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Working through the maze of educational tax savings available.

While there have always been tax savings available when paying for an education, the Taxpayer Relief Act of 1997 greatly increased both the types available and their complexity. New types of tax programs to assist those with educational expenses include:

* The HOPE Tax Credit

* Lifetime Learning Tax Credits

* Educational Savings Programs, which are 1. State Qualified Tuition Programs and 2. the use of an Educational IRA

* Use of Funds from a Retirement IRA

* Deduction of Interest on Educational Loan Interest

In addition to these, programs already available when paying educational expenses included:

* Employer Educational Assistance (extended for three years)

* Educational Business Expense Deduction for

1. the Self Employed, and for

2. Employees

* Series EE Savings Bonds

Most of the tax savings come with requirements your client must meet before receiving the tax benefit, limitations on what educational expenses are covered, and either reductions or phase-outs of the amounts deductible or of the tax credits.

These restrictions will be discussed for all of the educational tax savings programs available. This article will also discuss how to choose which program(s) to use.

Restrictions & Qualifications Common to Most of the Programs

Most of the educational tax savings programs are mutually exclusive, and so the best program should be chosen. While tuition and fees qualify as educational expenses for all the programs, other costs only qualify in certain programs.

Funds used for education must be reduced by the amount of funds that are received tax free, such as scholarships and veterans benefits before any deductions or credits are allowed. If a deduction is allowed, a credit or another deduction for using the same funds isn't allowed as well.

For the funds to qualify, they must be paid to qualified educational institutions. These institutions are generally those eligible to participate in the Department of Education student aid programs.

Educational Tax Credits

A centerpiece of the Taxpayer Relief Act of 1977 was the introduction of educational tax credits. While these can be of immense benefit to taxpayers, the alternative minimum tax can limit or even eliminate their benefit. They are also generally nonrefundable tax credits and aren't carried forward, so if the tax credits exceed the amount of income tax, any excess credit is lost.

There are two of these credits available, the HOPE credit, and the Lifetime Learning Credit. These are known as Code Section 25A credits. The HOPE and Lifetime Learning Credit cannot be used during the same tax year for the same individual.

The student must be either the taxpayer, the taxpayer's spouse, or the taxpayer's dependent. The taxpayer must be entitled to the personal exemption for the dependent. The credits are denied if the student has been convicted of a felony drug offense before the end of the tax year, or if a Married Filing Separate tax return is filed. In addition, the correct social security number of the student(s) must be on the tax return to claim either credit.

The HOPE Credit is available during the first two years of post secondary education for each student. It amounts to 100% of the first $1,000 in tuition and fees paid to the school, and 50% of the next $1,000 paid while the student qualifies.

To qualify for the HOPE Credit, the student must be at least a half time student during one academic period of the tax year at an accredited post-secondary educational institution.

The Lifetime Learning Credit may be claimed whether the courses are to improve job skills, for general education (but not for sports, games, or hobbies), or towards a degree. The credit is 20% of the first $5,000 ($10,000 after 2002) of qualified expenses per taxpayer return. This credit is available for expenses paid after July 1st of this year.

Both of the credits are phased out after $40,000 of adjusted gross income (AGI) other than for a joint return where the phase-out begins at $80,000 AGI. The range will be indexed for inflation starting in 2001. The phase out is generally at a rate of 10% of AGI, and 5% of AGI on a joint return.

Educational IRAs, Qualified Tuition Programs, Using Other IRAs

Beginning this year, IRA accounts can be set up for children's future educational expenses. There is no deduction for the contribution to an educational IRA, but the investment grows with taxes deferred just like a regular IRA. No contribution is allowed the same year in which a contribution is made to a state tuition program.

In the case of an educational IRA or a qualified tuition program, money withdrawn for qualified educational expenses is exempt from federal income tax. The maximum amount that can be deposited is $500 per child regardless of who makes the deposit, and cannot be made after the child reaches age 18.

Qualified expenses include not only tuition and fees, but also books and supplies required, as well as room and board. The qualified expenses do not require half-time status as they do for Section 25A Credits, other than for funds used for room and board.

Any distributions not used for qualified educational purposes are treated the same as early distributions from nondeductible IRAs. The 10% penalty applies (unless due to death, disability, or scholarship received) as does tax to the earnings.

The funds must be used by age 30, but funds may be rolled over from one beneficiary to another, as long as both beneficiaries are also members of the same family.

The maximum amount able to be contributed is phased out for the contributor when their income is between $95,000 and $110,000 AGI for all other than joint returns, and between $150,000 and $160,000 for joint returns. This can often be avoided by gifting the sum to other family members who then make the deposit.

Funds withdrawn from other IRAs to be used for qualified educational purposes will not have the 10% premature distribution penalty imposed. Tax will be due on any previously non-taxed funds.

Deduction of Educational Loan Interest

Starting in 1998, interest paid on Qualified Educational Loans may be deducted during the first 60 months in which interest payments are required. This deduction is allowed whether or not the individual itemizes deductions. All student loans, including refinancing, are treated as one loan. The deduction cannot be taken while a dependent of another taxpayer, or on a Married Filing Separate Return.

The qualified educational loan is any indebtedness incurred to pay for qualified higher education expenses of the taxpayer, spouse, or dependent at the time indebtedness occurred. The student must be at least a half time student.

The qualified higher education expenses include tuition, fees, books and supplies, and room and board paid at qualified educational institutions, reduced by assistance excluded from taxable income including educational IRAs and state tuition programs.

The maximum deduction is $1,000 in 1998, $1,500 in 1999, $2,000 in 2000, and $2,500 after that. The maximum amount able to be deducted is phased out for the taxpayer when their income is between $40,000 and $55,000 AGI other than for joint returns where the phase-out is between $60,000 and $75,000 AGI. This will be indexed for inflation after 2002.

Employer Educational Assistance

Prior law allowed a deduction for an employer, and an exemption from an employee's income of up to $5,250 in employer educational assistance. This provision was to have expired June 1 of 1997, and was extended for three years through May 31, 2000.

Educational Business Expenses

Prior law also allowed a deduction for educational expenses which qualified as maintaining or improving the skills required in the trade or business. This area of tax law has not changed. Self-employed individuals may still deduct these amounts on Schedule C. Employees may only deduct these amounts as miscellaneous itemized deductions, which means they may be reduced by up to 2% of AGI.

Series EE Savings Bonds

Series EE Savings Bonds can still be used for educational purposes, and have the interest exempt from income tax. Requirements include the student being the child of the taxpayer, the principal and interest being used for qualified educational expenses, the bonds be purchased after 1989 by a parent at least 24 years of age, and the bonds be in the parent's name and not the child's name.

The total amount able to be deducted is phased out for the taxpayer when their income is between $43,500 and $55,000 AGI other than for joint returns where the phase-out is between $65,250 and $75,000 AGI. This has been indexed for inflation since 1990.

Choosing the Right Program

The programs available can be divided into three groups. These are the pre-education programs, those with the tax savings occurring at the same time as the education, and the post-educational program. Some of them require planning, others can be decided on by April 15th of the next year.

Pre-educational Programs

In the first group are the State Qualified Tuition Programs, the Educational IRAs, and the Series EE US Savings Bonds. The state program isn't limited to $500 per year, but the colleges the child has prepaid to attend are limited. Of course, the educational IRAs are opposite, having a $500 per year limit, but the funds can be used almost anywhere for education. The bonds have the best of all worlds, both no real limit on the amount that can be invested, no limit on where the funds can be used for education, and indeed no requirement to use the funds for education to avoid paying a penalty.

The educational IRAs also have more flexibility with their rollover feature, and if they end up being distributed to the child at age thirty, the possibility of a lower tax being paid on the earnings than would have been paid otherwise, along with the benefits of deferring tax on the earnings more than compensates for the 10% penalty that may be imposed. For this reason, I believe it is beneficial for anyone who wishes to help their child or grandchild get a college education to see that an educational IRA is funded for the child.

The series EE bonds generally have such a low return that they are a poor choice for a college fund except for the most conservative investor. While the educational IRA can be invested in a mutual fund, the series EE bonds are limited to interest rates of the federal government. The tax advantage when funds are used can be phased out as well, while educational IRAs have no such limitation on the tax advantage when distributions are made.

Concurrent Educational Expenses And Programs

The next group includes most of the programs, and involves most of the need for choosing which plan is better, and how to use funds to receive the greatest benefits.

The best of the programs is, of course, the employer tuition assistance plan. If courses can be taken free, no other plan can do more for the taxpayer.

If the student is in the first two years of college, the HOPE Credit is the best program available, as $1500 in tax credits per student far exceeds any of the other programs available. The alternative minimum tax could limit this benefit though, and so a pro-forma tax return may be required to verify that this is indeed the best approach.

For the self employed, unless they can use the HOPE Credit, their deduction from schedule C of the educational expenses provides more benefit than anything else they can do. They save (a net of) about 14.2% in self employment taxes in addition to the income taxes saved on both the state and federal level.

The Lifetime Learning Credit of 20% will normally be the next best choice, although it is also subject to the alternative minimum tax. If the individual is in higher than the 15% bracket, and has a great deal more than 2% in miscellaneous itemized deductions (including educational deductions), itemizing may be better than a 20% tax credit. It is important to remember that itemized deductions are usually also deducted on state returns as well.

The last possibility is generally not a good choice. While the law allows funds to be redeemed from a retirement IRA without penalty, only if no other way is available to pay for college should redeeming funds from a retirement IRA be considered. The reasons include the reduction or elimination of a tax shelter, and the reduction or elimination of retirement funds that may not be replaced.

Post-educational Program

The post-education program tax benefit is the deductibility of interest for the first sixty months of payments on student loans. Any educational expenses of a student, which do not benefit the taxpayer with credits, deductions, or other tax savings in the year paid, probably should be secured with a student loan in the student's name. The probability of being phased out and unable to take the deduction in the first five years after graduation are small, and the deduction is available even if the ex-student doesn't itemize deductions.


While planning can be done, with phaseouts, limitations due to alternative minimum tax, and planning for an uncertain future, all accountants can do is guide their clients in getting educational tax savings. Additionally, the new tax law will require many returns to be prepared in different ways to see the best way to use the tax savings available.
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Title Annotation:Taxpayer Relief Act of 1997
Author:Cooper, Robert H.
Publication:The National Public Accountant
Date:Mar 1, 1998
Previous Article:Roth IRA provides tax-free interest income.
Next Article:The formation, intergenerational transfer, and valuation of family limited partnership interests.

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