A Lesson from CPAs on the New Education Tax Breaks

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NEW YORK, Mar. 2, 1998 -- With the costs of college education approaching $8,000 a year at four-year public universities and colleges and more than $18,000 at private universities, parents and students need a helping hand. And they are getting one this year from Uncle Sam in the form of some valuable tax credits and other tax breaks. The Taxpayer Relief Act of 1997 includes some education-related tax provisions that can benefit families with children in college.

HOPE SCHOLARSHIP CREDIT

Starting in 1998, the new Hope Scholarship Credit is available against federal income taxes for qualified tuition and related expenses paid for a student's first two years of post-secondary education. The credit is equal to 100 percent of the first $1,000 of qualified expenses paid during the year, plus 50 percent of the next $1,000. That makes the maximum credit for 1998 $1,500 per student.

The Hope Credit is effective for expenses paid after December 31, 1997, for academic periods beginning after that date on behalf of the taxpayer, taxpayer's spouse, or a dependent. Such expenses include qualified tuition and related expenses, but not room, board, or books.

LIFETIME LEARNING CREDIT

Another new credit established by the new tax law is the Lifetime Learning Credit, which is equal to 20 percent of the first $5,000 of qualified tuition and fees paid after June 30, 1998, for education beginning after that date. The maximum credit is $1,000 per family. Unlike the Hope Credit, a taxpayer may claim the Lifetime Learning Credit for an unlimited number of tax years.

INCOME LIMITS

The ability to claim the credits depends on your adjusted gross income (AGI). The credits are phased out for single taxpayers with modified AGIs of $40,000 to $50,000 and for couples filing jointly with modified AGIs between $80,000 and $100,000. The credits are not available to married taxpayers filing separately.

EDUCATION IRAs

As a result of the new tax law, taxpayers now have the opportunity to create a nondeductible education IRA for each child under age 18. These IRAs are trust or custodial accounts that are created exclusively to pay for higher education expenses.

As with all IRAs, the earnings on the funds will not be taxed until the funds are withdrawn. However, there is a bigger break as well: Distributions generally will not be included in gross income as long as the distribution does not exceed your educational expenses for that year.

Annual contributions to these IRAs are limited to $500 per beneficiary and cannot be made after the beneficiary reaches age 18. Another rule to keep in mind is that you cannot contribute to an education IRA in the same year in which you contribute to a qualified state tuition plan.

As with the Hope and Lifetime Learning Credits, high-income taxpayers may not be able to take advantage of Education IRAs. Income phase-out rules apply to taxpayers with modified AGIs between $95,000 and $110,000 if single and $150,000 and $160,000 if married filing jointly.

The two credits, as well as the tax-free withdrawals from education IRAs, are mutually exclusive. So, for each eligible student, the parent or other taxpayer must elect either one of the tax credits or the exclusion from gross income for withdrawals from education IRAs.

PENALTY-FREE IRA WITHDRAWALS

If you don't meet the requirements for the tax credits or the education IRA, you may still be able to use IRAs to help finance qualified higher education costs. Under the new tax law, you can make withdrawals from IRAs before reaching age 59-1/2 and not incur the 10-percent penalty if the distribution is used to pay for qualified education-related expenses. This rule is effective for distributions from IRAs made after December 31, 1997 for academic periods beginning after that date. Of course, you still have to pay income taxes on this distribution.

STUDENT LOAN INTEREST DEDUCTION

Another new tax law change allows deductions for student loan interest of the taxpayer, spouse, or a dependent. Depending on your income, you may take an above-the-line deduction for interest expense on qualified education loans. This means both those who itemize as well as non-itemizers may apply the deduction when determining adjusted gross income.

Qualified higher education expenses include the cost of tuition, fees, and room and board, as well as related expenses incurred when attending a post-secondary institution, certain vocational schools, or some other internship or residency programs.

The maximum deduction for 1998 is $1,000. It then increases to $1,500 in 1999, $2,000 in 2000 and $2,500 in 2001. Only interest paid during the first 60 months of loan payments is deductible. The deduction begins to phase out for single taxpayers with AGIs of $40,000 to $55,000 and for couples filing jointly with modified AGIs of $60,000 to $75,000.

PLAN TO SAVE

Despite these new credits and deductions, the best way to ensure that you can meet the high costs of college is to save vigorously. Be sure to consider the impact of the new tax law on your savings strategy.

The AICPA (http://www.aicpa.org) is the national professional organization of CPAs with more than 331,000 members in public practice, business and industry, government and education.

CONTACT: Lynn Drake of American Institute of Certified Public Accountants, 202-434-9214, or LDrake@aicpa.org