TABLE OF CONTENTS
Coverdell Education Savings
Accounts (Section 530 Programs)
Many tax benefits are available to help you pay higher education costs, whether for your children or yourself. Because of the variety of benefits and programs, the amounts often involved and the fact that the use of some benefits can preclude others this area is one of the most complex an individual can face. This Financial Guide discusses, first, the programs which are in essence plans for building savings for higher education, and then the benefits available as and after the higher education takes place. In this area more than most, professional guidance is necessary.
The eligibility rules vary for each tax benefit, with many limited to taxpayers whose income falls below certain levels.
You can contribute up to $2,000 ($500 in 2001and earlier) each year to a Coverdell education savings account (Section 530 program) for a child under 18. These contributions are not deductible, but they grow tax-free until withdrawn. Starting with 2002, contributions for any year (say 2002) can be made through the (unextended) due date for the return for that year (April 15, 2003).
Only cash can be contributed to a Section 530 account and you cannot contribute to the IRA after the child reaches his or her 18th birthday.
Anyone can establish and contribute to a Section 530 account, including the child, as long as the contributors modified AGI doesnt exceed $220,000 ($160,000 for 2001 and earlier) for a joint return or $110,000 for a single filer. You may establish 530s for as many children as you wish, and the child need not be a dependent in fact, he or she need not be related to you. But the amount contributed during the year to each account cannot exceed $2,000 ($500 before 2002). This maximum contribution amount for each child is phased out for AGI between $190,000 and $220,000 (joint) ($150,000 and $160,000 before 2002) and $95,000 and $110,000 (single).
The child must be named (designated as beneficiary) in the IRA document, but the beneficiary can be changed to another family member (for example, to a sibling where the first beneficiary gets a scholarship or drops out). And funds can be rolled over tax-free from one child's IRA to another's. Funds must be distributed not later than 30 days after the beneficiary's 30th birthday (or 20 days after the beneficiary's death if earlier). For "special needs" beneficiaries the age limits (no contributions after age 18, distribution by age 30) dont apply in 2002 or later.
Withdrawals are taxable to the person who gets the money, with these major exceptions: Only the earnings portion is taxable (the contributions come back tax-free). Also, even that part isnt taxable income, as long as the amount withdrawn doesnt exceed a childs "qualified higher education expenses" for that year. The definition of "qualified higher education expenses" is broader than the term that applies to the education credits e.g., it also includes room and board and books. In figuring whether withdrawals exceed qualified expenses, expenses are reduced by certain scholarships and by amounts for which tax credits (see Tax Credits, below) are allowed. (Before 2002, such credits were barred if this exemption from income was claimed.) If the amount withdrawn for the year exceeds the education expenses for the year, the excess is partly taxable under a complex formula. Theres another formula (inapplicable before 2002) if the sum of withdrawals from this 530 program and from the qualified tuition (Section 529) program exceed education expenses.
You as the person who sets up the Section 530 account may change the beneficiary (the child who will get the funds) or roll the funds over to the account of a new beneficiary, tax-free, if the new beneficiary is a member of your family. But funds you take back (for example, withdrawal in a year when there are no qualified higher education expenses, because the child is not enrolled in higher education) are taxable to you, to the extent of earnings on your contributions, and you will generally have to pay an additional 10% tax on the taxable amount. However, you wont owe tax on earnings on amounts contributed in 2002 or later that are returned to you by June 1 of the year following contribution.
You may choose and change investments as freely with a Section 530 program as with an IRA in contrast to Section 529 programs and, of course, Series EE bonds.
Elementary and secondary schools
Starting in 2002, Section 530 programs can be used to build up funds for primary and secondary education (unlike IRAs, Section 529 programs, and Series EE bonds). The tax rules are similar to those for higher education: withdrawals taxable to the extent of earnings on contributions, except tax-free up to the childs qualified elementary and secondary education expenses. These expenses qualify whether the child attends a private, religious or public school. Expenses such as room, board, tuition, transportation and uniforms will qualify only where connected with private or religious schools, but some expenses books, computers, educational software and internet access apply as well to children in public school living at home.
The age limits for higher education apply here too: no contribution after child reaches age 18, distribution at age 30 except for special needs beneficiaries. Withdrawals in excess of qualified education expenses are taxable under a special formula.
Most states have programs allowing persons to prepay for future higher education, with tax relief. In fact, 47 states had such programs in effect as year 2002 began, with many variations among them. There are two basic plan types:
In approaching state programs one must distinguish between what the federal tax law allows and what an individual state's program may impose.
You may open a Section 529 program in any state. But when buying prepaid tuition credits (less popular than savings accounts), you will want to know to what institutions the credits will be applied.
Unlike certain other tax-favored higher education programs, such as the Hope and lifetime learning tax credits, federal tax law doesn't limit the benefit to tuition, but can also extend it to room, board, books, etc. (Individual state programs could be narrower.)
The two key individual parties to the program are designated beneficiary, the student-to-be, and the account owner, who is entitled to choose and change the beneficiary and who is normally the principal contributor to the program. There are no income limits on who may be an account owner. There's only one designated beneficiary per account. Thus, a parent with three college-bound children might set up 3 accounts. (Some state programs dont currently allow the same person to be both beneficiary and account owner.)
Contributions must be in cash, and must not total more than reasonably needed for higher education (as determined initially by the state). Neither account owner nor beneficiary may direct investments, but the state may allow the owner to select a type of investment fund (e.g., fixed income securities), and to change the investment annually, and when the beneficiary is changed. The account owner decides who gets the funds (can pick and change the beneficiary) and is legally allowed to withdraw funds at any time, subject to tax and penalty discussed later.
Funds in the account not yet distributed at the account owner's death pass as part of the probate estate under state law-though this is not the result for federal estate tax purposes, see below.
Federal tax rules. Income tax. Contributions made by the account owner or other contributor are not deductible for federal income tax purposes. Earnings on contributions grow tax-free while in the program.
Distributions from the fund are tax-free to the extent used for qualified higher education expenses. (Such distributions in 2001 and earlier to the designated beneficiary for qualified education were taxed to the beneficiary--the student. Distributions from private institutions continue taxable under this rule until 2004.) The taxable amount of the distribution is that portion which represents earnings.
A Section 529 distribution can be tax-free even though the student is claiming a Hope or lifetime learning credit, or tax-free treatment for a Section 530 distribution, if the programs arent covering the same specific expenses.
Distribution for a purpose other than qualified education is taxed to the one getting the distribution. In addition, a 10% penalty must be imposed on the distribution, comparable to the 10% penalty in Section 530 plans. (Theres no penalty on pre-2004 taxable distributions from private institutions used for qualified higher education.) In 2001 and earlier, there was a penalty, normally 10% or more of earnings, determined by the state that went to the state's program, not to the U.S.
The account owner may change beneficiary designation from one to another in the same family. Funds in the account roll over tax-free for the benefit of the new beneficiary.
Gift tax. For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them. Thus they qualify for the up-to-$11,000 annual gift tax exclusion ($10,000 before 2002). One contributing more than $11,000 may elect to treat the gift as made in equal installments over the year of gift and the following 4 years-so that up to $55,000 can be given tax-free in the first year.
A rollover from one beneficiary to another in a younger generation is treated as a gift from the first beneficiary-an odd result for an act the "giver" may have had nothing to do with.
Estate tax. Funds in the account at the designated beneficiary's death are included in the beneficiary's estate-another odd result, since those funds may not be available to pay the tax. Funds in the account at the account owner's death are not included in the owner's estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $11,000 ($10,000 before 2002). For example, if the account owner made the election for a gift of $55,000 in 2002, a part of that gift is included in the estate if he or she dies within 5 years.
State tax. State tax rules are all over the map. Some reflect the federal rules, some quite different rules.
For more on state programs: For specifics of each state's program, see http://www.collegesavings.org.
Professional guidance: Considering the wide differences among state plans, the federal and state tax issues, and the dollar amounts at stake, professional guidance is advised.
Education Planning and the Bush Tax Cut "Sunset"
As a budgetary device, the many education and other provisions of the 2001 Tax Relief Act are scheduled to endunless retained by separate legislationat the end of 2010. This usually wouldnt affect what you do currently. But the Section 529 and 530 programs include 2001 Act provisions granting tax exemption for program distributions to pay for education. If youre counting on tax exemption for distributions that will occur after 2010, you will want to get your professional advisers views on the prospects that this exemption will survive.
You can use a traditional or Roth IRA as a savings plan to pay qualified higher education expenses. With a traditional IRA you will owe income tax on at least part of the withdrawal; since Roth IRA investments are already tax-paid, withdrawals are less likely to be taxable. Withdrawals before age 59 1/2 to pay qualified higher education expenses are not subject to the additional 10% tax on early withdrawals.
To escape the 10% tax, you must pay education costs that at least equal your withdrawal amount. The education costs must be "qualified," i.e. for tuition, fees, books, room and board, supplies, or equipment at a qualified institution of learning and they must be for yourself, your spouse, or the children or grandchildren or yourself or your spouse. The qualified institution of learning may be any college, university, vocational school, or other post-secondary school that is eligible to participate in federal Department of Education aid programs.
However, you cannot count education costs paid with proceeds from the following in determining whether your IRA withdrawal is to be free of the 10% tax:
Tax-free distributions from a Coverdell education savings account (Section 530 program), formerly called an education IRA;
Tax-free scholarships, such as a Pell grant;
Tax-free employer education assistance program;
Any tax-free payment (other than a gift or bequest) that is due to enrollment at the qualified institution.
You can exclude from your gross income interest on qualified U.S. savings bonds if you have qualified higher education expenses during the year in which you redeem the bonds. The exclusion phases out where the bondholder has (modified) adjusted gross income over a specified amount in the year the bond is redeemed. The amount, indexed for inflation, is $59,850 in 2004 ($89,750 on a joint return; unavailable to marrieds filing separately).
The education must be of the bondholder, his or her spouse or dependent. Qualified higher education expenses are tuition and fees, and contributions to Section 529 and 530 programs, reduced for tax-free scholarships and other relief.
A qualified U.S. savings bond means a Series EE bond issued after 1989. The bond must be either in your name or in the names of both you and your spouse, and you must be at least 24 years old before the bonds issue date.
Two tax credits are available for education costs the Hope credit and the lifetime-learning credit. These credits are available only to taxpayers whose joint adjusted gross income does not exceed about $100,000 for a joint return and $50,000 on other returns.
How These Credits Work
The amount of the credit you can claim depends on (1) how much you pay for qualified tuition and other expenses for students and (2) your adjusted gross income (AGI) for the year.
You must report the eligible students name and Social Security number on your return to claim the credit. You subtract the credits from your federal income tax. If the credit reduces your tax below zero, you cannot receive the excess as a refund. If you receive a refund of education costs for which you claimed a credit in a later year, you may have to repay ("recapture") the credit.
Which costs are eligible. Qualifying tuition expenses mean tuition and fees required for enrollment or attendance at an eligible education institution. They do not include books, room and board, student activities, athletics (other than courses that are part of a degree program), insurance, equipment, transportation, or any personal, living, or family expenses. For expenses paid with borrowed funds, count the expenses when they are paid, not when borrowings are repaid.
Eligible students. You, your spouse, or an eligible dependent (someone for whom you can claim a dependency exemption, including children under age 24 who are full-time students) can be an eligible student for whom the credit can apply. If you claim the student as a dependent, qualifying expenses paid by the student are treated as paid by you, and for your credit purposes are added to expenses you paid. A person claimed as another's dependent can't claim the credit. The student must be enrolled at an eligible education institution (any accredited public, non-profit, or private post-secondary institution eligible to participate in student Department of Education aid programs) for at least one academic period (semester, trimester, etc.) during the year.
No "double-dipping." The tax law says that you can't claim both a credit and a deduction for the same higher education costs. It also says that if you pay education costs with a tax-free scholarship, Pell grant, or employer-provided educational assistance, you cannot claim a credit for those amounts.
Income phase-outs. Your education credits are gradually phased out if your modified AGI for 2005 is between $43,000 and $53,000 ($87,000 and $107,000 for joint returns) ($42,000, $52,000, $85,000 and $105,000, respectively, for 2004). Once your modified AGI reaches the top limit of these ranges, you cannot claim any education credit. "Modified AGI" generally means your adjusted gross income. The "modifications" only come into play if you have income earned abroad.
The Hope Credit
You may be able to claim up to $1,500 of the Hope credit. You can claim the Hope credit for each eligible student you have for which the Hope credit requirements are met. The credit can be claimed for only two years per eligible student.
Special qualification rules. In addition to being an eligible student, he or she:
Amount of credit. The amount of the Hope credit is 100% of the first $1,000 plus 50% of the next $1,000 you pay for each eligible student. The maximum you can claim is $1,500 times the number of eligible students. Thus, you will benefit from the maximum $1,500 amount for each eligible student for whom you pay at least $2,000. Remember, however, that the credit may be reduced based on your AGI.
The Lifetime Learning Credit
You may be able to claim a Lifetime Learning credit of up to $2,000 (20% of the first $10,000 of qualified expense) for eligible students (subject to reduction based on your AGI). The eligibility rules for the Lifetime Learning credit are broader than those that apply to the Hope credit:
Choosing the Credit
You can't claim both credits for the same person in the same year. But you can claim one credit for one or more family members and the other credit for expenses for one or more others in the same year for example, a Hope credit for your child and a lifetime learning credit for yourself.
Electing Not To Take the Credit
There are situations in which the credit is not allowed, or not fully available, if some other education tax benefit is claimed where the higher education expense deduction is claimed for the same student, see below, or where credit and tax exemption (under a Section 529 or 530 program) are claimed for the same expense. In that case the taxpayer or, more likely, the taxpayers tax adviser will determine which tax rule offers the greater benefit and if its not the credit, elect not to take the credit.
For years 20022005, a limited deduction is allowed for "qualified higher education expenses" tuition and related expenses under the same definition as for tuition credits, above. Business deduction is allowed already, without dollar limit, for education that serves the taxpayers business, including employmentsee below. The new deduction for 20022005 extends to expenses having no business connection, which is the usual case with higher education expenses. Where the taxpayer claims another education-related deduction, such as a business or interest deduction, this deduction cant be claimed for the same items.
The law doesnt prescribe who the expense must be paid for self, dependent, etc. but it precludes deduction for one who is anothers dependent or who is married filing separately. And it cant be claimed where a tuition credit is claimed (by anyone) for the same student.
For 20023, deduction is allowed only if taxpayers (modified) adjusted gross income (AGI) is $65,000 or less ($130,000 or less on a joint return). Maximum deduction is $3,000. For 20045, the maximum deduction is $4,000; and deduction up to $2,000 is allowed taxpayers with AGI between $65,000$80,000 ($130,000 $160,000 on a joint return).
"Qualified higher education expenses" must be reduced by any such expense paid with an amount treated as tax-free under the rules for excluding income from Series EE bonds, or Section 529 or 530 programs.
The deduction is above the line meaning its not subject to the 2% floor on itemized deductions and is allowed whether or not the standard deduction is claimed.
If your employer paid education assistance benefits (e.g., reimbursements of tuition), part or all of them may be tax-free. You can exclude up to $5,250 per year of the benefits you receive under a qualified education assistance program. But you can't both exclude and deduct the same item, even if it's otherwise deductible. In order to qualify your employer must have established and educational assistance plan that does not discriminate in favor of highly paid employees or owners. The exclusion applies to undergraduate level courses other than those involving sports, game and hobbies. The courses do not need to relate to your job. The exclusion is available for tuition, fees, books and supplies but not meals, lodging or transportation. And it applies to benefits for graduate level courses that begin after2001.
In addition to the exclusion for qualifying education plans, your employer can provide reimbursement for business related courses, including graduate courses that began before 2002. If your employer does not reimburse you for these expenses, you may be entitled to deduct them as a miscellaneous itemized deduction subject to the 2% deduction floor. To qualify, the expense must meet the requirement of your employer or the law or maintain or improve skills in your current job. The course must not meet minimum education requirements for your job or qualify you for a new trade or business.
You may be able to deduct interest on student loans. You may also be able to exclude income that you would otherwise have to report if a student loan is cancelled.
You may deduct student loan interest you pay, including interest paid thats not currently due because payment is deferred.
Deduction is allowed even though it would otherwise be nondeductible personal interest. But you may deduct only if you are the one legally bound to pay the interest, and only on loans solely for qualified expenses (so not under open credit lines).
The student-loan deduction is available only to taxpayers whose AGI is below $135,000 (joint amount) or $65,000 (single amount). Married couples filing separately can't deduct. The deduction is phased out for those whose AGI is above $50,000 (single amount) or $105,000 (joint amount). The dollar amounts are indexed for inflation; these are the amounts for 2005 and 2006. The student-loan interest deduction is an "above the line" deduction you dont have to itemize to claim it. The loan must have been taken out to cover education expenses of at least half-time study for yourself, your spouse, or a person who was your dependent when you took out the loan. The maximum deduction is $2,500.
Cancellation of Student Loan
If certain requirements are met, cancellations of student loans that are intended to induce students to perform certain services do not increase the students gross income. This relief extends to certain private programs, as well as government and public programs.
Shows the due dates for filing tax returns, reporting tax information and taking certain actions to obtain a tax benefit.
Books And Other Publications
Kalman A. Chany and Geoffrey Martz, The Student Access Guide to Paying for College, (Villard Books, 1998), ISBN 0679764690.
Patrick L. Bellantoni, College Financial Aid Made Easy, (Ten Speed Press, 1998), ISBN 0898158818.
Donít Miss Out: The Ambitious Studentís Guide to Financial Aid, Octameron Associates. Tel: 703-836-5480. (Octameron has other titles relating to college admissions and financing available.)
"Educational Assistance Programs: A Re-examination in the Wake of
the Small Business Job Protection Act," by Shirlee Dennis-Escoffier
and Lawrence C. Phillips, TAXES, (September 1996), pp. 523-533.