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529 E-ditorials

04-4: I’m just the messenger
Joe Hurley
Wednesday, August 25th 2004

Looking for someone to blame for the bewildering array of tax provisions aimed at families saving and paying for college? Cast your eyes towards Washington. In their zeal to help families pay for college, Congress and the last couple of Presidents have created a maze of tax provisions that is altogether too complicated.

I can point to at least ten separate sections of the Internal Revenue Code granting special tax breaks for families saving and paying for college. The mere number of tax breaks is not the problem. The problem is the way they collide with each other. In offering multiple breaks, Congress has also imposed multiple sets of "coordination" rules to prevent you and me from gaining more than one tax benefit on any particular educational expenditure.

In some cases the tax breaks are mutually exclusive. In other cases they must follow a chain of priority. Consider this conundrum:
- If you claim the above-the-line deduction for your child's college tuition, you cannot claim a Hope or Lifetime - - - - Learning credit in the same tax year.
- If you claim a Hope or Lifetime Learning credit, the amount you can withdraw tax-free from a Coverdell ESA is reduced.
- If you withdraw from a Coverdell ESA, the amount of above-the-line deduction you can claim is reduced.

How does one get off this merry-go-round?

It gets worse when the tax law gives you the option to claim education credits on your tax return or on your dependent's return … when the alternative minimum tax becomes an issue … when your child's dependency status is in play … and so on.

I can now officially consider myself a victim of this complexity. My oldest child, Megan, has just enrolled at college. I'm putting together my strategy for taking withdrawals from 529 plans, for claiming available tax credits, for taking interest deductions on college loans, and for shifting income from our tax return to hers. I've determined that we can reduce our combined tax bills by a substantial amount by making sure that Megan fails the tax dependency test.

But the strategy that works for me may not work so well for you. You may want to look to a tax professional for some help.

But shouldn't we also be looking to our federal government for help? I think so, and I believe it might actually happen before long. The U.S. Treasury Department has listed tax simplification as one of its major goals, and several changes aimed at the education provisions were included in the Bush budget proposals earlier this year. Candidate Kerry's proposal to create a single higher-education credit would also simplify things. But no matter who wins the elections in November, entrenched interests always make such measures difficult to adopt.

In the meantime, here are some simplification suggestions of my own:

1) Trash the Coverdell education savings account

I could never figure out why Congress enacted the Coverdell ESA (originally the Education IRA) one year after giving the green light to state-sponsored college savings programs (529 plans). The ESA contains a number of little-understood complexities. We should eliminate the ESA and force conversion of all existing ESAs into Roth IRAs. Simultaneously, add a rule that permits any Roth IRA to be withdrawn tax-free for college (and probably for K through 12 expenses as well, although I won't get into the politics of that).

2) Wipe the various credits and deductions for college tuition off the income tax return

Take what is now the Lifetime Learning credit and permit accredited higher-education institutions to request it from the federal government on behalf of their students. The schools can then apply the money directly against student tuition bills. Let's face it-many schools have already bumped up their tuitions in anticipation of families receiving tax benefits. Why not make the schools themselves responsible for administering the credit? This will make our lives a lot easier, reduce the chances of error and cheating, and ensure that the benefit reaches thousands of (mostly low- and moderate-income) families who would otherwise miss out because they either fall below the tax threshold or because they can’t afford a good accountant.

3) Fix or eliminate the alternative minimum tax (AMT)

Congress gave families a reprieve last year by allowing the Hope or Lifetime Learning credit to reduce AMT, but we may be stuck this year. The AMT is an unfair trap for the unwary.

4) Make the 529 tax exclusion permanent

Don't keep us guessing about whether the current exclusion will expire at the end of 2010.

Let's hope our government in Washington gets serious about tax simplification.

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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