Tax Incentives for Education

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by Jack Veale

For families with children in private school or college, education costs can be prohibitive. Financial aid is can be hard to obtain and scholarships can be even more elusive. For many families, tax incentives are the only assistance left. The following is a survey of tax-related incentives you may want to consider.

Education IRAs

Middle-income taxpayers may use an individual retirement account (IRA) as a vehicle to help save for education costs. Joint filers with modified adjusted gross income (MAGI) below $150,000 and single filers with MAGI under $95,000, may contribute up to $500 per beneficiary under the age of 18 each year to an education IRA in addition to other IRAs. Taxpayers may not deduct contributions, but earnings will be distributed tax free if used to pay a beneficiary’s qualified education expenses. If not, the income earned on the contributions will be taxed when distributed and a 10% penalty will apply. The 10% penalty will not apply if the distribution is made because of death, disability, return of excess contributions and earnings, or because the student is receiving a scholarship or allowance for education expenses. The IRA must be distributed within 30 days after the beneficiary dies or reaches the age of 30.

Qualified education expenses include tuition, fees, books, supplies and equipment required for enrollment in a post-secondary educational institution offering credit toward a bachelor’s degree, associate’s degree, graduate degree, professional degree, and vocational or proprietary school degrees. The student may attend part time, full time or less than half time. But room and board expenses are eligible only if the student is enrolled at least half time.
Keep in mind that a distribution from an educational IRA will not be tax-free in any year in which the taxpayer claims the Hope credit or the Lifetime Learning credit.

The IRS treats a contribution to an education IRA by someone other than the beneficiary on that beneficiary’s behalf as a gift of a present interest that is shielded from gift tax by the annual exclusion of $10,000. If a grandparent makes the gift, it is also excluded from the generation-skipping transfer tax under the $10,000 exclusion.

Hope Scholarship Credit

Joint filers whose modified adjusted gross income does not exceed $100,000 or single taxpayers with MAGI under $50,000, may claim credit up to $1,500 per student per year for each of the first two years of post-secondary education. The credit is 100% of the first $1,000 of tuition and related expenses (inflation adjusted) plus 50% of the next $1,000 of expenses (also inflation adjusted). The maximum credit per student in 1999 is $1,500.

The credit applies only to the first two years of post secondary education including college and vocational and proprietary school programs. The student must attend at least half time to qualify. The credit phases out for taxpayers with MAGI of between $40,000-$50,000 for singles and $80,000-$100,000 for joint filers. A major limitation: A taxpayer may not take the Lifetime Learning credit and may not exclude education IRA distributions from income for any year in which the Hope credit is used.

Lifetime Learning Credit

Joint filers with a MAGI under $100,000 and single taxpayers with a MAGI under $50,000 may take a credit of 20% of tuition and related expenses up to $5,000. This credit applies to tuition and related expenses for any year of eligible post-secondary expenses, not just the first two as with the Hope Scholarship credit. This credit is not determined on a per student basis. For 1999, the credit limit is $1,000 (20% of $5,000). The credit phases out for MAGI between $80,000-$100,000 if filing jointly and $40,000-$50,000 if single. If you claim the Lifetime Learning credit in any year, you may not claim the Hope credit or exclude income from an education IRA.

U.S. Savings Bonds Redeemed To Pay Educational Expenses

A taxpayer aged 24 or older who buys U.S. savings bonds issued at a discount (such as series EE bonds) after 1989, may exclude from income the gains on the redemption of the bonds in some circumstances. To be excluded, the amount of the income may not exceed all qualified education expenses net of scholarships that are exempt from income tax and educational assistance payments, gifts from others to pay educational expenses, and tuition and related expenses that are used to compute the Hope Scholarship credit and the Lifetime Learning credit.

The type of expenses that are eligible are generally the same as those eligible for the Hope credit. Only middle and lower income taxpayers may claim the exemption from income. The limits are adjusted for inflation. For 1999, the limit if filing jointly is $109,650 with a phase out beginning at $79,650. For single taxpayers, the amount is phased out from $53,100 to $68,100. No exclusion is available if you are married and filing separate returns.

Gift Tax Exclusion

Ordinarily, a person may give $10,000 to each student free of gift tax. Any gift above that amount will be taxable. A husband and wife may jointly give up to $20,000 free of gift tax. Gifts include all kinds of transfers to or for the benefit of another. But some gifts are not considered in these calculations, including gifts to pay tuition and related expenses. To qualify, the donor pays the institution directly, not the donee. The gift must be for tuition only, but is not limited to post-secondary education as are some of the other tax incentives.

Deductibility of Interest On Student Loans

Since 1998, taxpayers may deduct interest on higher education loans up to $1,500 for 1999, $2,000 for 2000 and $2,500 for 2001 and beyond. The deduction is “above the line” and thus used to determine adjusted gross income. The interest deduction applies only to the first 60 months of payments on the loan and the IRS treats the original loan and all refinancings as the same loan.

Employer Educational Assistance Programs

An employer may pay up to $5,250 of educational expenses for employees’ spouses and dependent children under a plan that does not discriminate in favor of highly compensated employees, and payments will be excluded from the employee’s income. Payments may be for tuition, fees, books, supplies and other related items. The courses do not need to be job related but can not involve sports, games or hobbies. Undergraduate courses beginning before June 1, 2000, are eligible. Graduate courses are not eligible
at all.

Deductibility of Education Expenses

Taxpayers may deduct education expenses if the education maintains or improves a skill required by the worker in his or her employment or other trade or business. If the education meets the employer’s express requirements or the requirements of law or regulations imposed as a condition for retention of an established employment relationship, status or rate of compensation, the expenses may also be deducted. These expenses are itemized deductions subject to the 2% of adjusted gross income floor for deductibility.

 Other Special Situations

Employees of educational institutions may exclude from income tuition costs provided by the institution to them, their spouses and dependent children. In addition, some scholarships and fellowship grants are also excluded from income.

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