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.
This article
focuses on explaining the education-related
changes as well as planning strategies CPAs
can discuss with their clients. As in the
past, the differing limitations, definitions
and interactions of these provisions, along
with the education benefits already in the
Internal Revenue Code, make tax planning
complicated. It is more important than ever
for CPAs to carefully analyze and evaluate
which of the education tax benefits discussed
below their clients should use in a particular
situation. |
Taxwise Saving for
College Parents and
grandparents put $10 billion in
states’ 529 college savings plans in
2001, up from $2.5 billion in 2000.
Projected contributions for 2002 are
estimated at $25 billion. | |
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.
Prepaid Tuition vs.
Savings Plans IRC section 529
permits states to establish tax-exempt qualified
tuition programs, either as prepaid tuition or
as savings plans. In a prepaid tuition plan,
participants attempt to hedge against tuition
inflation by purchasing tuition credits or
certificates on behalf of a designated
beneficiary. The credits will entitle the
beneficiary to waive payment of qualified higher
education expenses (QHEE) when the time arrives
for the beneficiary to attend college. With a
savings plan, participants contribute to an
account that is specifically established to pay
the QHEE of a designated beneficiary. The
account is generally maintained with a private
financial institution such as a bank, brokerage
firm or mutual fund company that manages it on
behalf of a particular state. |
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