By Richard Greenfield, CPA, Reminick, Aarons and Company, LLP

The Economic Growth and Tax Relief Act of 2001 enhances the federal tax incentives for taxpayers that incur education costs, providing additional value for saving and paying for education.

Education IRAs

Old law. Under the old law, a taxpayer could make nondeductible contributions of up to $500 per designated beneficiary to education IRAS exclusively to pay for qualified higher education expenses such as tuition, fees, books, supplies, and equipment. If the beneficiary was at least a half-time student at an eligible educational institution, room and board, subject to limitations, was also a qualified higher education expense. An eligible educational institution was any college, university, vocational school, or other postsecondary educational institution eligible to participate in student aid programs administered by the Department of Education.

The $500 contribution limitation phased out for taxpayers with modified adjusted gross income (AGI) between $95,000 and $110,000 ($150,000 and $160,000 for joint returns). No contributions could be made to an education IRA of any designated beneficiary that had reached age 18. A 6% excise tax was imposed on contributions to an education IRA if contributions were made to a qualified state tuition program (QSTP) on behalf of the same beneficiary in the same year.

Distributions from education IRAs were not taxable as long as the funds were used for qualified higher education expenses. Distributions in excess of qualified expenses were subject to income tax plus a 10% penalty. The balance in an education IRA had to be distributed within 30 days after the date that the beneficiary reached age 30, or within 30 days of the date that the beneficiary died, if earlier. A Hope or Lifetime Learning Credit could not be claimed for an individual’s education expenses if a tax-free distribution was also made from an education IRA for the same individual in that tax year.

New law. Effective for tax years beginning after December 31, 2001, a taxpayer can make nondeductible contributions of up to $2,000 per designated beneficiary. The phase-out range for joint filers increases to between $190,000 and $220,000.

Qualified education expenses have been expanded to include expenses for elementary and secondary school (kindergarten through 12th grade). Public, private, or religious schools are eligible. The costs of uniforms, transportation, academic tutoring, special needs services, supplemental items or services (including extended day programs), computer equipment, and qualified computer software now qualify as eligible expenses.

In the case of special needs beneficiaries, contributions can be made beyond age 18 and distributions do not have to be made by age 30. Taxpayers may now claim a Hope or Lifetime Learning Credit for a tax year and exclude amounts distributed from an education IRA (both the contributions and earnings portions) from income on behalf of the same beneficiary as long as the distribution is not used for the same educational expenses for which the credit is claimed.

The 6% excise tax is repealed for contributions made to an education IRA during the same tax year in which contributions are made to a QSTP on behalf of the same beneficiary.

The new law clarifies that corporations and other entities, including tax-exempt organizations, are permitted to contribute to education IRAs, regardless of their income during the year of the contribution.

Qualified State Tuition Programs

Old law. Under the old law, QSTPs, also known as section 529 plans or college savings plans, allowed taxpayers to contribute funds to pay for a designated beneficiary’s future higher education expenses. Taxpayers could either contribute to an account set up to meet future qualified higher education expenses, or purchase tuition credits or certificates. Earnings accumulated tax-deferred and became taxable to the beneficiary when the funds were distributed to pay for the expenses.

The beneficiary could claim a Hope or Lifetime Learning Credit for the tuition and related expenses paid for with the distributions from the program, if the other requirements for claiming those credits were satisfied and if the modified AGI phase-outs for the credits did
not apply.

Tuition credits or account balances could be transferred tax-free to another beneficiary, provided that the old and new beneficiaries were members of the same family. The following relatives would be eligible family members:

New law. Effective for tax years beginning after December 31, 2001, tax-free transfers can also be made to first cousins of the original designated beneficiary.

QSTPs can now be established by private educational institutions that satisfy the requirements of section 529 and that receive an IRS ruling confirming their status. Persons participating in the private institution’s program can purchase tuition credits or certificates on behalf of a designated beneficiary, but will not be allowed to make contributions to a savings account plan.

Beginning in 2002, distributions from QSTPs will be tax-exempt, rather than just tax-deferred, if the distributions are used to pay for qualified higher education expenses. The same treatment will apply to private programs, beginning in 2004. The new law coordinates the income exclusion with the Hope and Lifetime Learning Credits so that the tax-exempt distribution cannot be used for the same expenses for which the credit is claimed. Limits will apply to the room and board allowance. Beginning in 2002, a 10% penalty will apply to distributions from QSTPs that are not used to pay for qualified education expenses. The penalty will apply to distributions from private programs, beginning in 2004.

Amounts or credits may now be rolled over tax-free from one qualified program to another for the same beneficiary, but only one rollover per year is permitted.

Employer-Provided Educational Assistance

Old law. Under the old law, employer-paid educational expenses of up to $5,250 were deductible by the employer and excludible from the employee’s wages each year. Graduate courses did not qualify. In order for the exclusion to apply, the educational assistance must have been provided as part of a written plan of the employer; the program must not have discriminated in favor of highly compensated employees; and not more than 5% of the amounts paid or incurred by the employer during the tax year for educational assistance could be for the class of employees consisting of greater-than-5% owners (and their spouses and dependents).

The provision was scheduled to expire for courses beginning after December 31, 2001.

New law. Effective for courses beginning after December 31, 2001, the exclusion becomes permanent, rather than temporary, and will apply to graduate courses.

Student Loan Interest Deduction

Old law. Under the old law, taxpayers could claim an above-the-line deduction for interest paid on qualified education loans. The deduction was subject to an annual cap, $2,500 for 2001. The deduction was allowed only for interest paid during the first 60 months in which interest payments are required. Voluntary interest payments were not deductible. The deduction phased out for taxpayers with modified AGI between $40,000 and $55,000 ($60,000 and $75,000 for joint filers). No deduction was allowed for married taxpayers filing separately or for a taxpayer claimed as a dependent on another taxpayer’s return for that tax year.

New law. The 60-month limit is repealed for interest paid on qualified education loans after December 31, 2001. Voluntary interest payments are now deductible. The income phase-out range increases to between $50,000 and $65,000 ($100,000 and $130,000 for joint filers).

Deduction for Higher Education Expenses

Old law. Under the old law, an individual generally could not deduct the costs of education and training for herself or her dependents. Education or training expenses were deductible, however, as miscellaneous itemized deductions subject to the 2% of AGI limitation, if they maintained or improved a skill required in a trade or business currently engaged in by the taxpayer, if they met the express requirements of the taxpayer’s employer, or if the requirements of applicable law or regulations imposed them as a condition of continued employment. Education expenses were not deductible if they were required to meet certain minimum educational requirements or were for education or training that allowed the taxpayer to begin working in a new trade or business.

New law. For 2002 and 2003, taxpayers with AGI not exceeding $65,000 ($130,000 for joint filers) can deduct up to $3,000 above-the-line for qualified higher educational expenses. For 2004 and 2005, the maximum deduction will be $4,000 for taxpayers with AGI not exceeding $65,000 ($130,000 for joint filers). For 2004 and 2005, if AGI is between $65,000 and $80,000 ($130,000 and $160,000 for joint filers), the maximum deduction will be $2,000. After 2005, the above-the-line deduction will be repealed.

Qualified higher educational expenses are defined the same as for the Hope credit.

Taxpayers cannot claim a deduction for qualified higher educational expenses if they claim a Hope or Lifetime Learning Credit in the same tax year for the same student. In addition, a deduction cannot be taken for amounts used in determining the amount excludible due to a distribution of contributions and earnings from an education IRA, or the amount excludible with respect to education savings bonds. A taxpayer cannot claim a deduction for a distribution from a qualified plan that is excludible from income. In other words, a taxpayer can claim a deduction for the distribution attributable to a return of contributions, but not to earnings.