June, 2004 Tax Newsletter

Let Uncle Sam Help You Pay for Higher Education

Unlike several years ago when parents or students were pretty much on their own to pay for education, in the 1990’s the government began providing many tax benefits to help alleviate the high cost of higher learning.  This month’s newsletter describes several of these tax breaks.

Higher Education Expense Deduction

From 2002 through 2005, an above-the-line deduction is allowed for tuition expenses.  This means that you do not have to itemize deductions on your income tax return to take this deduction.   For 2004 and 2005 a maximum of $4,000 can be deducted by single taxpayers with incomes up to $65,000 or married taxpayers with joint incomes up to $130,000.   Also in 2004 and 2005, taxpayers with higher incomes (single filers with incomes between $65,000 and $80,000 and joint filers between $130,000 and $160,000) can claim a deduction of up to $2,000. Taxpayers cannot claim this deduction and the Hope or Lifetime Learning credit (see below) for the same student. Married taxpayers must file jointly to claim the deduction.

Coverdell Education Savings Accounts

These trust or custodial accounts were created exclusively for the purpose of paying the beneficiary's qualified higher education expenses or, after 2001, expenses for grades K-12 at public or private schools.  The maximum allowable annual contributions of $2,000 are not tax deductible. Contributions must be made by the beneficiary's 18th birthday, except for special needs students who are exempt from the age limit.  Corporations and tax-exempt organizations can now also make contributions.

Distributions for qualified education expenses are tax-free.  Any amounts withdrawn that are not used for qualified expenses (e.g. tuition, books, supplies, room and board, computer equipment, etc.) or that are in excess of qualified expenses are taxed and also subject to a 10 percent penalty tax. When the beneficiary reaches age 30, any money left will be taxed and assessed a 10 percent penalty tax, which may be avoided by possible rollover strategies.

Hope Scholarship Credit

The Hope Credit helps you pay for a two-year degree or certificate program at a community college, or for the first two years of a four-year program. The credit covers 100% of the first $1,000 of tuition (but not room, board or books), plus 50% of the next $1,000 of tuition and related  expenses, for a maximum $1,500 credit per student, per year.  As this is a credit, not a deduction, the entire amount reduces your income taxes, but it is not refundable if the credit reduces your taxes to less than zero.

To qualify, the student must be enrolled in a program that leads to a degree, a certificate, or some other recognized vocational training. The student also needs to be enrolled at least half-time in such a program. Finally, qualifying students may not have had a felony conviction for possessing or distributing drugs or other controlled substances.  Married taxpayers must file jointly to claim the credit.

Lifetime Learning Credit

The Lifetime Learning Credit is broader than the Hope scholarship credit in its application.  It allows a wide range of students and educational programs to qualify, including adults taking classes that are not toward a degree.  Beginning in 2003 this tax credit can be as much as $2,000 per taxpayer return, calculated as 20 percent of tuition and fees up to $10,000.  As with the Hope credit, this credit is used to reduce your income taxes, but it is not refundable if the credit reduces your taxes to less than zero and married taxpayers must file jointly to claim the credit. 

Note: A taxpayer cannot take both the Hope and Lifetime Learning credits with respect to the qualified expenses of one eligible student in the same year.  Also, both credits begin to phase out as modified adjusted gross income reaches prescribed levels. (For 2004 - $85,000 married filers; $42,000 single filers)

Student Loan Interest Deduction

Taxpayers can deduct interest on qualified higher education loans as an above-the-line deduction, meaning that you do not have to itemize to take the deduction.

Qualified higher education loans are debts incurred to pay qualified higher education expenses for the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer as of the time the debt was incurred. Loans for classes to improve or acquire skills do not qualify. The loan must be for expenses that were paid or incurred within a reasonable period of time before or after the debt is incurred. The student must qualify as an eligible student under the Hope Scholarship Credit definition.  Married taxpayers must file jointly to claim the deduction.

Qualified Tuition Programs (Section 529 Plans)

Code Section 529 plans are a relatively recent savings vehicle for college expenses.  There are no income limits to worry about and the contribution limits are generous - up to $11,000 per child per year, or up to $55,000 in one lump sum.  The earnings are tax-free as long as the account is used for qualified post-secondary education expenses, which include tuition, fees, books and room and board.  Depending on your state's plan, a 529 contribution may generate a state income tax deduction.  Withdrawals for non-education purposes are taxed as ordinary income and subject to an additional 10% penalty.  If you have substantial sums that can be put aside for education, a 529 plan can be a major factor in future tax planning.

The plans meet federal requirements that allow taxpayers to save for or prepay tuition for a beneficiary.  Before 2002, the beneficiary student was taxed on the growth in the account when it was distributed.  Beginning in 2002, distributions used for qualified expenses are not taxed.  Nonqualified withdrawals are subject to a 10% penalty tax.  Tuition plans are for degree programs, not for classes to improve or acquire skills.  Rollovers from one plan to another with the same beneficiary are limited to once in 12 months.

Two types of plans fall under Sec. 529: 

Prepaid tuition plans -  It is important to check a prepaid plan to determine what flexibility you have if the student attends an out-of-state school or a private college.  Formerly, only state educational institutions could set up these plans.  However, beginning in 2001, both public and private educational institutions can offer prepaid tuition programs and distributions from the latter programs will be tax-free beginning in 2004.  Prepaid tuition programs have less flexibility than the more recent and more popular savings plans in that they don’t provide investment options, are more restrictive in expenses covered, and may set age or grade limits..

Savings plans - Compare deferred savings plans from several states to find the best arrangement for you and your family. Evaluate the investment choices and the variety of schools that are covered.

Gift taxes may be owed if more than $11,000 is contributed per year. However, a contribution can be treated as if made over up to five years, allowing single contributions of up to $55,000 without gift tax consequences.

Employee Assistance Plans

Employers may offer programs under which employees can receive financial assistance for education of up to $5,250 per year that is not reported as income, whether or not the classes are job-related.   The exclusion has been made permanent and applies to both graduate and undergraduate classes.

 Everyone's tax situation is different and state and federal tax law can be complex.  I would be happy to determine which college savings options are best for you.