Tax Benefits for College Tuition
The Taxpayer Relief Act of 1997 provided several higher education tax incentives. These provisions create several new benefits for families who are saving for, or already paying, higher education costs. We would like to give you some guidance regarding these new provisions.
The Hope Scholarship Credit
This credit is a nonrefundable credit against federal taxes. A nonrefundable credit may be taken to the extent that you have a federal tax liability. In other words, if the credit is in excess of your tax liability, you will not receive a refund. The Hope Scholarship credit may be claimed for the qualified tuition and related expenses of each student in the taxpayer's family who is enrolled at least half-time in one of the first two years of postsecondary education and who is enrolled in a program leading to a degree, certificate, or other recognized educational credential.
The credit is calculated on a per student basis. The amount that may be claimed is equal to 100% of the first $1,000 of qualified tuition and related expenses, plus 50% of the next $1,000 of qualified tuition and related expenses for the first two years of the student's postsecondary education. Books are not considered qualified expenses.
The credit is phased out ratably for taxpayers with modified adjusted gross income between $40,000 and $50,000 ($80,000 and $100,000 for married taxpayers filing jointly). Married taxpayers filing jointly with modified adjusted gross income of more than $100,000 may not claim the credit.
The credit may be claimed for a taxpayer, his spouse and other eligible dependents. Either the parent or the child, but not both, may claim the credit for the child's expenses. If a taxpayer claims the child as a dependent, only the taxpayer may claim the credit. In order to claim a child as dependent, you must provide more than one-half of the total support during the calendar year. If you or your child does not claim the dependency exemption, the child may claim the credit.
Out-of-pocket expenses are taken into account in calculating the credit. Qualified tuition expenses (not including books) paid with a student's earnings, a loan, gift, inheritance or personal savings are included in the calculation. Tuition expenses paid with a Pell Grant, or other tax-free scholarship, tax-free distribution from an Education IRA or tax-free employer-provided educational assistance are not considered in the calculation of the credit. (This applies to the Lifetime Learning Credit as well).
Lifetime Learning Credit
This credit provides that taxpayers may elect a non-refundable credit equal to 20% of qualified tuition and related expenses. For expenses paid after June 30, 1998 and before January 1, 2003, up to $5,000 of qualified tuition and related expenses per taxpayer is eligible for the maximum credit of $1,000 ($5,000 @20%). For expenses paid after December 31, 2002, up to $10,000 of qualified tuition and related expenses per taxpayer is eligible for the maximum $2,000 credit ($10,000 @20%).
Again, this credit is phased out ratably for taxpayers with modified adjusted gross income between $40,000 and $50,000 ($80,000 and $100,000 for married taxpayers filing jointly).
The Lifetime Learning credit is available for qualified tuition and related expenses incurred for undergraduate, graduate-level and professional degrees courses. Also, the credit is available for course taken to acquire or improve job skills regardless of whether the course is taken on a full-time or part-time basis.
Please note that you cannot take both the HOPE Scholarship and Lifetime Learning credit for the same student in the same year.
Education IRAs
An education IRA may be established as a trust for the payment of higher education expenses of a designated beneficiary. There must be a written instrument creating the trust, contributions must be made in cash and contributions may not be made after the designated beneficiary reaches age 18.
The annual contribution limitation for an education IRA is $500 and is phased out ratably for contributors with modified adjusted gross income between $95,0000 and $110,000 ($150,000 and $160,000 for married filing joint). The IRA is also transferable to another beneficiary.
Only one education IRA may be established for any one beneficiary. And no contributions may be made to an IRA established on behalf of a designated beneficiary during a year in which contributions are made to a qualified State tuition program on behalf of the same beneficiary.
Penalty-free withdrawals from IRAs
You are exempt from the 10% early withdrawal penalty tax of distributions from a traditional IRA to pay for qualified higher education expenses of the taxpayer, spouse, child or grandchild.
Hiring your children to work in your business creates a tax deduction for you and may shift family income to lower tax brackets, depending on the age of the child. Children with earned income may be eligible to contribute to an IRA. A maximum contribution of $2,000 to an IRA will compound tax-free from their teens through to retirement. Funds can be withdrawn without penalty for qualified higher education expenses or for the purchase of their first home.
We are finding that many of our clients do not qualify for any of these credits due to the income limitations and phase-outs. A child with earned income may be eligible to take advantage of these credits. As mentioned above, if you are eligible to claim a student as a dependent, but choose not to, your child may claim his/her education credits even if the funds came from you. Just make sure that you child's income is sufficient to take advantage of these credits.
State Tuition Program or "529 Plans"
Most states have established state tuition plans created under Internal Revenue Code Section 529. The programs vary state to state but you can invest in any state plan that you wish. Massachusetts offers a 529 investment plan called the U. Fund. This is a professionally managed portfolio which grows tax deferred. The portfolio is invested in higher yielding vehicles such as mutual funds, stocks and bonds. Investment earnings are not taxed until used to pay for qualified higher education expenses and are then taxed at the student's tax rate. Invested funds can be used for educational expenses at any federally accredited college in the country.
This is a great vehicle for grandparents to establish for young beneficiaries. For example, if a grandparent establishes U. Fund account for a grandchild that ultimately does not attend college, the trust may be transferred to another beneficiary of the same generation without penalty or tax consequence.
A gift tax benefit gives you the availability to invest up to $50,000 in a single year by pro-rating the gift at $10,000 per year over a five-year period. This would exhaust the $10,000 gift tax exemption for the beneficiary for those years.
The main variance in different state plans is where the portfolio is invested and the fees charged. The Massachusetts U. Fund investments are managed by Fidelity Investments. The minimum investment is $50 if the Fidelity Automatic Account Builder is elected where automatic payments are transferred directly from a bank account or through a payroll deduction. Otherwise, the minimum investment requirement is $1,000. The maximum amount that you can invest for the year 2000 is $164,375.
State Tuition Plan - "U. Plan"
The U. Plan is another vehicle offered in Massachusetts. This is a prepaid tuition program where you basically lock in tomorrow's tuition at today's rates by purchasing Tuition Certificates. The U. Plan purchases a special form of state bond issued and guaranteed by the Commonwealth of Massachusetts. The return on the U. Plan bonds is guaranteed to equal the increase in the rate of college tuition plus any mandatory fees at a participating college.
The percentage of tuition locked in is determined by dividing the amount invested by the actual tuition plus mandatory fees. You are not required to specify the college until you redeem the tuition certificates when the student enrolls. If the student does not attend one of the 80 participating Massachusetts colleges or universities, the Tuition Certificate will be redeemed at maturity with interest accrued at the CPI index over the years.
It is important to note that the Tuition Certificates will cover a percentage of undergraduate tuition and mandatory fees. They will not cover the cost of room and board, books or supplies.
The minimum purchase of Tuition Certificates is $300 per maturity year.
MEFA Loans
The primary borrower cannot be the student, although he/she will be required to co-sign the loan with the same responsibilities and obligations for repayment as the primary borrower. Applicants must pass an independent credit review, the guidelines of which are the same as normal lending standards for approval of personal credit extensions.
There is no application fee, although an origination fee is included in the loan. The current interest rates for 2000-2001 are 7.85% (APR 8.49%)for a fixed rate MEFA Loan and 7.24% (APR 7.86%) for the variable rate MEFA Loan. The interest rate for a fixed rate MEFA Loan for a non-Massachusetts school is 9.85%.
Repayment usually begins within 45 days after the funding of the loan. Prepayments can be made in full at any time, however, this will not impact the origination fee included in the loan.
A Home Equity Option is also available through MEFA. Securing your loan with equity in your home may allow you to deduct the interest as an itemized home mortgage interest deduction on your tax return. You will need to contact us as to the deductibility of interest in your situation.
You may gather more information on the Massachusetts plans and loans by logging onto the www.mefa.org website. This website is equipped with various tools and calculators to assist you in your decision making. Another helpful website is www.salliemae.com which has a calculator to assist you in determining the family contribution when applying for financial aid and/or loan financing.
dietrich@cpa.net
last revised December 26, 2000
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