The Hope Scholarship Credit can only be claimed for amounts spent on qualified tuition and related fees required for enrollment at an eligible institution. Amounts paid for any course or other education involving sports, games, or hobbies are not eligible for the credit unless part of the degree program. Charges and fees associated with room, board, student activities, athletics, insurance, books, equipment, transportation, and similar personal, living, or family expenses are not qualified tuition or related expenses.

The Hope Scholarship Credit, applied on a per student basis, equals 100% of the first $1,000 and 50% of the next $1,000 of the student’s qualified expenses. The maximum credit for a taxable year is $1,500 per each student in the family that meets the eligibility criteria. Taxpayers must have a modified adjusted gross income (AGI) of less than $40,000 to take advantage of the maximum credit ($50,000 for married taxpayers filing jointly). Modified AGI is generally the taxpayer’s AGI from all sources (other than Social Security) plus the foreign earned income exclusion and any tax-exempt interest income. The credit is phased out between $40,000 and $50,000 for single taxpayers ($80,000 and $100,000 for married taxpayers filing jointly).

For example, assume a married couple with modified AGI of $92,000 has one child who is a full-time college freshman. The maximum available credit of $1,500 must be reduced because their modified AGI exceeds the $80,000 limit for married filing jointly. The percentage reduction is computed as the amount by which modified AGI exceeds the limit, expressed as a percentage of the phase-out range [($92,000 – $80,000) / $20,000], here 60%. Therefore, the maximum available credit is $600 ($1,500 ¥ 40% allowable portion).

Lifetime Learning Credit

The Lifetime Learning Credit is also governed by IRC section 25A and allows for a nonrefundable tax credit of up to $1,000 for total qualified tuition and related expenses paid during the tax year for students enrolled in eligible educational institutions. Unlike the Hope Scholarship Credit, the Lifetime Learning Credit—

The amount of the Lifetime Learning Credit is 20% of the first $5,000 a taxpayer pays for qualified tuition and related expenses for all students in the family. This credit is phased out exactly like the Hope Scholarship Credit.

Interest Deduction for Student Loans

Beginning in 1998, qualified education loan interest can be claimed as an adjustment to gross income; taxpayers that do not itemize can still take this deduction. Interest on loans taken out to pay the cost of attending an eligible educational institution for themselves, their spouse, or a dependent is generally deductible. The maximum deduction for each taxpayer is $1,000 in 1998, $1,500 in 1999, $2,000 in 2000, and $2,500 in 2001 and thereafter. The deduction applies to interest payments made during the first 60 months that payments are required on the loan and only for interest payments due and made on or after January 1, 1998. Taxpayers that were eligible for the deduction for 1998 or 1999 but failed to claim it can file an amended return.

In order for the interest to be deductible, the loan proceeds must be used to pay the costs of attending an eligible educational institution and the student must be enrolled in a program leading to a degree, certificate, or other recognized educational credential. In addition, the deduction is allowed for a year only if the individual is an eligible student (carrying at least one-half the normal full-time load for the course of study) for at least one academic period beginning during such year. For purposes of the student loan interest deduction, eligible educational institutions also include institutions that conduct an internship or residency program leading to a degree or certificate awarded by an institution of higher education, a hospital, or a health care facility that offers postgraduate training.

The costs of attendance encompass more than those covered under qualified tuition and related expenses for purposes of the Hope Scholarship and Lifetime Learning Credits: all the costs of attendance for purposes of calculating a student’s financial need in accordance with the Higher Education Act, including tuition, fees, room, board, books, equipment, and other necessary expenses, such as transportation.

To claim the maximum deduction, a taxpayer must have modified AGI of $40,000 or less ($60,000 for married taxpayers filing jointly). The deduction is completely phased out at $55,000 for a single taxpayer and $75,000 for married taxpayers filing jointly. The deduction is reduced by the extent to which modified AGI exceeds $40,000 ($60,000 for married taxpayers filing jointly), as a percentage of the $15,000 phase-out range. For example, a single taxpayer with modified AGI of $43,000 paid $1,800 in qualified education loan interest in 1999. The $1,500 maximum deduction must be reduced by the amount that modified AGI exceeds the limit, expressed as a percentage of the phase-out range [($43,000 – $40,000) / $15,000], or 20%, making the available deduction $1,200 (80% of $1,500).

Education IRAs

Education IRAs, which are governed by IRC section 530, are trusts or custodial accounts created exclusively for paying the qualified higher education expenses of a named beneficiary. As of January 1, 1998, taxpayers may deposit up to $500 cash per year into an Education IRA. Parents, grandparents, other family members, friends, and even the child may contribute to the account; however, the total contributions for the child during the taxable year cannot exceed the $500 limit. Annual contributions of more than $500 are subject to a 6% excess contribution penalty. Contributions may be made until the date the beneficiary turns 18. The $500 maximum per child contribution is gradually reduced by the extent to which the contributor’s modified AGI exceeds $95,000 ($150,000 for married taxpayers filing jointly), as a percentage of the phase-out range ($95,000 – $110,000 for an individual filer, $150,000 – $160,000 for married taxpayers filing jointly). For example, married taxpayers filing jointly with a modified AGI of $154,000 are contributing to an Education IRA. The percentage reduction, expressed as a percentage of the phase-out range [($154,000 – $150,000) / $10,000], results in a 40% reduction, making the maximum allowable contribution $300.

Although the contributions are not deductible, amounts deposited in the account grow tax-free until distributed and are excludable from the gross income of the beneficiary to the extent that the distribution is used to pay qualified higher education expenses.

Qualified higher education expenses are defined more broadly for Education IRA purposes than for purposes of other higher education plans. For Education IRAs, qualified education expenses include tuition, fees, books, supplies, and equipment for graduate or undergraduate courses. Room and board also qualify if the beneficiary is at least a half-time student at an eligible educational institution. However, the qualified expenses must be reduced by any scholarship or other payment, other than a gift or inheritance, that is excluded from gross income by any provision in the IRC.

If the total withdrawals for a tax year are more than the qualified higher education expenses, that excess portion is taxable to the beneficiary and subject to an additional 10% tax unless an exception applies. This income inclusion and penalty can be avoided if the excess amount is contributed or rolled over to an Education IRA benefiting another family member under age 30.

Qualified State Tuition Programs

Under IRC section 529, a state can create and maintain a qualified state tuition program (QSTP) through which a person may either prepay tuition benefits on behalf of a beneficiary so that the beneficiary is entitled to a waiver or a payment of qualified higher education expenses or contribute to an account that is established for paying qualified higher education expenses of the beneficiary. The definition of qualified higher education expenses is the same as that for Education IRAs.

The difference between the amount contributed to the fund and the amount used to pay qualified higher education expenses is included in the gross income of the student (not the parent) using an annuity-type calculation to distinguish between contributions and income. Taxable distributions are reported to the student on Form 1099G and are included on line 21 of the student’s Form 1040. Therefore, there are no tax consequences to the parent if the amount contributed is used for qualified higher education expenses. Generally, if the child does not attend college, the parents are refunded their payments plus interest, which the parents will have to include in their gross income.

As required under IRC section 529, contributions to a QSTP must be made in cash, and neither the contributor nor the beneficiary can direct the amounts invested. Like Educational IRAs, QSTPs allow rollovers or changes of beneficiary to be made only between members of the same family. Any refund of earnings not used for qualified higher educational expenses of the beneficiary must be penalized by the QSTP; therefore, the tax code does not discuss the penalty. A penalty is not required, however, if the refund is made because of the death or disability of the beneficiary or if the refund is made because the beneficiary received (and the refund is not more than) a scholarship, a veteran’s educational assistance allowance, or other nontaxable payment (other than a gift, bequest, or inheritance) for educational expenses.

States, brokerage firms, and other institutions offer various section 529 programs. Information on state programs can be obtained from the College Savings Plan Network,

c/o National Association of State Treasurers,
2760 Research Park Drive,
PO Box 11910, Lexington, KY 40578-1910 or
www.collegesavings.org.

Educational Savings Bonds

Another higher education incentive is provided under IRC section 135: the interest income exclusion on educational savings bonds, which comprise qualified U.S. series EE bonds issued after 1989 or qualified U.S. series I bonds. The interest on series EE U.S. government savings bonds may be excluded from gross income if the bond proceeds are used to pay qualified higher education expenses. The bond must be issued either in the name of the taxpayer as the sole owner or, in the case of married taxpayers filing jointly, the bond must be issued in both spouses’ names (as co-owners; the exclusion is not available for married taxpayers filing separately). In addition, the bond owner must be at least 24 years old before the bond issue date.

To be excludable, the bond’s redemption proceeds must be used to pay qualified higher education expenses for the taxpayer, the taxpayer’s spouse, or a dependent the taxpayer claims as an exemption. These qualified higher education expenses include tuition and fees to an eligible educational institution, contributions to a qualified state tuition program, and contributions to an Education IRA. Expenses for room and board or for courses involving sports, games, or hobbies not part of a degree program do not qualify. Qualified higher education expenses must be reduced by any tax-free scholarships, tax-free withdrawals from an Education IRA, expenses used in calculating the Hope and Lifetime Learning Credits, and nontaxable payments (other than gifts, bequests, or inheritances) received for attending an eligible educational institution. These nontaxable payments include veterans’ educational assistance benefits, benefits under a qualified state tuition program, and tax-free employer-provided educational assistance.

If the total proceeds (interest and principal) from the qualified U.S. savings bonds redeemed during the year are equal to or less than the taxpayer’s qualified higher educational expenses, all of the interest can be excluded. If the proceeds exceed the expenses, the taxpayer can exclude only part of the interest, determined by multiplying the interest earned by the qualified expenses paid during the year and divided by the total proceeds received during the year. In addition, the interest exclusion is phased out if the taxpayer’s modified AGI is between $53,100 and $68,100 (between $79,650 and $109,650 for joint returns) for 1999; these amounts are indexed and are adjusted annually. Form 8815 is used to compute the exclusion, which is reported on Schedule B (Form 1040) or Schedule 1 (Form 1040A) and reduces taxable interest.

Comparison of phase-out levels. Taxpayers should consider the phase-out levels of each plan when deciding which to use. The Exhibit summarizes the various phase-out levels.

Restrictions on Using Plans Together

Several restrictions apply when a taxpayer attempts to use more than one plan simultaneously. First, no contribution may be made to an Education IRA in the same year that contributions are made to a section 529 QSTP on behalf of the same beneficiary. In addition, the Hope Scholarship and Lifetime Learning Credits cannot be claimed in the same tax year in which a student receives a tax-free withdrawal from an Education IRA. If a taxpayer waives the Education IRA income exclusion under IRC section 530(d)(2)(C), however, the education expenses qualify for the credits. Finally, if qualified higher education expenses are used in determining the Hope Scholarship and Lifetime Learning Credit or the exclusion for distributions from an Education IRA, these expenses cannot be used to calculate the interest exclusion from U.S. Savings Bonds on Form 8815. Because there is no income exclusion, distributions from qualified state tuition programs do not impact the use of education credits or other benefits. Likewise, distributions from Education IRAs and proceeds from eligible U.S. Savings Bonds can be contributed to state tuition programs tax-free.

Effects on Student Financial Assistance

Student financial assistance is based on a student’s financial need and uses family income, line 74 of the free application for federal student aid (FAFSA), as part of the basis for calculating that need. Since income taxes reduce the income used to determine a family’s need, a reduction of income taxes resulting from higher education tax provisions will decrease the family’s need and possibly financial assistance. For example, when a family takes advantage of the Hope Scholarship or Lifetime Learning Credit, the family’s expected contribution for the following school year (under the federal formula) is increased by 47% of the claimed credit if the family’s adjusted available income is greater than $21,201. If the adjusted available income is less than $21,201, the expected family contribution is increased by a lesser amount. If the student claims either the Hope Scholarship or Lifetime Learning Credit and has income of more than $2,200, the family’s expected contribution for the following year will be increased by 50% of the claimed credit.

A withdrawal from an Education IRA is treated as income for the purposes of calculating a student’s financial need. Under the federal formula, a withdrawal by a parent is likely to decrease the student’s need-based assistance by 47% of the amount withdrawn. However, the deduction for interest on education loans has the opposite effect. Because the loan interest deduction reduces income used to determine financial need, it is likely to increase the student’s need-based assistance by 47% of the deduction if claimed on a parent’s return or 50% of the deduction if claimed on the student’s return.

Editors:
Edward B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Robert H. Colson, PhD, CPA
The CPA Journal

©2009 The New York State Society of CPAs. Legal Notices