Click on any of the topics in the Table of Contents listed below to go directly to that discussion.
home | reference library | e-mail

TABLE OF CONTENTS

Education Credits
Education IRAs
Withdrawals from Traditional and Roth IRAs 
Student Loans
Education Savings Bonds
Qualified State Tuition Programs
Employer-Provided Education Assistance
INFOSOURCES

Many tax benefits are available to help you pay higher education costs, whether for your children or yourself. This Financial Guide discusses the following tax benefits for education costs:

• Two new education tax credits;
• Education IRAs;
• Withdrawals from traditional and Roth IRAs to pay education costs;
• Deducting interest paid on student loans and excluding income on the cancellation of such loans:
• The exclusion for interest earned on certain U.S. savings bonds;
• Tax relief for qualified state tuition programs; and
• The exclusion for employer-provided educational assistance.

The eligibility rules vary for each tax benefit, with many limited to taxpayers whose income falls below certain levels.

EDUCATION CREDITS

Two tax credits are available for education costs--the Hope credit and the lifetime-learning credit. These credits are available only to taxpayers whose joint adjusted gross income does not exceed about $100,000 for a joint return and $50,000 on other returns.

How These Credits Work 

The amount of the credit you can claim depends on (1) how much you pay for qualified tuition and other expenses for students and (2) your adjusted gross income (AGI) for the year.

You must report the eligible student’s name and Social Security number on your return to claim the credit. You subtract the credits from your federal income tax. If the credit reduces your tax below zero, you cannot receive the excess as a refund. If you receive a refund of education costs for which you claimed a credit in a later year, you may have to repay ("recapture") the credit.

Which costs are eligible. Qualifying tuition expenses mean tuition and fees required for enrollment or attendance at an eligible education institution. They do not include books, room and board, student activities, athletics (other than courses that are part of a degree program), insurance, equipment, transportation, or any personal, living, or family expenses.  For expenses paid with borrowed funds, count the expenses when they are paid, not when borrowings are repaid. 

TIP: If you pay qualified expenses for a school semester that begins in the first three months of the following year, you can use the prepaid amount in figuring your credit. (However, you cannot use any amounts you paid in 1997 to figure the credit.)

Example: You pay $1,500 of tuition in December 1998 for the winter 1999 semester, which begins in January 1999. You can use the $1,500 in figuring your credit.  If you paid in January instead, you would take the credit on your 1999 return.

TIP: As future year-end tax planning, this rule gives you a choice of the year to take the credit for academic periods beginning in the first 3 months of the year; Pay by December and take the credit this year; pay in January or later and take the credit next year.

Eligible students. You, your spouse, or an eligible dependent (someone for whom you can claim a dependency exemption, including children under age 24 who are full-time students) can be an eligible student for whom the credit can apply. If you claim the student as a dependent, qualifying expenses paid by the student are treated as paid by you, and for your credit purposes are added to expenses you paid.  A person claimed as another's dependent can't claim the credit.  The student must be enrolled at an eligible education institution (any accredited public, non-profit, or private post-secondary institution eligible to participate in student Department of Education aid programs) for at least one academic period (semester, trimester, etc.) during the year.

No "double-dipping." The tax law says that you can't claim both a credit and a deduction for the same higher education costs. It also says that if you pay education costs with a tax-free scholarship, Pell grant, or employer-provided educational assistance, you cannot claim a credit for those amounts.

Income phase-outs. Your education credits are gradually phased out if your modified AGI is between $40,000 and $50,000 ($80,000 and $100,000 for joint returns). Once your modified AGI reaches the top limit of these ranges, you cannot claim any education credit. "Modified AGI" generally means your adjusted gross income. The "modifications" only come into play if you have income earned abroad.

The Hope Credit

For amounts paid for semesters starting after 1997, you may be able to claim up to $1,500 of the Hope credit. You can claim the Hope credit for each eligible student you have for which the Hope credit requirements are met. The credit can be claimed for only two years per eligible student.

Special qualification rules. In addition to being an eligible student, he or she  following must apply:

• Must be a freshman or sophomore;
• Must be enrolled in a program leading to a degree, certificate, or other recognized credential;
• Must be taking at least half of a normal full-time load of courses, for at least one semester or trimester beginning in the year for which the credit is claimed; and
• May not have any drug-related felony convictions.

Amount of credit. The amount of the Hope credit is 100% of the first $1,000 plus 50% of the next $1,000 you pay for each eligible student. The maximum you can claim is $1,500 times the number of eligible students. Thus, you will benefit from the maximum $1,500 amount for each eligible student for whom you pay at least $2,000. Remember, however, that the credit may be reduced based on your AGI.

The Lifetime Learning Credit 

You may be able to claim a Lifetime Learning credit of up to $1,000 (20% of the first $5,000 of qualified expense) for eligible students (subject to reduction based on your AGIs). The eligibility rules for the Lifetime Learning credit are broader than those that apply to the Hope credit:

• Unlike the Hope credit, students need not be in the first two years of undergraduate education; all undergraduate and graduate programs qualify. 
• Further, for courses taken to acquire or improve job skills, there are no requirements as to course loads, so that even one or two courses can qualify.
• The number of years for which this credit can be claimed is not limited.

TIP: Use the Hope credit during any year for which you are eligible (the first two years of your child’s college education), since it is more valuable.

Choosing the credit

You can't claim both credits for the same person in the same year.  But you can claim one credit for one or more family members and the other credit for expenses for one or more others in the same year--for example, a Hope credit for your child and a lifetime learning credit for yourself.  Your choice may require careful figuring where exclusions or deductions are also available since, depending on circumstances and amounts involved, one type of relief is more valuable than others. 

EDUCATION IRAs

Beginning in 1998, you can contribute up to $500 each year to an education IRA for a child under 18. These contributions are not deductible, but they grow tax-free until withdrawn.

Only cash can be contributed to an education IRA. You cannot contribute to the IRA after the child reaches his or her 18th birthday.

Anyone can establish and contribute to an educational IRA, including the child, as long as the contributor’s modified AGI doesn’t exceed $160,000 for a joint return or $110,000 for a single filer. You may establish education IRAs for as many children as you wish, and the child need not be a dependent -- in fact, he or she need not be related to you. But the amount contributed during the year to each education IRA cannot exceed $500. This $500 maximum contribution amount for each child is phased out for AGI between $150,000 and $160,000 (joint) and $95,000 and $110,000 (single).

Note: A 6% excise tax applies to excess contributions.  These are amounts in excess of the contribution limit ($500 or lower phase out amount) and contributions for a year that amounts are contributed to a qualified state tuition program for the same child.  The 6% tax continues for each year the excess contribution stays in the education IRA.

The child must be named (designated as beneficiary) in the IRA document, but the beneficiary can be changed to another family member (for example, to a sibling where the first beneficiary gets a scholarship or drops out).  And funds can be rolled over tax-free from one child's IRA to another's.  Funds must be distributed not later than 30 days after the beneficiary's 30th birthday (or 20 days after the beneficiary's death if earlier).

When withdrawals are made, as long as the amount withdrawn doesn’t exceed a child’s "qualified higher education expenses" for that year, the child won’t owe any tax on the withdrawal. The definition of "qualified higher education expenses" is broader than the term that applies to the education credits--e.g. it also includes room and board and books. If the amount withdrawn for the year exceeds the education expenses for the year, the excess is partly taxable under a complex formula.

TIP: The child may waive tax-free treatment for which he or she would otherwise qualify in order to allow the parents to claim an education credit.  Waiver is often wise because a credit is often worth more than an exclusion.  For example, waiving an exclusion for $4,000 costs $600 in a child's 15% tax bracket wile a Hope credit can save $1,500 of tax for the parent.

Withdrawals from Traditional and Roth IRAs

Beginning in 1998, you can withdraw from a traditional or Roth IRA (though not an education IRA or SIMPLE IRA) to pay qualified higher education expenses without having to pay the additional 10% tax on early withdrawals (which would otherwise apply to a withdrawal before age 59-1/2).  With a traditional IRA you will owe income tax on at least part of the withdrawal; since Roth IRA investments are already tax-paid, withdrawals are less likely to be taxable. 

To escape the 10% tax, you must pay education costs that at least equal your withdrawal amount. The education costs must be "qualified,"--i.e. for tuition, fees, books, room and board, supplies, or equipment at a qualified institution of learning--and they must be for yourself, your spouse, or the children or grandchildren or yourself or your spouse. The qualified institution of learning may be any college, university, vocational school, or other post-secondary school that is eligible to participate in federal Department of Education aid programs.

TIP: You do not actually have to use the IRA funds to pay education costs. You can pay the costs with your own earnings or savings, with a loan, or with a gift or inheritance received by the student or the person making the withdrawal. You can use savings from a qualified state tuition program.

However, you cannot count education costs paid with proceeds from the following in determining whether your IRA withdrawal is to be free of the 10% tax:

• Tax-free distributions from an education IRA;
• Tax-free scholarships, such as a Pell grant;
• Tax-free employer education assistance program;
• Any tax-free payment (other than a gift or bequest) that is due to enrollment at the qualified institution.

STUDENT LOANS

You may be able to deduct interest on student loans, as long as the loan interest is due and paid after 1997. You may also be able to exclude income that you would otherwise have to report if a student loan is cancelled.

Interest Deduction

The student-loan interest deduction is available only for interest paid during the first 60 months that interest payments are required on the loan. You must count months before 1998 when interest was due, but do not count months when you don’t have to make payments because your loan is deferred.

Deduction is allowed even though it would otherwise be nondeductible personal interest.  But you may deduct only if you are the one legally bound to pay the interest, and only on loans solely for qualified expenses (so not under open credit lines).

The student-loan deduction is available only to taxpayers whose AGI is below $75,000 (joint amount) or $55,000 (single amount). Married couples filing separately can't deduct.  The deduction is phased out for those whose AGI is above $40,000 (single amount) or $60,000 (joint amount). The student-loan interest deduction is an "above the line" deduction--you don’t have to itemize to claim it.  The loan must have been taken out to cover education expenses of at least half-time study for yourself, your spouse, or a person who was your dependent when you took out the loan. The maximum deduction is $1,500 for 1999, $2,000 for 2000, and $2,500 for 2001 and later years.

TIP: Where interest fails to qualify under these tests, consider a home equity loan, interest on which is generally deductible.

Cancellation of Student Loan

If certain requirements are met, cancellations of student loans that are intended to induce students to perform certain services do not increase the student’s gross income.  This relief extends to certain private programs, as well as government and public programs. 

EDUCATION SAVINGS BONDS

You can exclude from your gross income interest on qualified U.S. savings bonds if you have qualified higher education expenses during the year in which you redeem the bonds. 

A qualified U.S. savings bond means a Series EE bond issued after 1989. The bond must be either in your name or in the names of both you and your spouse, and you must be at least 24 years old before the bond’s issue date.

QUALIFIED STATE TUITION PROGRAMS

Many states have programs allowing persons to prepay for future higher education, with tax relief. In fact, 43 states had such programs as year 2000 began, with many variations among them. There are two basic plan types:

1. The prepaid education arrangement. Here one is essentially buying future education at today's costs, by buying education credits or certificates. This is the older type of program, and tends to limit the student's choice to schools within the state.
   
   
2. Education savings accounts. Here, contributions are made to an account to be used for future higher education. Here, neither the student nor the contributor need be resident in the state, nor need the school be in the state.
   
   In approaching state programs one must distinguish between what the federal tax law allows and what an individual state's program may impose.
   
   Unlike other tax-favored higher education programs, such as the Hope and lifetime learning tax credits, federal tax law doesn't limit the benefit to tuition, but can also extend it to room, board, books, etc. (Individual state programs could be narrower.)
   
   The two key individual parties to the program are designated beneficiary, the student-to-be, and the account owner, who is entitled to choose and change the beneficiary and who is normally the principal contributor to the program. There's only one designated beneficiary per account. Thus, a parent with three college-bound children might set up 3 accounts.
   
   Contributions must be in cash, and must not total more than reasonably needed for higher education (as determined initially by the state). Neither account owner nor beneficiary may direct investments, but the state may allow the owner to select a type of investment fund (e.g., fixed income securities). The account owner decides who gets the funds (can pick and change the beneficiary) and is legally allowed to withdraw funds at any time, subject to tax and penalty discussed later.
   
   Funds in the account not yet distributed at the account owner's death pass as part of the probate estate under state law-though this is not the result for federal estate tax purposes, see below.
   
   Federal tax rules. Income tax. Contributions made by the account owner or other contributor are not deductible for federal income tax purposes. Earnings on contributions grow tax-free while in the program.
   
   Distributions from the fund to the designated beneficiary for qualified education are taxed to the beneficiary (the student)-almost always at a lower rate than that applicable to the account owner. The taxable amount of the distribution is that portion which represents earnings.
   
   Distribution for a purpose other than qualified education (apparently even if distributed to the designated beneficiary) is taxed to the account owner. In addition, a penalty must be imposed on the distribution unless made because of the beneficiary's death or disability, or because the beneficiary received a scholarship or the equivalent and the distribution doesn't exceed that amount. The penalty, normally 10% or more of earnings, is determined by the state and goes to the state's program, not to the U.S.
   
   The account owner may change beneficiary designation from one to another in the same family. Funds in the account roll over tax-free for the benefit of the new beneficiary.
   
   Gift tax. For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them. Thus they qualify for the up-to-$10,000 annual gift tax exclusion. One contributing more than $10,000 may elect to treat the gift as made in equal installments over the year of gift and the following 4 years-so that up to $50,000 can be given tax-free in the first year.
   
   A rollover from one beneficiary to another in a younger generation is treated as a gift from the first beneficiary-an odd result for an act the "giver" may have had nothing to do with.
   
   Estate tax. Funds in the account at the designated beneficiary's death are included in the beneficiary's estate-another odd result, since those funds may not be available to pay the tax. Funds in the account at the account owner's death are not included in the owner's estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $10,000.
   
   State tax. State tax rules are all over the map. Some allow deduction for some of the account owner's contribution, some allow tax relief on distributions for qualified education, with some the tax treatment turns on the taxpayer's residence or the school's location.
   
   For more on state programs: For specifics of each state's program, see http://www.collegesavings.org.
   
   Professional guidance: Considering the wide differences among state plans, the federal and state tax issues, and the dollar amounts at stake, professional guidance is advised.
   
   

EMPLOYER-PROVIDED EDUCATION ASSISTANCE

If your employer paid education assistance benefits (e.g., reimbursements of tuition), part or all of them may be tax-free. You can exclude up to $5,250 per year of the benefits you receive under a qualified education assistance program. But you can't both exclude and deduct the same item, even if it's otherwise deductible. In order to qualify your employer must have established and educational assistance plan which does not discriminate in favor of highly paid employees or owners. The exclusion applies to undergraduate level courses other than those involving sports, game and hobbies. The courses do not need to relate to your job. The exclusion is available for tuition, fees, books and supplies but not meals, lodging or transportation. However, it does not apply to benefits for graduate level courses that began after June 30, 1996.

In addition to the exclusion for qualifying education plans, you employer can provide reimbursement for business related courses, including graduate courses. If your employer does not reimburse you for these expenses, you may be entitled to deduct them as a miscellaneous itemized deduction subject to the 2% deduction floor. To qualify, the expense must meet the requirement of your employer or the law or maintain or improve skills in your current job. The course must not meet minimum education requirements for your job or qualify you for a new trade or business.

BACK TO TOP

Related FGs

• SELLING YOUR HOME: How To Minimize The Tax On The Gain

• ANNUITIES: How They Work And When You Should Use Them

• ROTH IRAs: How they Work And How To Use Them

• RETIREMENT PLAN DISTRIBUTIONS: HOW To Take Them

• RETIREMENT PLAN DISTRIBUTIONS: WHEN To Take Them

• MUTUAL FUND TAXATION: How To Cut The Tax Bite

• RECORDKEEPING AND CASH FLOW: Effective Techniques

External Sites

Because tax planning is so specific to a taxpayer's needs and situation, External Sites—which are, of  necessity, general in their scope and application—-can be misleading.  Accordingly, professional guidance should be sought for your particular tax planning needs.

Books And Other Publications

• Kalman A. Chany and Geoffrey Martz, The Student Access Guide to Paying for College, (Villard Books, 1998), ISBN 0679764690.
• Patrick L. Bellantoni, College Financial Aid Made Easy, (Ten Speed Press, 1998), ISBN 0898158818.
• Don’t Miss Out: The Ambitious Student’s Guide to Financial Aid, Octameron Associates. Tel: 703-836-5480. (Octameron has other titles relating to college admissions and financing available.)
• "Educational Assistance Programs: A Re-examination in the Wake of the Small Business Job Protection Act," by Shirlee Dennis-Escoffier and Lawrence C. Phillips, TAXES, (September 1996), pp. 523-533.
  

BACK TO TOP