Tax Breaks for Education

By Dr. John L. Stancil
Tax Analyst, WebTaxCenter.com

The Federal government currently has several opportunities for taxpayers to save on their taxes by making qualified educational expenses. In addition, if your student is enrolled in an eligible higher education institution in the Gulf Opportunity Zone, there are additional tax benefits that you can obtain.

In taking advantage of these various opportunities, be aware that there is frequently an interaction among them. For example, you cannot take a Hope or Lifetime Learning Credit for expenses paid out of a Coverdell Education Savings Account distribution.

Coverdell Education Savings Accounts

Coverdell Education Savings Accounts (CESA) were formerly known as Education IRA's. Fortunately, the name was changed, as these have nothing to do with retirement. A CESA differs from most of the other tax breaks for education in that expenditures for elementary and secondary education expenses can be included In addition to higher education expenses. A Coverdell account cannot be used to pay for home schooling expenses.

A Coverdell is a trust account that is set up to pay the qualified education expenses of a designated beneficiary. Generally, any individual may contribute to a CESA if they meet the adjusted gross income requirements. A grandparent, aunt or uncle, or even a family friend may establish an account. A married couple may fully contribute to a Coverdell if their adjusted gross income is less than $220,000. If their income exceeds $190,000 the amount they can contribute is reduced. For other filers, the limits are $110,000 and $95,000. You may contribute to accounts for an unlimited number of beneficiaries.

CESA's also have a broader definition of "qualified education expenses" than many of the other education programs. These expenses for CESA's include:

• Tuition
• Fees
• Books and supplies
• Equipment
• Room and Board - Must be enrolled at least half time.

A Coverdell does not provide an immediate tax advantage, but allows funds to increase over time and may be withdrawn tax-free when used for qualified education expenses.

The rules for a Coverdell are:

• The annual limit is $2,000 per beneficiary per year.
• Contributions maybe made until the beneficiary reaches age 18.
• Funds must be withdrawn by age 30, but may be rolled over for the benefit of another family member.

Funds that are withdrawn for uses other than qualified education expenses are subject to taxation and a 10% penalty. The tax and penalty apply only to the earnings on the account.

Employer-Provided Educational Assistance

Your employer may provide up to $5,250 of education assistance benefits per year. Benefits up to this amount may be excluded from your income. The funds may be used for undergraduate and graduate-level courses. Funds in excess of this amount should be included in your wages in box 1 of your W-2.

If the amount above $5,250 is classified as a working condition fringe benefit your employer does not have to include those amounts in your income. A working condition fringe benefit is a benefit that would be deductible if you had paid for it. For example, if you take graduate classes to increase your knowledge in your present job, the cost would be deductible if you paid for it. Consequently, a reimbursement by your employer would not be taxable even if the amount exceeded $5,250.

Hope and Lifetime Learning Credits

There are two education credits available. You may only use one in any given year for each eligible student. The Hope Credit and the Lifetime Learning Credit have several elements in common.

You can claim the credit if:

• You pay the qualified education expenses for a student attending an eligible education institution.
• The student is yourself, your spouse, or a dependent for whom you can claim an exemption on your return.

You cannot claim the credit if:

• Your filing status is married filing separately.
• You are listed as a dependent on another person's tax return.
• You Modified Adjusted Gross Income (MAGI) is $110,000 or more ($55,000 or more if not filing a joint return).
• You or your spouse was a nonresident alien for any part of the year and did not elect to be treated as a resident alien for tax purposes.

Qualified education expenses include tuition and student activity fees. Expenses for course related books, supplies, and equipment are included as qualified education expenses only if the expenses must be paid to the institution as a condition of enrollment or attendance. If the student may purchase these items elsewhere they are not qualified expenses.

An eligible education institution is a college, university, vocational school, or other postsecondary education institution eligible to participate in a student aid program administered by the Department of Education. Most accredited private, public, and for-profit postsecondary schools are included in this list.

You can claim an education credit for qualified education expenses paid with the proceeds of a loan. You can claim a credit for expenses not refunded when a student withdraws from school. Expenses paid by your dependent are considered as paid by you.

The institution should provide you with a 1098-T indicating the amount of qualified education expenses incurred in a given year. You determine the amount of your credit by completing Form 8863.

The Hope Credit is 100% of the first $1,100 in qualified education expenses and 50% of the next $1,100 for a maximum of $1,650 credit per student. Rules for the Hope Credit:

• It is available for only two years per student.
• The student must be pursuing an undergraduate degree or other recognized educational credential.
• The student must be enrolled at least half time (as determined by the educational institution) for at least one academic period beginning during the year.
• The student can have no felony drug convictions.
• $1,650 limit is per student.

The Lifetime Learning Credit is 20% of the first $10,000 in qualified education expenses for a maximum credit of $2,000. It has a broader scope than the Hope Credit. The applicable rules:

• It is available for all years of postsecondary education and for courses to improve or acquire job skills
• It is available for an unlimited number of years.
• The student does not need to be pursuing a degree or other credential.
• There is no felony drug conviction rule.
• The $2,000 limit is per return, not per individual.

If the eligible student is enrolled at an eligible educational institution in the Gulf Opportunity Zone, the amount of the Hope and Lifetime Learning Credits are doubled. You do not have to reside in this area, merely have a student attending an eligible school in Louisiana, Mississippi, or Alabama.

529 Plans

A 529 plan, also known as a Qualified Tuition Program, is an educational savings program that will help you set aside funds for future college costs. These plans may be savings plans or prepaid plans. Every state now operates at least one 529 plan. You do not have to live in the state to contribute to that state's plan and they do not lock you into attending school in that state. Educational institutions can offer 529 prepaid plans, but not savings plans.

There are four distinct advantages of 529 plans.

1. The contributions to the fund are not tax deductible, but the investment grows tax-free and withdrawals for qualified educational expenses are not taxable.
2. As the donor you control the account. The named beneficiary has no access to the funds, you determine when the withdrawals occur and for what purposes.
3. Once you establish a plan, you can fund it as you choose, including automatic deposits. The ongoing investment of the account is handled by the plan administrator.
4. Everyone is eligible to take advantage of a 529 plan - there are no income limitations and you can fund the plan rather substantially. In addition, you can combine 5 years of gift giving into the plan. In other words, given the current annual limit of $12,000 for a tax-free gift you can contribute up to $60,000 at once with no gift tax consequences.

If the funds are not used for qualified education expenses, withdrawals of the income from the plan are subject to income tax and a 10% penalty.

Withdrawals from an IRA

Although designed as a retirement plan, an IRA can serve as a useful method for financing qualified higher education expenses. Unlimited withdrawals may be made from a Traditional or Roth IRA without having to pay the 10% penalty if the funds are used for qualified higher education expenses. Regular income tax will be paid on at least a portion of the early withdrawal. The withdrawal may be for you, your spouse, children, or grandchildren.

Savings Bond Interest Exclusion

You may be able to exclude from income interest received on the redemption of U. S. Savings bonds during the year in which you pay qualified higher education expenses. Bonds qualifying for the exclusion are series EE bonds issued after 1989 or any series I bonds. In order to be eligible for the exclusion:

• You cannot have the status of "married filing separately"
• The bonds must be issued in your name as owner or with your spouse as co-owner.
• You must be at least 24 years of age when the bonds are issued.
• You must have qualified education expenses in the year of redemption. For purposes of this exclusion, qualified education expenses include tuition and fees paid for you , your spouse, or dependent to attend an eligible education institution.

Qualified education expenses must be reduced by:

• The tax-free portion of scholarships and fellowships
• Expenses used to determine the tax-free portion of Coverdell ESA distributions.
• Any tax-free payments received for education expenses such as veterans' benefits or employer-provided tuition assistance.

Amount Excludable - If the total of principal and interest received upon redemption (proceeds) is not more than your higher education expenses, you may be able to exclude all of the interest. If the proceeds are more than the expenses, you can only exclude a portion of the interest income. To determine the amount excludable divide the qualified expenses by the total proceeds and multiply by the interest income.

Limitations - If your modified adjusted gross income exceeds certain levels, you will receive a reduced exclusion. If your filing status is married filing jointly, the phase out begins at $91,850. Above $121,850 you cannot take the exclusion. For other taxpayers, the phase out begins at $61,200 and ends at $76,200.

To determine your modified gross income complete instructions for line 9, Form 8815. This form is the form on which you determine the amount of your exclusion.

Work-Related Education Expenses

If you incur education expenses in relation to your job you may be able to deduct those expenses as a miscellaneous itemized deduction subject to the 2% limitation. In order to deduct educational expenses you must meet three criteria:

1. Be working
2. Itemize your deductions on Schedule A if you are an employee or file Schedule C or F if you are self-employed.
3. Have expenses for education that meet the requirements for work-related education.

In order to meet the requirements for work related education, the education must:

• Be required by your employer or the law to keep your present salary, status, or job.
• Maintain or improve skills needed in your present work.

It is not deductible if the education is needed to meet the minimum educational requirements of your present trade or business or is part of a program that will qualify you for a new trade or business. For example, if you are employed in a CPA office, and are taking classes that will meet the educational requirement to become a CPA, those expenses are not deductible. As another example, assume you are employed in Human Resources and are taking law classes. This education is not deductible as it may qualify you be become an attorney which is a new trade or business.

Deductible education expenses include

• Tuition, books, supplies, lab fees, and similar items
• Transportation expenses in getting to school

The cost of travel as education is not deductible even if directly related to your duties in your work.

Student Loan Interest

Qualified student loan interest may be deducted on line 33 of page 1 of the 1040 (or line 18 of 1040A). You do not have to itemize your deductions to deduct student loan interest. A qualified student loan is one that you took out solely to pay qualified education expenses for you, your spouse, or a dependent. These expenses must have been paid or incurred within a reasonable time of taking out the loan. Loans from relatives and you employer are not considered qualified student loans.

Qualified education expenses for this purpose are limited to tuition and fees, room and board, books and supplies, equipment, and other necessary expenses.

This deduction is limited to $2,500 and the student must have been enrolled at least half-time in a degree program.

Deduction for Educators

Certain elementary and secondary school educators are allowed a deduction of up to $250 for expenses incurred in relation to their employment. These expenses could include books, supplies, computer equipment, and software, and other classroom materials.

Tuition and Fees Deduction

Taxpayers with an adjusted gross income up to $65,000 (single) and $130,000 (joint) can deduct on page 1 of the 1040 up to $4,000 in qualified education expenditures.

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Dr. John L. Stancil, a tax analyst for WebTaxCenter.com, has been a member of the Florida Southern College faculty since 1998. He received his bachelors degree from Mars Hill College and holds a M.B.A. from the University of Georgia. He later earned his doctorate in accounting from the University of Memphis. He holds four professional certifications, including CPA, CMA, CFM and CIA. Stancil has received the Florida Institute of CPAs 2005 Outstanding CPA in Public Service Award. (This award is given annually to a Florida CPA who has demonstrated significant contributions through community and civic activities.) He has also been recognized as the Expert of the Month on several occasions by allexperts.com.

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