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Tax Incentives for Education After the 2001 Tax Relief Act

(June 7, 2001) - On June 7, 2001 the President signed into law comprehensive and significant tax relief which included provisions for assistance to families funding higher education, as well as certain breaks for elementary and secondary school.



The cost of higher education continues to rise at twice the rate of inflation. The need to become familiar with education financing and financial planning for higher education has never been greater.



Although most of the new tax law doesn’t become effective until on or after January 1, 2002, families should familiarize themselves now with these provisions to better plan their education financing and thereby take full advantage of these tax breaks and maximize their savings. While there are no deductions for contributions to savings, there are certain deductions for tuition and incentives for savings. Most of the provisions in this new legislation are to “sunset” December 31, 2010, requiring Congress to act to extend such provisions note that the pre-existing law would remain intact if no action were taken.



As with most tax breaks, there are income and other limitations imposed so this information is presented to help you to determine what you qualify for. Most of these provisions supplement existing law. The material in bold reflects the provisions of the new tax law.



The following provides a summary of these “education incentives” but is qualified in its entirety by reference to the “Tax Relief Reconciliation Act of 2001” and other components of the existing federal tax law. Readers are encouraged to visit Savingforcollege.com for more information and resources on the material discussed. Readers should further consult with their own financial or tax adviser to best determine how these provisions may affect their own situation.




1. Available for Participation by Families at Every Income Level

529 Plans
- There are nearly 40 different investment programs available for residents of any state to participate in, each sponsored by a state and managed by a reputable bank, mutual fund or investment management company at expenses comparable to mutual fund expenses. Each offers various investment options specifically designed for saving for college. These programs allow funding ranging from $15 per month to a total of $250,000, over time or at once. Up to $50,000 ($100,000–joint) may be contributed at once without a gift tax (assuming no other gifts to same beneficiary within 5 years) for use at the college or grad school of your choice (public or private; in-state or out-of-state). There is no age or time limitations imposed by federal tax law. The account is owned by the adult that opens the account, not the future student, but is generally not included in the owner’s estate for estate tax purposes. There are no taxes due on earnings while on deposit with the program but non-qualified withdrawals are subject to a penalty.



Earnings on 529 plans withdrawn after December 31, 2001 for qualified expenses (tuition, room & board, books, supplies and fees) are never subject to federal income taxes and as a result, mostly exempt from state income tax as well. Currently earnings are taxable to the beneficiary.



This exemption applies to the increase in value of the contract or tuition units of a state-sponsored tuition prepayment program and, effective January 1, 2004, for a tuition prepayment program sponsored by any accredited post-secondary institution (including independent colleges) or consortium of such institutions.



Non-qualified withdrawals are subject to a penalty in the form of a 10% tax on the amount of a distribution that is includible in the recipients’ gross income, in lieu of the state administered penalty, often 10% as well.



Employer assistance
– Up to $5,250 per year of certain employer-paid educational expenses (tuition, fees, books, supplies but not room & board) for school may be excluded from income. The education does not have to be work related for the exclusion to qualify, but the employer must maintain the program as qualified. Deductions cannot be claimed for employer-paid expenses.



This provision was expiring but is now permanent and reinstates graduate school expenses as qualifying expenses.



2. Available for Families with an AGI less than $220,000


Education IRAs
- Trust or custodial accounts may be established for a child under the age of 18 for the purpose of paying their qualified educational expenses. Earnings withdrawn from Education IRAs for qualified expenses are totally exempt from federal income tax, and as a result, from income taxes in most states as well.



Funding to one or more accounts not to exceed an aggregate of $2,000 a year per beneficiary/child may be contributed by joint filers with federal adjusted gross income (“AGI”) of $190,000 or less or by single filers with an AGI of $95,000 or less. Lesser amounts may also be contributed by those with slightly higher incomes (such as $1,000 a year for joint filers with an AGI of $205,000 or $667 for a single filer with an AGI of $105,000) and $0 may be contributed by those single filers with AGIs over $110,000 and joint filers with AGIs over $220,000.



Qualified withdrawals include those expenses permitted for 529 plans and also include amounts transferred to a 529 plan.



Qualified withdrawals from Education IRAs now also include tuition, fees, academic tutoring, books, supplies, room & board, uniforms, transportation, computer technology or equipment for kindergarten through grade 12 at any school.



Contributions may be made up to the time of filing the return for such taxpayer, similar to other IRAs, and may also be made in the same taxable year in which contributions to a 529 plan are made. Entities other than individuals, such as corporations, may make contributions without reference to the contributor’s income level.



Hope and Lifetime Learning Credits (later described) may be taken for those qualified higher education expenses paid, but not from withdrawals from an Education IRA, in the same taxable year. Deductions for tuition and fees (later described) may not be taken if paid from Education IRA withdrawals when claiming an exemption from taxation for earnings used to pay such expenses.




3. Available for Families with an AGI less than $130,000


Tuition and Fees Deduction - Up to $3,000 may be deducted above the line from a filer’s taxable income in 2002 and 2003 for tuition and fees required for enrollment or attendance at an accredited undergraduate or graduate school. For years 2004 and 2005 up to $4,000 per year may be so deducted.



Taxpayers with an AGI of $130,000 and $65,000 for joint and single filers, respectively, are eligible for such deduction. There is no phase-out.



In 2004 and 2005, taxpayers with an AGI of $160,000 and $80,000 for joint and single filers, respectively, are eligible for a $2,000 deduction.



The deduction is not available when taking a Hope or Lifetime Learning Credit in that same year or for amounts withdrawn from an Education IRA for the same student but is allowed for the principal or contribution portion withdrawn from a 529 account to pay tuition and fees.



Note - this provision is not currently authorized beyond 2005.



Student Loan Interest Deduction
– Interest on qualified educational or refinanced educational loans is deductible above the line from the filer’s taxable income. The maximum allowable annual deduction is $2,500. No deduction is allowed to an individual if that individual is claimed as a dependent on another’s taxpayer’s return for that taxable year.



Taxpayers with an AGI of $100,000 and $50,000 for joint and single filers respectively, can deduct the full amount of interest paid each year (not to exceed $2,500). Taxpayers with an AGI up to $130,000 and $65,000 for joint and single filers, respectively, are able to deduct a portion of interest paid. For example, joint filers with an AGI of $115,000, who pay $3,000 of interest on a qualified educational loan in a particular year, are able to deduct $1,250 (50% of the $2,500 maximum). A single filer with an AGI of $57,500, who paid $1,500 of interest, is able to deduct $750 (50%). These income levels are to be adjusted annually for inflation.



There is no limitation on the term of the loan or prohibition of voluntary payments (payments while loan is in deferral or forbearance).



4. Available for Families with an AGI of $100,000 or less




Hope and Lifetime Learning Tax Credits
– Joint returns with an AGI of $80,000 or less (single filers with an AGI of $40,000 or less) are able to claim a credit of up to $1,500 toward federal income taxes due for payment of tuition and/or fees required for attendance. The credit is phased out completely for joint returns above $100,000 and single returns above $50,000. Thus, a joint return with an AGI of $90,000 is entitled to a Hope credit of $750 for qualified expenses of $2,000 or more.



The Hope credit is 100% of the first $1,000 plus 50% of the next $1,000 paid for each eligible student at an accredited college for a maximum 2 years for each student.



The Lifetime Learning Credit is 20% of the first $5,000 paid for qualified expenses for all eligible students in the family. It is available for undergraduate and graduate school and has no limit on the number of years that it can be taken.

Now the Hope or Lifetime Learning Credits can be claimed in the same year as a withdrawal from an Education IRA or a 529 plan so long as the distribution from the Education IRA or 529 account is not used for the same qualified educational expenses for which a credit is being claimed.



These credits were authorized by previous law and as such have no sunset.

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