Educational Tax Benefits
Deductions, Credits, Tax-Free Savings Vehicles

By Gary E. Carpenter

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Tax Deductions

Tuition and fees. Taxpayers filing jointly with a modified adjusted gross income (MAGI) of less than $130,000 can deduct up to $4,000 of tuition and fees. If their MAGI is between $130,000 and $160,000, they can deduct up to $2,000 of tuition and fees. Taxpayers filing single can deduct up to $4,000 of tuition and fees if their MAGI is less than $65,000, and up to $2,000 if their MAGI is between $65,000 and $80,000.

This deduction is an “above-the-line” deduction taken on the front of Form 1040. It cannot be taken if the Hope Scholarship Credit or Lifetime Learning Credit is taken, or if the taxpayer’s filing status is married filing separately. Under current law, this deduction will not be available after December 31, 2007.

Student loan interest deduction. This deduction is phased out if the taxpayer’s MAGI is between $110,000 and $140,000 and the taxpayer is filing a joint return ($55,000 and $70,000 for taxpayers filing single). The maximum deduction available to taxpayers is $2,500 per year and the deduction for the student loan interest is taken on the front of Form 1040 or 1040A. The deduction cannot be taken if the taxpayer’s status is married filing separately.

Prior to June 2001, the deduction was limited to the first 60 payments of a student loan. The limit on the deduction was removed by the Economic Growth and Tax Relief Reconciliation Act of 2001, but the law’s sunset clause means that it will expire on December 31, 2010, if not extended. In this case, the law will revert to its prior state and the deduction will again be limited to the first 60 payments.

Tax Credits

Hope Scholarship Credit. In the first two years of post-secondary education, a taxpayer may elect to claim the Hope Scholarship Credit. This credit is based on the first $2,200 in required tuition and fees paid directly to the college. The maximum credit allowed is $1,650 per year per student, but the amount cannot exceed the taxpayer’s income tax liability.

The credit is available to the taxpayer, spouse, and dependents, and it can be used only for the first two years of higher education. The credit is subject to phaseout limits. For taxpayers who are married filing jointly, the credit phases out at a MAGI between $94,000 and $114,000. For single and head-of-household taxpayers, the credit phases out at a MAGI between $47,000 and $57,000. The credit is not available to taxpayers who are married and filing separately.

When determining the qualifying education expenses, several items must be considered. First, taxpayers cannot use education expenses that they have already received a tax benefit for (e.g., expenses used to figure the tax-free portion of a distribution from a Coverdell Education Savings Account or from an IRC section 529 plan). Second, taxpayers may have to adjust the qualified education expenses for tax-free educational assistance they have received (e.g., the tax-free portion of a scholarship, employer-provided assistance, or veterans’ assistance). Finally, taxpayers who decide to use the tuition and fees deduction cannot use the Hope Credit.

Lifetime Learning Credit. The Lifetime Learning Credit is available to taxpayers who have qualified education expenses for tuition and fees of $10,000 or less. The maximum credit is $2,000 per year, per tax return, not to exceed the taxpayer’s income tax liability.

The credit is available to the taxpayer, spouse, and dependents. The Lifetime Learning Credit has the same income phaseout limits as the Hope Scholarship Credit but is available for any year of post-secondary education. The credit is not available to taxpayers whose filing status is married filing separately.

The same rules apply for the Lifetime Learning Credit as for the Hope Scholarship Credit when determining qualified education expenses. Taxpayers who elect to use the tuition and fees deduction cannot use the Lifetime Learning Credit.

Tax-Free Savings Vehicles

Coverdell Education Savings Accounts. The Coverdell Educational Savings Account (ESA) is set up for a child under the age of 18. The child is the beneficiary of the account and must use the funds before reaching the age of 30. The account owner can change the beneficiary to another member of the beneficiary’s family under the age of 30.

Multiple Coverdell ESAs can be set up for one child, but the total of all contributions to all accounts cannot exceed $2,000 per year. The contributions are nondeductible, must be in cash, and are subject to income phaseout limits. For taxpayers filing jointly, phaseout limits for contributions are a MAGI of $190,000 to $220,000. For taxpayers whose filing status is single, head of household, or married filing separately, the phaseout limits are a MAGI of $95,000 to $110,000.

Earnings from these accounts are tax-free if used for K–12 or post-secondary education expenses. The Economic Growth and Tax Relief Reconciliation Act of 2001 increased the annual contribution from $500 to $2,000. But the law’s sunset provisions mean that if it is not extended or permanently amended by December 31, 2010, the contribution limits will revert to the old amount of $500.

529 plans. Qualified tuition programs, or IRC section 529 plans, have become the most popular way to save for college. Earnings on the accounts are tax-free if used for qualified higher education expenses. Qualified tuition programs or 529 plans are established and administered by the individual states and vary in their investment approach and fees.

An account owner can set up a 529 plan and name any individual as the beneficiary. The account owner has control over the account, including the ability to change beneficiaries and withdraw funds from the account. At the same time, contributions made to the account are removed from the account owner’s estate. Contributions must be in cash and are nondeductible. The account owner may contribute up to $12,000 per year with no gift tax due. Larger amounts can be contributed if an election is made to treat them as given over a five-year period. There are no income limitations on contributions. The Pension Protection Act of 2006 made the provisions of 529 plans permanent.

Distributions from a 529 plan impact the ability to take the Hope Scholarship or Lifetime Learning Credit, as well as the tuition and fees deduction. Unqualified withdrawals are permitted by the account owner, but earnings are subject to ordinary income tax plus a 10% penalty.

For a further discussion of Coverdell ESAs and 529 Plans and how they can work alongside IRAs, see “Rethinking College Savings Opportunities” on page 48 of this issue.

U.S. savings bonds. U.S. savings bonds issued after December 31, 1989, whose proceeds are used for qualified higher education expenses may be tax-free. The requirements for the interest on these bonds to be tax-free are as follows:

• The bonds can be EE bonds or I bonds, issued after December 31, 1989.
• The purchaser must be 24 years or older.
• The proceeds from the bonds must be used for the higher education expenses of the bondholder, spouse, or dependents.
• The bonds must be issued in the purchaser’s name as sole owner, or in the name of both the purchaser and spouse as co-owners.
• The purchaser is subject to income phaseout limits as follows: married filing jointly $98,400 to $128,000; all others $65,000 to $80,600.

IRAs. Another vehicle for saving for college that is often overlooked is an IRA for the child. If the child has earned income, she could open a Roth or traditional IRA and, depending upon income, could contribute up to $4,000 per year.

Funds can be withdrawn from these retirement accounts penalty-free if they are used for qualified higher education expenses. Any taxable income on these withdrawals would be taxed as ordinary income (depending on the individual situation of the student and the amount of taxable income at “kiddie tax” rates).

Next to their home, college is the second-largest expenditure most families will make in their lifetime. Knowing what educational tax benefits are available may help ease that burden.

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