INCOME TAX

EDUCATION INCENTIVES

The following education incentives or benefits are available through the federal income tax system:

1.     “Hope Scholarship Credit” a federal income tax credit for higher education expenses.

2.     “Lifetime Learning Credit” a federal income tax credit for higher education expenses and job skills classes.

3.     Coverdell Education Savings Account.

4.     Income tax deduction for interest paid on student loans.

5.  Penalty-free withdrawals from IRAs when used to pay for higher education expenses.

6.     Tax deferred earnings on contributions to qualified state tuition programs.

 IMPORTANT RESTRICTIONS:

A. For any tax year, a taxpayer is permitted to elect only one of the following with respect to any one student:

1. The Hope Scholarship Credit, OR

2. The Lifetime Earning Credit, OR

3. The exclusion from the 10% tax penalty on distributions taken from a regular IRA, or from an Education Savings Account and used to pay eligible higher education costs.

B.    In any tax year you can contribute to an Education Savings Account or to a qualified state tuition plan for a child, but not to both.

C. You cannot make a tax-free transfer money from an IRA or Roth IRA into an Education Savings Account.

D. Numerous other restrictions apply to each education incentive including various specific income/earnings phase-out limitations.

HOPE SCHOLARSHIP CREDIT AND LIFETIME LEARNING CREDIT SHARED RULES: (General rules that apply to both the Hope Scholarship Credit and Lifetime Learning Credit)

A.  The Hope Scholarship Credit and the Lifetime Learning Credit are nonrefundable credits so a taxpayer can only use the credits to reduce the taxpayer’s income tax liability to zero.  Any excess unused credits CAN NOT be carried forward to future tax years. 

B. This election is separate for each student so a parent may elect to take the Hope Scholarship Credit for one child and the Lifetime Learning Credit for another child.

C.    The definition of “qualified tuition and related expenses” is the same for both credits: tuition and fees required for enrollment or attendance ONLY.  Charges and fees associated with books, lodging, meals, student activities, athletics, insurance, transportation, and similar personal, living or family expenses are not eligible.

D.    Qualified tuition and related expenses paid must be reduced dollar-for dollar by any tax-free scholarships and fellowship grants received, education assistance allowances received which are not required to be reported as income such as Veterans education benefits, and any tax-free education assistance received from an employer.  Any of the above amounts received must be applied first against qualified tuition and related expenses in arriving at the net amount of those expenses eligible for either of the credits.

E.     Married persons must file a joint return to claim either of the credits.  No credits are available to married persons filing separate returns.

F.   Both credits are subject to the same income phase-out levels of $42,000 to $52,000 for single filers and $85,000 to $105,000 for joint returns, so single filers earning over $52,000 and joint filers earning over $105,000 are not eligible for either of the credits.

G.    The taxpayer, spouse or dependents are eligible for both credits.

H.    The name and identification number of the student must be shown on the tax return for the year the credit is claimed.  Failure to include a dependent student’s social security number will result in disallowance of the credit.

I.      The credits must be recaptured if the taxpayer or the student receives a refund of qualified tuition or related expenses that were used as a basis for the credit claimed in a prior year.

J.      Qualified tuition and related expenses paid with proceeds of a loan are eligible for the credits in the payment year, not the year the loan is repaid.

K.    The credits are available for private or state operated schools.

HOPE SCHOLARSHIP CREDIT

This credit is available for qualified tuition and related costs paid to cover a student’s first two years (ONLY) of higher education at an eligible institution.  For each student, the credit is equal to the first $1,000, and 50% of the next $1,000 of qualified education expenses paid during the first and second years of college.  To qualify, a student must be enrolled on at least a half-time basis at an eligible education institution.

LIFETIME LEARNING CREDIT

This credit is available for qualified tuition and related costs paid to cover a student’s education costs AFTER the first two years of college OR for courses taken to acquire or improve job skills, including most courses taken at vocational schools.  The credit is equal to 20% of the first $10,000 of qualified education expenses paid.  The total dollar limit of this credit is on a per tax return basis, regardless of the number of family members in school during the year, although you can claim this credit for one person and the Hope Scholarship Credit for another person on the same return.

TUITION AND FEES DEDUCTION

NOTE:  THIS DEDUCTION EXPIRED ON DECEMBER 31, 2005.  CONGRESS HAS DISCUSSED  EXTENDING THE DEDUCTION, BUT HAVE NOT YET DONE SO AS OF JULY 6, 2006.

For the tax years 2002 through 2005, taxpayers were allowed to claim a tax deduction for tuition and fees paid for qualified higher education expenses.  This deduction was an adjustment to adjusted gross income (AGI), an "above-the-line deduction, so it could be claimed even if the taxpayers do not itemize deductions.  For the years 2004 and 2005, the maximum deduction allowed was $4,000.  This is a per-return deduction so the maximum was calculated regardless of the amount paid or the number of dependent students paying tuition.  The deduction was reduced and then completely phased-out at certain income levels.   The maximum was reduced to $2,000 when the taxpayer's AGI exceeded $65,000 ($130,000 for joint filers, and was completely eliminated if the taxpayer's AGI exceeded $80,000 ($160,000 for joint filers).  In addition, the deduction could not be claimed if the Hope or Lifetime Learning Credits were claimed for the same student.  Qualified expenses must have been reduced by the amount of tax-free educational assistance received such as scholarships, Pell grants, employer-provided tuition assistance, tax-free distributions from Education Savings Accounts, and any other non-taxable payments received for education.

COVERDELL EDUCATION SAVINGS ACCOUNT (formerly known as EDUCATION IRA)

You can make nondeductible contributions of up to $2,000 a year to an Education Savings Account for youngsters under age 18.  Although multiple Education Savings Accounts can be established for any youngster, the total contribution to ALL of these accounts cannot exceed the annual limit.  If joint taxpayers’ income exceeds $220,000, $110,000 for single filers, no contribution can be made to an Education Savings Account.  Taxpayers that are disqualified from making the contribution may want to give the money to a parent or relative who does not have as high an income level and have that person make the contribution to the youngster’s Education Savings Account.  Funds in the account that are withdrawn to pay qualifying education expenses at elementary and secondary public or private schools are tax-free.  Funds withdrawn that exceed qualified education expenses are taxable to the beneficiary and also subject to a 10% tax penalty.  The funds in the Education Savings Account may be transferred to another qualifying child in the same family.  Funds in the Education Savings Account that are not used for qualified education expenses MUST be distributed to the beneficiary by age 30, and the income earned on the account is then taxable as income to the beneficiary, and is also subject to a 10% tax penalty.  Distributions from Education Savings Accounts can be made in the same year that the Hope or Lifetime Learning credits are claimed, as long as long as the Hope or Lifetime Learning credits are not claimed for the same education expenses that are allocated to the Education Savings Account distributions.  I still feel that a Section 529 prepaid tuition plan is far superior to this account, and even a tax-efficient mutual fund might be a better tuition investment option. 

TAX DEDUCTION FOR  INTEREST PAID ON STUDENT LOANS

You can deduct the amount of interest you pay on student loans.  Only the person legally obligated to repay the loan can claim the deduction.  If the student took out the loan in his/her own name, only he/she can claim the deduction, not the parent who offers to make the payments for the child.  This deduction is an “above-the-line” deduction, which means that you do not have to itemize deductions to claim the expense as a tax deduction, so the deduction can be claimed even if the standard deduction is used.  The annual deduction amount is limited to $2,500.  No deduction can be claimed by a single taxpayer with income over $65,000, or joint taxpayers with income over $130,000.  Interest paid on loans from most sources, government or private, qualify except, for loans from related parties such as parents, grandparents, spouse, children or certain controlled business interests. 

There are many complex and specific rules that must be met to qualify for this deduction.  No deduction is allowed to an individual who can be claimed as a dependent on another taxpayer’s return.  Married couples filing separately cannot take the deduction.  The student must have been at least a half-time student when the loan was incurred.  Qualified expenses must be reduced by nontaxable scholarships and education assistance.  The loan must have been used for qualified higher education expenses paid or incurred within a reasonable period before or after the indebtedness was incurred.  If the interest qualifies as a tax deduction in another category, such as mortgage interest, it must be claimed in that category rather than as student loan interest.

PENALTY-FREE WITHDRAWALS FROM IRA ACCOUNTS

Normally, distributions from an IRA account by a person under age 59½ are subject to a 10% penalty.  The 10% penalty is waived for IRA and Roth IRA distributions that are taken to pay for qualified education expenses.  Qualified expenses include tuition, fees, room, board, books, and supplies required for attendance or enrollment at an eligible post-secondary institution for both undergraduate and graduate studies.  Qualified expenses must be reduced by any amounts received from nontaxable scholarships and education assistance.  The expenses must be paid on behalf of the taxpayer, spouse, child, stepchild, or grandchild of the taxpayer or the taxpayer’s spouse.

TAX DEFERRED EARNINGS FROM QUALIFIED STATE TUITION PROGRAMS

This is my recommend way to fund college education.  Contributions made to a qualified state tuition program, known as a Section 529 plan, are not tax deductible.  All interest earned on such contributions is tax-deferred until withdrawn and distributions from the account are considered as first coming from contributions until distributions exceed all contributions.  After all contributions have been distributed, the remaining distributions constitute income to the student and are taxable income at that time, UNLESS the funds are used for qualified education expenses in which case the interest is non-taxable.  To the extent that distributions are used to pay qualified education expenses, either the Hope Tax Credit or the Lifetime Earning Credit may be available if all of the other qualifications for these credits are met.

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