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Education tax incentives after the Taxpayer Relief Act of 1997.


Introduction: Description And Definitions

After the tax consequences of QSTPs were clarified in 1996, the number of states offering some type of prepaid college expense program increased rapidly. As of September, 1997, 30 states had adopted or approved such programs. They fall into two categories:

* Prepaid Programs, which lock in future tuition at today's rates; and

* Savings Plan Trusts, which are like a state-operated tax deferred mutual fund, and may grow to more or less than college costs when needed (of the first 30 programs, only four, Kentucky, Louisiana, Utah and New York, belong to this category).

After the 1997 Taxpayer Relief Act, which expands favorable tax treatment of such prepaid college expense programs to room and board, most states are expected to run such programs. Each state has its own rules. Thus, there may be application fees, penalty provisions, contribution limitations, differing rollover rules, minimum and/or maximum age requirements on beneficiaries upon withdrawal, minimum investment horizons, limitations on types of colleges to be attended, such as state colleges only, etc. In any event, prepaid college expense programs have been highly successful and people are using these funds to make gifts to their children, grandchildren, nieces and nephews, and other beneficiaries. Each state's unique program may be surveyed on the Internet at: The tax consequences are summarized below:

Income Tax Considerations

The main income tax rules are:

* A QSTP is a tax-exempt organization under Code Section 529. Thus, the funds accumulate tax free until withdrawn, including the educational period, e.g., six years of college;

* There is no deduction or credit allowed for contributions to the plan (except at the local level, in some states);

* Anyone, e.g., a parent, grandparent, friend or neighbor can contribute to a plan for a given beneficiary;

* No contribution can be made to an education IRA (see below) in a year anyone contributes to a QSTP, for the same beneficiary;

* There is no limit on the amount contributed to a QSTP except that only "Qualified Higher Education Expenses" are to be funded. Since tuition and room and board expenses vary widely from school to school and most QSTP gives a broad choice of colleges the beneficiary may attend, the contributions may be quite large. Many states set their own limit, however. In addition, to be a QSTP the state must impose a meaningful penalty on withdrawals in excess of "qualified higher education expenses" (with exceptions for the death of the beneficiary, scholarships received, etc.) Graduate programs, including law school, and medical school may be funded as well;

* The education must be taken at an eligible institution and must aim at a degree, certificate or credential;

* The two college tuition credits are available for amounts withdrawn to pay "qualified higher education expenses";

* The U.S. savings bond interest exclusion is available for proceeds from such bonds contributed to a QSTR However, the beneficiary's adjusted basis in the proceeds equal the original purchase price;

* No one may borrow against or from a QSTP, and no one can direct its investments, other than the State;

* No taxation results upon changing the "designated beneficiary" or on a rollover to a plan (old or new) with a different "designated beneficiary." However, the new beneficiary must be a relative of the grantor, broadly defined as a child, grandchild, sibling, niece, nephew, even certain "in-laws," (anyone if the QSTP was entered into before 8/20/96);

* Distributions will be made to the beneficiary up to the amount of "qualified higher education expenses." Any excess will be returned to the contributor. Neither party will be taxed unless receiving more than the contributions made.

Either party is taxed under the annuity rules, i.e., under the "exclusion ratio" approach if distribution exceeds contributions.


a) Parent contributes $300,000 over the years to a QSTP for Child. Distributions of $300,000 (or less) are made on behalf of Child for tuition, fees, books, room and board, etc. The excess of $300,000 (or less) is returned to Parent. Neither party is taxable.

b) Same as a) except Parent and/or Child receives in excess of $300,000. The following fraction of all payments made during any taxable year is excluded from gross income.

Investment in Contract (Adjusted Basis in Contribution Made)

Sum of All Distributions Made to Beneficiary (Contributor) Thus, any excess distributions are taxed over the years received, which could often be four years or more.

Gift & Estate Tax Considerations

* Contributions made are treated as gifts of present interests, eligible for the Code Section 2503(b) exclusion of $10,000 a year (as indexed after 1998). The contributor may elect (on a gift tax return, Form 709) to treat a contribution in excess of the exclusion as having been made ratably over five years starting with the year of contribution. Thus, only gifts in excess of $50,000 will have gift tax consequences;

* No gift tax is levied on qualified rollovers or change of designated beneficiaries (if eligible "members of the family" of the contributor are named), nor on distributions;

* If the contributor dies with "unallocated gifts" (within the 5-year elective gift period) or before the beneficiary has received all amounts due, the unallocated gift and/or the plan balance, are includible in the contributor's Gross Estate.


QSTPs provide a hedge against inflation, grow tax-deferred, and distributions can be partly or totally tax-exempt. Contributions are typically free of gift tax. In addition, QSTPs provide a "forced college savings" program and make ideal and enduring gifts to grandchildren. Unlike most other college tax incentives, the ability to use QSTPs are not phased out at high income levels. This, coupled with the historical inability of low and middle income taxpayers to afford even deductible savings, make QSTPs most relevant for the comfortably well off.


An exclusion from gross income for interest on U.S. Savings bonds used to pay for "Qualified Higher Education Expenses" has been available since 1990 under Code Section 135. It survived the Taxpayer Relief Act of 1997, despite the many new tax incentives for higher education discussed below. The main features of the exclusion are:

* To the extent education U.S. savings bonds i.e., U.S. (EE) savings bonds issued after 1989, to a taxpayer age 24 or over, are redeemed and used to pay for "Qualified Higher Education Expenses" for taxpayer, taxpayer's spouse or dependent in a given year, to such extent the interest received is excluded from gross income;

* The exclusion of interest may be computed using the following formula:

Qualified Higher Education Expenses Paid with Proceeds / Total Proceeds Received from U.S. Savings Bonds x Interest Received from U.S. Savings Bonds

Thus, if 72% of total proceeds are used to pay for tuition, 72% of the interest portion is excludable.

* eligible expenses include tuition reduced by nontaxable scholarships. The usual exception for sports, games, and hobbies apply, unless required for a degree;

* The exclusion is phased out ratably at modified adjusted gross incomes from $50,850 to $65,850 for singles, $76,250 to $106,250 on joint returns (in 1997). The numbers are indexed for inflation. Married taxpayers must file jointly;

* The amount excluded is ineligible for the two tuition credits (discussed below).

Employee Educational Assistance Programs

Code Section 127, which provides for up to $5,250 of tax-free employer paid employee education per year, deductible to the employer, has expired and been reinstated several times over the years.

As it now stands, the exclusion applies to courses starting prior to June 2000. Important aspects of the exclusion are as follows:

* Excludable expenses do not include meals, lodging or transportation;

* Graduate courses starting after June, 1996, are ineligible for tax-free reimbursement;

* Sports, games and hobby-oriented courses are ineligible, unless required for a degree.

Even if a reimbursement for education expenses is gross income, the employee may deduct the expenses if the education maintains or improves skills necessary at work. However, the taxpayer must itemize and the expense is included in "miscellaneous itemized deductions," deductible only to the extent they exceed 2% of adjusted gross income.


The Taxpayer Relief Act of 1997 provides for penalty-free withdrawals for education from "traditional" IRAs after 1997, as well as from the new IRA Plus or Roth IRA, which does not exist until 1998. The following should be considered:

* Only the penalty is waived. Every dollar withdrawn from funds accumulated with tax deductible contributions is still gross income;

* Further tax deferral is lost;

* For Roth IRAs the taxpayer may elect to withdraw the nondeductible contribution tax free (and therefore penalty free). To the extent the income is used the penalty does not apply either, but the income is taxable;

* The withdrawals must be used to pay "qualified higher education expenses" (tuition, fees, books, supplies and equipment for post-secondary education, including graduate school) for taxpayers, taxpayer spouses, or either's child or grandchild. The expenses are reduced by the usual nontaxable scholarships or other educational assistance allowance.

It is generally considered ill advised to give up tax deferral and retirement savings to pay for education. The income generated also makes it more difficult to qualify for financial aid.


Education IRAs, sometimes referred to as "Education Investment Accounts" were introduced by the Taxpayer Relief Act of 1997 in new Code Section 530 starting in 1998. Education IRA is somewhat of a misnomer, given that the account, the contributions, the distributions, and the purpose of the account are all unrelated to retirement. The tax consequences may be highlighted as such:

* One or more contributor may make a total nondeductible annual contribution to a child under the age of 18 of $500 (not indexed for inflation);

* The contributions are unaffected by the contributor's deductible, nondeductible or Roth IRAs, if any;

* Contributions may be made one year and not another, by choice, because of income limitations, or because a tuition credit is claimed. In any event, there is not a catch-up provision;

* As with other college tax incentives, the accumulated funds are to be used by a "member of the family" of the contributor, for "qualified higher education expenses" at an eligible; institution. To the extent so used, distributions are tax free;

* The $500 maximum contribution is phased out as "modified adjusted gross income" goes from $95,000 to $110,000 for singles, and from $150,000 to $1650,000 for joint filers;

* Distributions from the IRA may be made tax free to a Qualified State Tuition Program (QSTP), but no contribution can be made on behalf of a beneficiary in a year during which anyone makes a contribution to a QSTP for such beneficiary;

* Tax-free rollover to, and the changing of beneficiary to, a "member of the family" of the contributor, such as a child, grandchild, niece, nephew, spouses of these, certain "in-laws," etc., are tax free;

* No tuition credit is allowed for a year any withdrawals are made to pay for education expenses. This is a significant restriction, unless the contributor has income at or above the phase out level for the tuition credits ($50,000 for singles, $100,000 for joint filers);

* The income portion of amounts distributed and not used for "qualified higher education expenses" is includible in the distributee's (contributor's, beneficiary's) gross income and subject to a 10% penalty even if the distributee is over 59 1/2. The penalty does not apply if the distribution is made on account of the beneficiary's death or disability;

* Any remaining funds must be distributed to the beneficiary by age 30 (with the attendant income tax and penalty consequences), unless a rollover is made to another "member of the family" under the age of 30;

* To keep track of the income portion in the account, each distribution is treated as consisting of a ratable share of accumulated income and gain;

In conclusion, education IRAs suffer from several weaknesses:

a) Withdrawals and tuition tax credits are mutually exclusive

b) The 10% penalty may be imposed

c) Principal and income portions of the account must be computed each time a distribution is made

d) A nondeductible, unindexed $500 a year is not significant and will be less so in time. Even if the maximum contribution is made for one beneficiary and earns a 10% return (which is optimistic), $500 a year for 18 years will result in some $23,000. This is hardly sufficient for one year's tuition, fees and books at many top private universities even in 1998. The current value of $23,000 18 years from now, assuming 3% inflation, is $13,510.


Code Section 221, part of the Taxpayer Relief Act of 1997, provides for a limited deduction for interest on loans to finance post-secondary school education. The provision may be summarized as follows:

* The maximum deduction is $1,000 in 1998, $1,500 in 1999, $2,000 in 2000 and $2,500 thereafter (with no indexing);

* The interest is deductible from gross income ("above the line"), i.e., taxpayers can also take the standard deduction;

* The deduction is phased-out as modified gross income goes from $40,000 to $55,000 for singles, $60,000 to $75,000 for joint filers. (These numbers are indexed after 2002). Married taxpayers must file jointly to claim the deduction;

* The deduction is for interest due and paid after 1997 and during the first 60 months during which such interest is due. Pre-1998 interest months do count;

* The interest on any loan (except from a related party) to enable taxpayers, their spouses and dependents to incur "qualified higher education expenses," qualify, e.g., credit card loans, federal education loans, etc;

* "Qualified higher education expenses" include tuition, fees, books, etc., and room and board expenses to work towards a degree, certificate or credential at an eligible institution;

* Eligible tuition must be reduced by any or all of the following: Employee educational assistance reimbursement, excluded interest on U.S. savings bonds, distributions from education IRAs, tax-free scholarships, etc;

* The interest cannot be otherwise deductible, e.g., interest on a home equity loan up to $100,000.

The phase-out ranges are realistic, since taxpayers with income below those levels are most likely to have to borrow for their children's college education. Parents above the income limit who need to borrow should consider home equity loans first.


For the first time ever The Taxpayer Relief Act of 1997 (in Code Section 25A) introduced tax credits for higher education, the Hope Scholarship Credit for the first two years of college and the Lifetime Learning Credit for any education, full or part-time beyond the first two years of college.

The Hope Scholarship Credit

The main aspects of the credit are:

* The credit is effective for education taken and paid in 1998 or later;

* The credit is available for the first two years of (an eligible) college only, can be taken for tuition (and related fees) only, and can be taken for only two years even if the student's freshmen and sophomore years straddle three (which they usually do) or more taxable years;

* The credit (adjusted for inflation after the year 2001) equals a maximum of $1,500, 100% of the first $1,000 of tuition paid for education taken during the taxable year and 50% of the second $1,000;

* The credit is elective, nonrefundable and is based on tuition actually paid. Thus tuition paid is net of employer tuition assistance, tax-free scholarships, tuition deducted as education expenses, but may be paid from gifts, bequests and inheritances, but not excludable distribution from education IRAs;

* The student must attend college at least half-time for at least one academic term (quarter, semester, trimester) to be eligible for the credit;

* The credit (or credits, if more than one student is eligible) is phased out at modified adjusted gross incomes of $40,000 to $50,000 for singles, $80,000 to $100,000 for joint filers (adjusted for inflation after 2000). Married taxpayers must file jointly to claim the credit;

* Courses involving sports, games and hobbies are ineligible, unless required for a degree.

Example 1. The taxpayer's child entered college in the Fall of 1996 and pursues a regular four-year degree. The tuition for Spring 1999 is due December 1, 1998. By paying the tuition on January 2, 1999 (or later) the credit available for 1999 is $1,500 maximum, rather than $1,000 (the limit on the Lifetime "Learning Credit" available for the junior years starting the Fall of 1999.

Example 2. A child attends community college for four consecutive semester at $1,000 per semester and receives an Associate of Arts degree. If the child started in the fall a maximum of $2,500 of credit is available ($1,500 for the second year consisting of two semesters, plus $1,000 for the first or third year, consisting of one semester). By starting in the Spring the full $1,500 credit is available for the two calendar years the child attends school. The tuition must be paid in the year education is taken, e.g., in January for the Spring semester which may result in a late payment fee.

The Lifetime Learning Credit

Starting in 1998 an elective credit of a maximum of $1,000 (20% of the first $5,000 of tuition) is available to a taxpayer for education taken beyond the first two years of college. Starting in 2002 the maximum credit doubles (in nominal terms) to $2,000 (20% of the first $10,000 of tuition). The following special rules apply:

* The credit and eligible tuition is not indexed for inflation;

* The same income phase out ranges apply as for the Hope Credit;

* The "Lifetime Credit" is available for any courses or degrees beyond the first two years of college, e.g., the junior and senior year, medical school, a Ph.D. program, etc. In addition, individual, part-time courses qualify if job skills are improved or acquired;

* The "Lifetime Credit" may be taken any year, every year, or all years, without limit, for any number of eligible students.

* The "Lifetime Credit" and the "Hope Credit" cannot be claimed in the same year with respect to the same student;

* No interest exclusion for redeemed U.S. savings bonds is allowable to the extent the proceeds are used to pay tuition with respect to which a tuition credit is claimed.


Valuable incentives, such as the tuition tax credits and the deduction of education loan interest, are only available to taxpayers who need them the most, the lower and middle classes. This admirable fact is accomplished through the use of income phase outs.

However, perhaps the most valuable incentive of all, the Qualified State Prepayment Plan, with virtually no monetary limit, is available to everyone without phase out. Such prepaid plans are likely to be utilized to the greatest extent by high income taxpayers.

Other incentives, notably the education IRA and the savings bonds interest exclusion, are too inconsequential to be of any interest to most taxpayers but have high income phase-out limits. It should be kept in mind that to the extent taxpayers utilize incentives, e.g., take credits and deductions, exclude interest, withdraws, IRA funds, etc., eligibility for financial aid decreases. Thus, incentives used after January of a student's junior year, are the most cost effective.
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Author:Auster, Rolf
Publication:The National Public Accountant
Date:Jan 1, 1998
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