Smart Education Tax Moves

EXECUTIVE SUMMARY

IN THE 2001 TAX ACT CONGRESS INCLUDED A NUMBER of expanded and improved education tax incentives. The differing limitations, definitions and interactions of these provisions with existing education benefits make it crucial for CPAs to plan carefully to ensure clients receive the maximum tax savings. CONGRESS EXPANDED QUALIFIED TUITION PROGRAMS (QTPs), adding private institutions as eligible sponsors of prepaid tuition type plans. The most important change to QTPs provides a complete tax exemption for distributions made after December 31, 2001 used to pay for qualified higher education expenses (QHEE). BEGINNING IN 2002 THE ANNUAL PER-CHILD contribution to education IRAs increases to $2,000 from $500. The act also makes these accounts more accessible to individual taxpayers by increasing the phaseout range for contributors who are married filing jointly to $190,000 to $220,000 in 2002. Taxpayers now also can make contributions to education IRAs and QTPs for the same beneficiary in the same year. UNDER THE NEW LAW ANY AMOUNT SPENT ON QHEE for which the taxpayer claims a Hope or Lifetime Learning Credit is not eligible for tax-free treatment as a QTP or education IRA distribution. Taxpayers can claim the credits in the same year they take tax-free distributions but not on the same expenses. Taxpayers must also reduce QHEE for any tax-free scholarships or employer-provided education assistance. THE EXCLUSION FROM GROSS INCOME OF UP TO $5,250 of employer-provided education assistance is now permanent. Congress extended the exclusion to include graduate-level courses. Other improved education provisions in the 2001 act include changes to the above-the-line student-loan-interest deduction and a new above-the-line deduction for higher- education expenses.

Ron West, CPA, JD, LLM, is an assistant professor of law and taxation and tax program director in the masters of taxation program at Fairleigh Dickinson University in Madison, New Jersey. His e-mail address is west@fdu.edu .

s the cost of a college education remains high, Congress continued to expand and improve education tax incentives in the Economic Growth and Tax Relief Reconciliation Act of 2001. The importance of education in the act is demonstrated by the large number of provisions, some of which provide tax breaks for savings toward future education while others help parents pay current costs. The changes automatically expire after December 31, 2010, unless Congress acts before then to renew and extend them or to amend existing provisions.

QUALIFIED STATE TUITION PROGRAMS
Congress redesignated these programs under IRC section 529 as qualified tuition programs (QTP) in order to include educational institutions (including private schools) as eligible sponsors of private prepaid tuition type plans but not savings type plans. (See box, Prepaid Tuition vs. Savings Plans .) Previously only states and state agencies were eligible sponsors. The school must obtain an IRS ruling and satisfy certain other requirements. The most important change to QTPs provides a complete exemption from gross income for distributions made after December 31, 2001 used to pay for qualified higher education expenses (QHEE). The exemption is broad and applies to accumulated earnings in existing QTPs. Under prior law, the earnings portion of distributions used for QHEE was taxed to the beneficiary. The new exclusion makes QTPs even more attractive when compared with other saving alternatives.

When cash distributions from a QTP exceed QHEE, part of the earnings must be included in gross income. A number of states already exempt from state income taxes the earnings on qualified QTP distributions. Many more states will exempt earnings because they use the federal definition of gross income as their starting point, making QTPs even more valuable.

Example. Tom makes a one-time deposit of $50,000 to a QTP account for his 4-year-old son Jonah who will begin attending college at age 18. At a tax-free 8% growth rate, the QTP balance grows to $146,860 in 14 years, of which $96,860 is accumulated earnings. Under the new law, none of the earnings is subject to federal income tax (or, possibly, state income tax) if Jonah uses the money for QHEE. Under prior law (assuming a 15% tax rate for Jonah), the federal income tax would have been $14,529.

The act eliminates a requirement that states impose a more than de minimis penalty. Instead, a 10% federal tax applies to the earnings portion of nonqualified QTP distributions included in gross income in the same manner as the penalty imposed on nonqualified education IRA distributions. Nonqualified distributions occur whenever withdrawals are used to pay for anything other than QHEE. Similarly, the same exceptions from the penalty for education IRAs apply. The account owner will need to compute and pay the penalty when filing his or her tax return.

Under existing law there is no distribution and hence no gross income inclusion, nor a penalty, where a new beneficiary on an existing account is a member of the old designated beneficiary’s family or, in the case of a rollover, the distribution to a family member is completed within 60 days. The act broadens the definition of family members to include first cousins (but not their spouses) of the original designated beneficiary. This addition can provide added flexibility where grandparents are contributors to a QTP for their grandchildren.

Example. Grandma has two daughters, Mira and Kathy. She establishes a QTP for grandson Michael, who is Mira’s son. If Michael does not attend college, Grandma can roll over the account balance tax-free to a QTP for granddaughter Ruby, who is Kathy’s daughter. Since Michael and Ruby are first cousins, the rollover does not have any tax consequences.

The new law permits tax-free rollover distribution (or transfer of credits) from one QTP for a beneficiary to another QTP for the same beneficiary, but only once in any 12-month period. For example, if a rollover for the same beneficiary occurs on July 2, 2002, another tax-free rollover for that beneficiary cannot be made before July 2, 2003. The new provision applies to rollovers from one state’s QTP to another’s, as well as to transfers between a prepaid tuition program and a savings program maintained by the same state, and between a state plan and a private prepaid tuition program. Although directing investments in a QTP is still prohibited, a by-product of the new rollover provision allows some measure of investment direction. If a QTP’s investment performance doesn’t measure up to a taxpayer’s expectations, or if other features are not satisfactory, the taxpayer can transfer monies to another state’s QTP with more desirable features or greater investment return.

Subsequently, in notice 2001-22, the IRS further relaxed the prohibition against investment direction by providing that the final QTP regulations will permit a change in investment strategy within the same QTP for any reason once per calendar year and anytime there is a change in designated beneficiary.

EDUCATION IRAs
Education IRAs have been renamed Coverdell Education Savings Accounts. The 2001 act liberalized Coverdell accounts in several ways. Beginning in 2002 the annual per-child contribution limit is quadrupled to $2,000 from $500, enabling taxpayers to accumulate more education funds. Assuming contributions begin at birth, at 6% simple interest annual contributions of $2,000 for 18 years would result in about $65,000 when the beneficiary is about to begin college, as opposed to only about $16,000 under the old $500 limit.

Although the $2,000 limit may appear small when compared with the maximum contribution to a QTP, the donor retains investment control and can apply funds toward elementary and secondary school. With the higher contribution limits, more financial institutions are likely to offer education IRAs, making these accounts more accessible to clients.

The act raises the previous phaseout ranges, making these accounts accessible to more individual taxpayers. For example, the old $150,000 to $160,000 modified AGI for joint filers increased to $190,000 to $220,000 for 2002. This new range is double that for single filers and is intended to reduce the effect of the marriage penalty. A new provision allows entities such as corporations and tax-exempt organizations and trusts to contribute to education IRAs without regard to income limitations. CPAs should recommend that clients subject to the phaseout consider having a relative, child or entity make the contribution.

Special needs beneficiary. Two ongoing age-based limitations don’t apply to a special needs beneficiary (SNB). Contributions need not terminate when the SNB reaches age 18. Also, distributions or rollovers for an SNB’s benefit can continue after he or she reaches age 30. An IRA will not be deemed distributed when the SNB reaches age 30. The definition of QHEE has expanded to include necessary expenses of SNBs in connection with enrollment or attendance at an eligible institution. SNBs will be further defined in future regulations. The term is intended to include people who, because of physical, mental or emotional condition (including learning disability), require additional time to complete their education.

The deadline for making contributions is no longer December 31. Instead, contributions can be made until the return due date; April 15 (without extensions). For example, contributions for 2002 can be made until April 15, 2003. The deadline to return excess contributions and earnings thereon is extended to May 31 of the following year, rather than the beneficiary’s return due date (including extensions), without incurring the 6% excise tax on excess contributions or the 10% penalty on the earning portion.

ALLOWED EDUCATION EXPENSES
For both QTPs and education IRAs, QHEE includes tuition, fees, books, supplies and equipment required for enrollment or attendance and the reasonable cost of room and board for any period during which the student is attending at least half-time. The act eliminates the low dollar allowance for room and board under prior law. The room and board allowance now more closely reflects the current higher cost of housing at eligible institutions that is provided in the updated Higher Education Act (HEA). Moreover, for students living on campus, actual cost incurred, if higher, is allowed under the new law.

The maximum tax-free room-and-board distribution is the allowance amount provided in the HEA as of June 7, 2001. For students living at home with parents, the allowance is determined by the educational institution; for students residing in housing owned or operated by the institution, the school determines the standard allowance based on amounts normally charged most of its residents for room and board. For all other students, the allowance is based on the expenses reasonably incurred for room and board.

For education IRAs only, the act establishes a new expense category. In addition to covering QHEE, these accounts now also cover elementary (including kindergarten) and secondary public, private and religious school expenses plus school-related costs. Among them are tuition, fees, books, supplies, tutoring, computer equipment, software and services, room and board, transportation, uniforms and extended-day-program costs. Also covered are computer technology or equipment (including software) and Internet access and services for the beneficiary and his or her family during the school year. When funds from other sources are available to pay precollege expenses, CPAs may want to recommend that clients not access an education IRA until as late as possible in college to permit greater tax-free accumulation.

Education IRA and QTP contributions in same year. Prior law did not permit contributions to an education IRA for a beneficiary in the same year anyone contributed to a QTP for the same beneficiary. A 6% excise tax applied. The new law repeals the excise tax, effectively allowing contributions to both accounts in the same year for the same beneficiary. Repeal of the excise tax eliminates a trap for many families whose various members wish to fund both types of programs for the same beneficiary and may not be aware of what others are contributing. The repeal also assumes added relevance in view of the enhanced utility of education IRAs with higher contribution limits and the expanded coverage for elementary and secondary education expenses. To save substantial sums, families may want to take advantage of both provisions. Those able to set aside amounts in excess of $2,000 might want to first fully fund an education IRA if control over investments is a priority.

HOPE AND LIFETIME LEARNING CREDITS
Under the new law, any amount spent on QHEE for which the taxpayer claims an educational credit is not eligible for tax-free treatment from either a QTP or an education IRA. Taxpayers can claim education credits in the same year they take tax-free distributions from a QTP, or from an education IRA, but not for the same expenses. With careful planning, CPAs can help clients maximize the tax benefits by paying for QHEE with a combination of tax-free QTP or education IRA distributions and funds from other sources.

Coordinating QTPs and education IRAs with education credits. To prevent multiple tax benefits, the new law provides rules to coordinate education credits, nontaxable scholarships and education IRA and QTP distributions that may occur in the same year. Generally, the same expense cannot serve as the basis for multiple tax benefits, such as a deduction, exclusion or credit. More specifically, taxpayers must reduce the amount of QHEE that would otherwise be eligible for nontaxable treatment. The first reduction is for scholarships and fellowships excludible from gross income under IRC section 117 and any other tax-free education benefits, such as employer-provided education assistance. Taxpayers also must reduce QHEE by amounts taken into account in determining the Hope or Lifetime Learning Credits. Thus, amounts paid for QHEE in any one year are eligible for either the Hope or Lifetime Learning Credits, or for nontaxable treatment as QTP or education IRA distributions, but not both.

Example. Mary attends an eligible educational institution where annual tuition is $10,000. Her QTP account balance is $8,000, consisting of $6,000 in contributions and $2,000 of accumulated earnings. Mary receives a $5,000 nontaxable scholarship. If she or her parents claim the maximum $1,500 Hope credit for $2,000 of QHEE, then only $3,000 qualifies for tax-free treatment as a QTP or education IRA distribution ($10,000 tuition less $5,000 scholarship less $2,000 that qualifies for Hope credit).

Under the new law, the Hope and Lifetime Learning credits are generally waivable. This might make sense where the source of payment supporting the credit is a QTP distribution and the credit’s value is less than the tax and penalty that would apply to the earnings portion of the distribution that no longer qualifies as tax-free.

When the combined distributions from a QTP and an education IRA for the year exceed QHEE, the taxpayer will have to allocate the expenses among the respective distributions. The law requires an allocation to determine the exclusion amount applicable to the QTP and the education IRA distributions. Although the new law does not prescribe an allocation method, a pro rata allocation should be acceptable.

Example. Continuing the prior example, assume Mary’s family takes a $3,000 QTP distribution and $2,000 from an education IRA. Since the combined distributions of $5,000 exceed the remaining $3,000 of QHEE, the law requires an allocation. Based on a pro rata allocation, $1,800 of QHEE apply to the QTP and $1,200 to the education IRA. Since the $3,000 QTP distribution exceeds the $1,800 allocated to the account, $1,200 of the distribution is not tax-free and some portion of the QTP’s accumulated earnings is includable in gross income. Similarly, some portion of the excess IRA distributions is included in gross income. When the combined QTP and education IRA distributions do not exceed the reduced QHEE for the year, the entire amount is tax-free.

EMPLOYER-PROVIDED EDUCATION ASSISTANCE
The exclusion from gross income of up to $5,250 a year for employer-provided education assistance, scheduled to expire on December 31, 2001, is now permanent. Moreover, the exclusion is extended to graduate-level courses, in addition to undergraduate courses. Making the exclusion permanent is likely to result in more employers adding this benefit to their menu of fringe benefits. Also, more employees will be able to pursue courses that lead to advanced degrees, such as law, medicine or MBAs. Employer-paid education assistance in excess of $5,250 may still be excludable as a tax-free working condition fringe benefit if the education maintains or improves job skills.

OTHER EDUCATION PROVISIONS
The 2001 act included several other tax-saving provisions related to education that CPAs should understand.

Above-the-line student-loan-interest deduction. The act repealed the rule that limited interest deductions to the first 60 months of required interest payments. Interest paid over any period of time on qualifying loans is now deductible. This will benefit students with loan terms longer than five years. Also, the act eliminated the rule that prevented a deduction for voluntary interest payments. The deduction now applies to voluntary payments such as interest-only payments. The new law did not change the annual deduction limit, which remains at $2,500. To broaden eligibility to include more taxpayers, the phaseout ranges were increased to modified AGI of $50,000 to $60,000 for singles and to $100,000 to $130,000 for joint filers. This will help students earning higher starting wages in fields such as law or medicine to benefit from the deduction.

Above-the-line deduction for higher-education expenses. Through 2005, certain eligible taxpayers will be able to claim a new limited above-the-line deduction for QHEE paid during the year (even if they don’t itemize). The maximum deduction is $3,000 for 2002 and 2003, rising to $4,000 for 2004 and 2005. To be eligible for the maximum deduction, modified AGI cannot exceed $130,000 for married taxpayers filing jointly and $65,000 for singles or heads of household. Married taxpayers filing separately and those who can be claimed as another taxpayer’s dependent are ineligible for any deduction. A lower deductible ceiling of $2,000 applies in 2004 and 2005 for taxpayers whose modified AGI is between $130,001 and $160,000 for married filing jointly and between $65,001 and $80,000 for singles and heads of households. The deduction is not subject to any phaseout.

No deduction is available at all if the taxpayer claims the Hope or Lifetime Learning Credits in the same year for the same student. CPAs will need to help taxpayers compare whether deducting expenses or claiming the credits will result in greater tax savings. Since the AGI limits on the deduction are higher than for the credits, some taxpayers may be eligible only for the deduction. Eligible expenses are the same ones that qualify for the education credits. To avoid duplication of tax benefits, the tuition deduction is reduced when the family takes nontaxable distributions from a QTP or education IRA, claims an interest exclusion on education savings bonds under IRC section 135 or receives certain scholarships.

NHS and armed forces scholarships. Generally, the exclusion for qualified scholarships does not extend to any amounts that represent payments for teaching, research or other services that are required as a condition for receiving the scholarship. The new law carves out exceptions for certain scholarships related to the health profession. Amounts awarded under the National Health Service Corps Scholarship Program and the Armed Forces Health Professions Scholarship and Financial Assistance Program are tax-free—even if a service obligation attaches to the scholarship. As with other qualified scholarships, the exclusion does not apply to any amount received for regular living expenses, including room and board.

MAKING COLLEGE MORE AFFORDABLE
As higher education costs continue to rise, Congress is doing its best to provide increased tax benefits of all kinds—deductions, credits, savings incentives—to make it easier for American families to afford these expenses. As the list grows, CPAs need to help clients plan carefully to make sure they get the maximum possible benefit. For some families the tax breaks may be the difference between being able to afford to send a child to the school of his or her choice.