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Educational Tax Breaks

Click here for a printable copy of the USA Today "Education Breaks" article

Last summer's Taxpayer Relief Act are a number of new education tax breaks. Unfortunately several of these will be unavailable to higher-income individuals because of phase out provisions. However, at least some benefits will be available to many taxpayers. This article summarizes what you need to know.

Two New Education Tax Credits

There will soon be a relatively generous new tax credit to help pay for postsecondary education costs. It's called the Hope Scholarship credit and it's available for tuition paid after this year. The credit amount is 100% of the first $1,000 of annual tuition expenses plus 50% of the next $1,000. In other words, you can reclaim up to $1,500 per student per year from Washington. However, the Hope credit covers only the first two years of college. The student must also take a half-load or more of classes for at least one academic period during the year for that year's expenses to qualify.

The second new credit is called the Lifetime Learning credit and it will be available for tuition paid after June 30, 1998. It's intended to help with college expenses that are not used to qualify for the Hope credit (i.e., college costs after the first two years), plus other postsecondary education costs to acquire or improve job skills. Graduate courses qualify, as do continuing professional education courses taken at an eligible educational institution. Tuition at certain vocational schools will also count. The Lifetime credit is 20% of annual tuition up to $5,000, for a maximum benefit of $1,000 per year. Unfortunately, this modest cap applies regardless of how many students you may have in your family. The good news is the credit is available for an unlimited number of years and eventually increases in 2003 to 20% of annual expenses up to $10,000-for a maximum credit amount of $2,000. Also, the student does not have to meet the half-load requirement to claim the Lifetime credit.

Qualifying expenses for both the Hope and Lifetime credits include tuition and fees (but not room and board, books, student activity fees, transportation, etc.) for you, your spouse, and any other person who can be claimed as a dependent on your tax return. However, there's a catch: both credits are phased out between adjusted gross income of $80,000 and $100,000 for joint filers and between $40,000 and $50,000 for single taxpayers. And if you're married and file separately, you're not entitled to any credit at all.

In situations where the parents' ability to claim a credit is phased out because of "too much income," it may make sense for them to avoid paying over 50% of the student's support for the year. That way the student will not be a dependent for the year and he or she can claim a credit.

Note that you cannot use the same expenses to claim both the Hope and Lifetime credits. Similarly, when U.S. Savings Bonds are redeemed to cover college expenses, you cannot use the same tuition costs to claim a credit and take advantage of the Savings Bond interest exclusion. Likewise, a credit cannot be claimed for expenses paid by tax-free employer education assistance programs; tax-free scholarships, fellowships, and grants; and amounts which the student claims as deductible business expenses.

New Write-offs for Interest on Student Loans

Under this year's tax rules, interest on a loan to pay for education expenses is considered a nondeductible personal expense-just the same as interest on a car loan. Next year, things will get better with a new deduction for interest on education loans that applies regardless of whether you itemize your deductions. The write-off is limited to $1,000 for 1998; $1,500 for 1999; $2,000 for 2000; and $2,500 for 2001 and later years. The same limit applies regardless of how many students are in your family.

Only interest required to be paid during the first 60 months that interest payments are called for under the terms of the loan is deductible (months the loan is in deferral status don't count for the 60-month rule). Proceeds from the loan must be used to finance expenses incurred for periods the student carries at least a half-load. Unfortunately under a phase out rule, the deduction vanishes between adjusted gross income of $60,000 and $75,000 for joint filers and between $40,000 to $55,000 for singles. And there's no write-off whatsoever for married individuals who file separately.

You might think the income phase out rule could be avoided by having the student rather than his or her higher-income parents take out the loan. But Congress already thought of that. The student can't deduct the interest in any year he or she is claimed as a dependent on the parents' return. However, for education loans where interest isn't due until after graduation-when the student presumably will no longer be a dependent-having the debt in the student's name would work.

New Education IRAs

Beginning in 1998, parents (or others such as grandparents) can contribute up to $500 annually to education IRAs set up for designated beneficiaries (usually a child or grandchild). The $500 limit is per beneficiary, so you can't beat the system by, for example, setting up a $500 account for your child and having both sets of grandparents fund two more accounts for a total of $1,500.

Education IRAs are somewhat similar to a scaled-down version of the new Roth IRAs. Contributions are nondeductible. Earnings accumulate tax-free and funds can then be withdrawn tax-free to pay for postsecondary tuition, fees, books, supplies, equipment, and room and board. (Expenses other than room and board qualify for tax-free withdrawals even if the student is carrying less than a half-load.) However, in any year that a tax-free education IRA withdrawal is taken for a student, that person's school expenses will not qualify for the Hope or Lifetime Learning credit.

Eligibility for an education IRA is unaffected by any amounts contributed to regular or Roth IRAs. For example, a single individual with two children can contribute up to $2,000 annually to any combination of regular and Roth IRAs plus up to $1,000 annually to two education IRAs set up for the kids ($500 for each child).

The relatively generous adjusted gross income phase out rules are the same as for Roth accounts-$95,000 to $110,000 for singles and $150,000 to $160,000 for joint filers-so this break is there even for those pushing against the upper limits of middle class status.

Education IRAs deliver the biggest payoff when funding starts early, because no contributions are allowed after the child reaches 18. The most that can be contributed is therefore $9,000 per child; it remains to be seen if this relatively skimpy limit will diminish taxpayer enthusiasm.

What if you set up education IRAs for both your kids and only one ends up going to college? No problem. You can roll over the funds in the unneeded account tax-free into the university-bound child's IRA (or even an education IRA set up for a grandchild or other family member). Also, the account beneficiary can simply be changed to another family member.

One final comment about education IRAs: although Congress apparently intended for any unspent funds in the IRAs to be distributed (and taxed) to beneficiaries once they reach age 30, the actual law doesn't include this limitation.

Expanded Breaks for Prepaid State Tuition Plans

Last year's tax legislation included breaks for contributions to prepaid state college tuition programs designed to cover tuition, fees, supplies, and books. This year's law opens the door wider by allowing these programs to also cover room and board expenses provided the student is carrying at least half the normal full-time workload for the course of study. Since room and board can easily cost as much as tuition and books, this often equates to doubling the tax advantages offered by prepaid state plans.

There are no income phase outs affecting prepaid state plans. In addition, although qualifying distributions from plan accounts are taxable to the student to the extent they exceed contributions to the plan, such distributions can qualify for the Hope and Lifetime credits. Also tax-free proceeds from redemptions of certain U.S. Savings Bonds can be used to fund contributions to prepaid state plans.

Penalty-Free IRA Withdrawals for Education Expenses

Starting in 1998, withdrawals from regular and Roth IRAs can be taken to pay higher education expenses without having to pay the 10% penalty tax that usually applies to the income portion of withdrawals before age 591/2. However, these withdrawals normally will still be subject to the "regular" federal income tax and the alternative minimum tax, if applicable.

Eligible expenses include tuition, fees, books, supplies, and equipment at a postsecondary educational institution. Graduate course expenses also qualify. In addition, room and board is an eligible expense if the student is attending the educational institution at least half-time.

The student can be you, your spouse, your child or grandchild, or the child or grandchild of your spouse. However, qualified expenses are reduced by tax-free payments from employer assistance programs, scholarships, etc.

Conclusion

While the really juicy tax credit and interest deduction benefits are subject to restrictive income phase out rules, the new law includes at least some educational incentives for just about everyone. So why not let Uncle Sam help pay some school bills for you and your family members?