Situation: Your client wants to know how to save for education costs using some of the tax provisions provided in the Internal Revenue Code.
Solution: The Internal Revenue Service provides tax credits, deductions and tax-savings programs to help your client pay for education expenses, not only for their spouse and dependents — from kindergarten to college — but also for themselves.
Tax credits and deductions
The tax code provides tax credits for current educational expenses.
HOPE Credit: For 2008, individual taxpayers can claim a non-refundable credit against federal income taxes of up to $1,800 per student for qualified tuition and related expenses in the first two years of the student’s post-secondary education in a degree or certificate program.
An adjusted gross income phase-out applies within ranges that are indexed for inflation.
The tax credit is available for the taxpayer, the taxpayer’s spouse and dependents.
Lifetime Learning Credit: The IRS also provides a non-refundable credit against federal income taxes equal to 20% of qualified tuition and related expenses incurred during the year for the taxpayer, the taxpayer’s spouse and dependents. This credit is available for an unlimited number of years for a maximum of $10,000 of expenditures and maximum credit of $2,000.
This option would be beneficial to a client, spouse, and dependents who are incurring retraining costs and/or seeking education related to a new career.
Stimulus Education Credit: The Emergency Economic Stabilization Act of 2008 broadened the base of expenses against which a taxpayer can claim a credit for course materials. For clients with Section 529 college savings plans, the act expands the definition of eligible expenses to include computer equipment.
Also, provisions in the act have the effect of equalizing the HOPE and Lifetime Learning credits by increasing the phase-out limitation for the HOPE Credit (American Opportunity Credit), but not the Lifetime Learning Credit.
Prior to the act, the Lifetime Learning Credit phases-outs were more generous.
Above-the-line tuition deduction: An individual is permitted a before-AGI deduction for certain qualified tuition and related expenses paid during a calendar year. The deduction is available for tuition expenses for the taxpayer, spouse and eligible dependents when they enroll in a qualified educational institution.
The maximum 2008 deduction is $4,000 with an AGI phase-out. This deduction is available but eliminates the availability of the HOPE and Lifetime Learning credits or the savings bond exclusion and can cause a problem in determining the best choice for the client. It would seem that a credit is better than a deduction, but since the tuition deduction is above the line, the effect on other items that are dependent on AGI must be measured.
Employer-provided benefits: Up to $5,250 of eligible expense paid for each employee by the employer would be excluded from the employee’s income. The employer provision must be part of a separately written plan, and the employer cannot discriminate in favor of highly compensated employees.
The employee cannot incur the expenses to qualify for a new profession. They can be incurred only for enhancing the employee’s current skills and provide a benefit to the employer.
Section 529 programs: All states have some form of Section 529 college tuition funding plans and many have more than one type of plan. The plans range from prepaid tuition programs to simple savings plans. The savings programs vary from investing in state determined investments with limited investment choices, to open programs available through brokerage houses that broaden the scope of the investments. Deciding which program is appropriate depends on the age of the child, available state tax deductions and investment choices.
In a prepaid tuition program, the state determines the annuitized amount to be paid each month to cover the cost of tuition and fees at the time the student enrolls. In a savings plan, the account owner chooses among available investments, and the funds accumulated are the result of market performance.
The advantage of a 529 college savings plan is that the funds withdrawn from the savings plan for qualified education expenses, including earnings, are not taxable.
The prepaid savings plan guarantees the student’s tuition as long as the student attends a school in the state that sponsored the plan. But if the student enrolls in a school in another state, only the amount covered by the sponsoring state will be paid. Any cost over that amount must be paid out-of-pocket by the student.
States set the limit on plan contributions (about $250,000, with some states higher or lower). Contributions are made with after-tax dollars.
Coverdell Education Savings accounts: Formerly known as the Education IRA, the Coverdell account is created per beneficiary and funded with after-tax dollars, with contributions limited to $2,000 per year. The account has an adjusted-gross-income phase-out, unlike 529 programs, which have no AGI limit.
A major difference between a 529 program and a Coverdell account is that the Coverdell is available for kindergarten through grade 12, while the 529 programs are available only for higher education.
Savings bonds: If U.S. savings bonds are cashed to pay for the costs of higher education, then the individual cashing the bonds owes no federal tax on the interest income. However, there is an AGI limit. The savings bond option is available for redemptions of Series EE bonds issued after 1989.
Advisers have to measure whether using the HOPE or Lifetime Learning credit is better than using a savings bond, because the same expenses cannot be covered by both. That is, the taxpayer cannot reap both the benefits of using a bond and also claim a credit.
Withdrawals from an IRA and qualified plan accounts: Your clients may withdraw funds from their individual retirement account or qualified plan accounts on a penalty-free, but not tax-free, basis to fund higher education expenses for themselves, their spouses and dependents.
Given the current market conditions with lower account values, this may be an opportunity for paying less tax on the withdrawal.
Scholarships and tuition reimbursement programs: There are many scholarships, fellowships, awards and grants available to eligible individuals. Most require some application process.
Financial aid officers are a good source of information on how to apply for these sources of funds.
After education benefits
Student loan interest deduction: Certain individuals who have paid interest on qualified education loans may claim an above-the-line deduction for such interest expenses, subject to a $2,500 limit with an AGI phase-out.
Debt forgiveness programs: The Internal Revenue Code exempts from the forgiveness certain programs where the student works in designated jobs for a period of time to obtain debt relief. Examples include teaching and inner city programs.
The tax provisions in the current bill in Congress will expand this debt forgiveness.
Advisers can get further information online at the websites for Sallie Mae Inc. (
salliemae.com) and Free Application for Federal Student Aid (
fafsa.ed.gov).
