontaxable distribution; $4,000 For AGI deduction Scenario Two--Distribution from an ESA Apply the scholarship exclusion, which applies to tuition and fees and books, etc. first. Thus, the $5,000 scholarship is totally excluded from income. Remaining qualifying expenses are: Tuition and fees $14,000 ($15,000-$1,000) Books, etc. 0 Room & board 6,000 Total $20,000 Assume that the distribution was from a Coverdell ESA instead of a QTP. The QTP gets favorable treatment in that only the excluded earnings portion reduces the qualifying expense. However, all of the distribution from a Coverdell ESA is deemed to reduce the qualifying expenses. Since the qualifying expenses are MORE than the distribution, none of the distribution is taxable and there are remaining expenses for the FOR AGI deduction for qualifying education expenses. The remaining qualifying expenses are: Tuition and fees $5,000 ($14,000-9,000) Books, etc. 0 Room & board 0 ($6,000-6,000) Total $5,000 The remaining qualifying expenses of $5,000 may be used for the deduction which is limited to $4,000 in 2004 and 2005. Summary: $5,000 scholarship exclusion; $15,000 nontaxable distribution; $4,000 For AGI deduction
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|Author:||Cook, Ellen D.|
|Date:||Jan 1, 2004|
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