 WICHITA, KANSAS Education Tax Incentives Created by the Taxpayer Relief Act of 1997 The enactment of the Taxpayer Relief Act of 1997 (the "TRA") created incentives to help taxpayers save for secondary education expenses and provided tax breaks during the payment of these expenses. All of the tax breaks and incentives are phased-out based on the taxpayers adjusted gross income (AGI). HOPE Tax Credit & Lifetime Learning Credit Taxpayers may take advantage of two types of income tax credits. The HOPE Tax Credit (the "HTC") and the Lifetime Learning Credit (the "LLC") have some similarities and differences that taxpayers should familiarize themselves with before deciding which one is best for them. Both types of credits are non-refundable and cover qualified tuition and related expenses for the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer. Expenses such as room and board, books and other personal living expenses are not covered. The primary differences that may affect which credit you choose are as follows:
A taxpayer may claim a HTC for a student in one year and a LLC for the same student in the next year, and vice versa. In addition, the HTC can be taken for one student and the LLC taken on other students in the same year. But, a taxpayer can not take both credits for the same student during the same year. Planning Tips: Until the year 2003, the HTC will always be larger than the LLC. Beginning in 2003, the LLC will be larger if eligible expenses are greater than $7,500. Therefore, during 1998 through 2002, if the qualifying expenses of a student occur in the first two years of their undergraduate education, the HTC offers the largest tax benefit. You should carefully coordinate the use of the above tax credits with distributions from education IRA's (discussed later) to ensure the maximum tax savings, as the tax credits are not available in years in which tax-exempt distributions from education IRA's are taken. Deduction for Student Loan Interest Beginning in 1998, a $1,000 (increasing to $2,500 in 2001) above the line deduction may be taken for interest payments on student loans. The reduction of AGI could affect the application of phase-outs for other deductions and credits. Unlike the HOPE and LLC, this deduction can be taken for interest on a loan for education expenses such as room and board, books, and other necessary expenses incurred for the taxpayer, the taxpayer's spouse, or any dependent as of the time the loan was taken out. The deduction is only available for interest paid during the first 60 months in which loan payments are required; and the student for which the loan was used must have been at least a half-time student. The IRS Restructuring and Reform Act of 1998 clarified that this deduction may only be claimed by a taxpayer who is required to make the interest payments under the terms of the loan. This eliminates any deduction by a parent for interest paid on a loan that a child is liable to pay. Therefore, planning who takes out the student loan becomes important. IRA's Taxpayers can establish education IRA's to save for higher education expenses. Contributions to an education IRA can be made by anyone, but are limited to $500 per beneficiary per year and are not deductible. The tax break occurs with distributions for expenses such as tuition, fees, room and board, and books, as they are not taxable. Additionally, distributions from conventional and Roth IRA's, although still subject to income tax, are not subject to the 10% early withdrawal penalty if used for higher education expenses. Education expenses for the taxpayer, the taxpayer's spouse, or any child, stepchild, or grandchild of the taxpayer will qualify for a distribution from an education IRA. Distributions in excess of a beneficiary's higher education expenses are subject to income tax and a 10% penalty, unless the distribution meets a qualified exception. Distributions from an education IRA can not be excluded from the income if a HTC or LLC is claimed for that beneficiary in the same year. Planning Tip: A beneficiary should consider postponing an education IRA distribution until a year in which the tax savings from the exclusion exceed the tax savings from a HTC or LLC. If a beneficiary elects to take an education IRA distribution in the same year they are eligible for an education tax credit, they may waive the income exclusion for the IRA distribution in order to take the tax credit. The foregoing article has been prepared by Bever Dye, LC, as a service to our clients for informational purposes only and does not constitute legal advice. It is designed to provide general information concerning recent developments and topics of interest in the areas of tax and estate planning law. Do not take action in reliance on items contained in this article without obtaining the advice of an attorney. |