Preeo, Silverman, Green & Egle, P.C.
Tax Library
Tax-Preferred Alternatives To Financing Education
By Steven M. Weiser, J.D., LL.M. (Taxation)
posted: June 1, 2010
The cost of higher education in the United States continues to soar. Many parents simply don’t know how they will be able to finance their children’s educations. Grants and scholarships are available though these sources of financial aid are often minimal. Student loans are another method of financing education, but not all parents want their children saddled with debt the moment they hit the workforce. The federal government, realizing the problems afflicting many families, has provided a number of tax benefits to assist parents of college-bound students.
In general, we can break all college savings options into two categories: investment incentives and tax breaks. Investment incentives include things like Coverdell Education Savings Accounts and Section 529 plans. Tax breaks include the lifetime learning credit and Hope scholarship credit.
Investment Incentives:
Coverdell Education Savings Accounts
The greatest advantage of investment incentives, is that amounts saved grow tax-free. The greatest drawback is that funds invested are restricted in use. A Coverdell Education Savings Account (CESA), formerly known as an “Educational IRA,” is created for the purpose of paying the qualified education expenses of the individual designated as the beneficiary of the CESA. Unlike traditional IRAs, contributions to CESAs are not tax deductible. Annual contributions to CESAs are limited to $2,000 per beneficiary. The ability to contribute to a CESA starts to phase out once income exceeds $190,000 for joint taxpayers ($95,000 for single taxpayers). The ability to contribute to a CESA is completely eliminated when income reaches $220,000 ($110,000 for single taxpayers). Organizations such as corporations and trusts can contribute to CESAs with no limitations due to income level.
As mentioned above, a CESA may be used to pay only qualified higher education and elementary and secondary educational expenses. Qualified higher education expenses include tuition, fees, books, special needs expenses incurred in connection with attendance at a higher educational institution, supplies and equipment required by the educational institution, contributions to qualified tuition programs. Reasonable expenses for room and board are often also eligible expenses. Qualified elementary and secondary education expenses include tuition, fees, special needs services, books, reasonable room and board, transportation services, and expenses for computers, related equipment and internet access.
Distributions from a CESA are excluded from the beneficiary’s gross income to the extent distributions do not exceed qualified education expenses. In general, a 10% penalty and inclusion in taxable income will occur if distributions exceed qualified education expenses.
Contributions to a CESA may occur as late as April 15th of the following tax year. For example, Taxpayer A may open a CESA on January 1, 2005 for his minor child C and contributes $4,000 to the CESA on that date. Because the contribution is made by April 15th, $2, 000 of the contribution relates to 2004 while the remainder relates to 2005.
Section 529 Plans
Here in Colorado we here a lot about 529 Plans. CollegeInvest is a nonprofit division of the Colorado Department of Higher Education that offers investors the opportunity to save money through a Section 529 plan. Section 529 plans refer to that section of the Internal Revenue Code which allows taxpayers to save money in a qualified tuition program (QTP). Through a QTP a taxpayer may purchase tuition credits or make cash contributions on behalf of a QTP beneficiary for the payment of qualified higher education expenses.
A QTP allows persons to either (1) purchase tuition credits or certificates on behalf of a designated beneficiary, that entitles the beneficiary to a waiver or payment of higher education expenses, or (2) in the case of a QTP established by a State or agency thereof, make contributions to an account that is established for the sole purpose of meeting qualified higher education expenses of the QTP account’s beneficiary.
Distributions from a QTP are not taxable to the extent used for the payment of qualified higher education expenses. Distributions in excess of qualified higher education expenses are generally subject to a 10% penalty as well as inclusion in taxable income. For purposes of QTPs, qualified higher education expenses include tuition, fees, books, supplies and required equipment, expenses for special needs, and the cost of room and board.
A change in the designated beneficiary of a QTP account is not treated as a distribution if the new beneficiary is a member of the former beneficiary’s family. This allows for funds remaining in a QTP at the expiration of one person’s higher education to become available for another family member’s (e.g., a younger sibling) higher education expenses.
Creating a trust to serve as the account owner of a QTP brings additional and significant benefits. First, QTP beneficiaries can take advantage of the trust’s spendthrift provisions as protection from creditors. Second, properly planned trust provisions can provide an opportunity for dynastic planning; that is, educational planning and funding that may benefit more than just one individual and more than just one generation.
Education-Related Tax Breaks
Before examining the following tax breaks a word about tax deductions and credits. First, as far as deductions are concerned we can generally lump these into the following two broad categories: (1) above-the-line deductions, and (2) itemized deductions. An “above-the-line” deduction refers to where the deduction appears on an individual income tax return. Specifically, the “line” refers to the location on which adjusted gross income is entered on a return. Above-the-line deductions are viewed as a greater benefit because they can be claimed by all taxpayers, not just those that itemize deductions.
Tax credits are an even greater benefit than deductions because they reduce tax liabilities dollar-for-dollar. Deductions only reduce taxable income, meaning that a dollar of deduction equates to less than a dollar of tax savings. For example, for a taxpayer in the 35-precent tax bracket a dollar of a deduction equates to only a 35-cent tax savings.
Deduction for Tuition
Among educational related tax-breaks one of the more useful alternatives is a deduction for tuition and related expenses paid for enrollment of the taxpayer, spouse or dependent at an accredited post-secondary educational institution. The deduction is limited to $4,000 and is generally available for single taxpayers with gross incomes not above $65,000 and joint taxpayers with incomes not above $130,000. A reduced deduction of up to $2,000 is allowed for single taxpayers with incomes between $65,000 and $80,000, and for joint filers with incomes between $130,000 and $160,000. The availability of the deduction was scheduled to expire after December 31, 2009, but Congress is likely to extend its availability to 2010.
The deduction is disallowed when a Hope scholarship credit (see below) or lifetime learning credit is claimed with respect to the same student. Other limitations may apply.
American Opportunity Credit
The American opportunity credit (formerly, the Hope Scholarship credit) is available for tax years beginning in 2009 or 2010. The credit is available for qualified tuition and related expenses with respect to an eligible student’s first four years of secondary education. The maximum credit is $2,500 per year based on a percentage of qualifying expenses. Student eligibility is based upon enrollment in a qualifying educational institution, course-load, criminal history (the student must not have been convicted of a drug-related felony for the year in which the credit is claimed), and the student must not have completed, as of the beginning of the tax year, the first two years of post-secondary education.
The American opportunity credit is phased out for taxpayers with sufficiently high incomes. The phaseout begins at $160,000 for joint filers ($80,000 for single filers) and is completely phased out at $180,000 for joint filers ($90,000 for single filers).
Lifetime Learning Credit
The lifetime learning credit allows a credit equal to 20-percent of qualified tuition expenses paid for any year the Hope scholarship credit is not claimed. The maximum amount of the credit is $2,000.
The lifetime learning credit is per taxpayer and has no reference to the number of students in a single family. This means that joint taxpayers with multiple college students, for example, can only claim lifetime learning credits of up to $2,000, period! If a taxpayer elects the American opportunity credit for a student’s expenses the Lifetime Learning credit is not available for the same student. However, the Lifetime Learning credit can be claimed for a different student.
The lifetime learning credit is phased out for taxpayers with sufficiently high incomes. In 2009, phaseouts began at $100,000 for joint filers ($50,000 for single filers).
Deduction for Interest On Educational Loans
Interest paid during a tax year on qualified educational loans is deductible for tax purposes. Interest is only deductible if the underlying debt was incurred to pay qualifying higher education expenses. The maximum annual interest deduction is limited to $2,500. The deduction is phased out once incomes of single taxpayers begins to exceed $50,000 ($100,000 for joint taxpayers).
The student loan interest deduction is an above-the-line deduction.
Deductible Business Expenses
Educational expenses can also be claimed as a miscellaneous itemized deductions, but only to the extent such deductions exceed 2-percent of adjusted gross income. However, in order for an education expense to be deductible the education must (1) maintain or improve a skill required in the taxpayer’s employment, or (2) meets the express requirements of the taxpayer’s employer, laws or regulations, and is imposed as a condition of continued employment or rate of compensation. In no case may a taxpayer deduct educational expenses if the additional education is required to meet the minimum requisites for the taxpayer’s trade or business, or are part of a program of study qualifying the taxpayer for a new trade or business.
Employer Reimbursed Educational Expenses
Should you be fortunate enough to work for an employer that maintains a program through which employees are reimbursed for educational expenses, such reimbursements are tax-free up to $5,250. Eligible reimbursements cover the cost of tuition, fees, books, supplies, etc., even if such costs are not job related (except courses that relate to sports, games or hobbies). Unfortunately, reimbursements are only tax-free for employees. Reimbursements for costs associated with members of the employee’s family are not tax-free.
Scholarships and Grants
Finally, scholarships and grants are generally tax-free income to the recipient student, so long as the cash award is used for qualified tuition and related expenses such as fees, books, supplies and equipment. Awards used for room and board are taxable, as are awards that are contingent on providing a service to an educational institution such as teaching or research assistance (though athletic scholarships do qualify for tax-free treatment).
Tuition reductions to employees of education institutions are similarly excludible from income, even if the education is provided to a member of the employee’s family.
