I was rusty on Section 529 Qualified Tuition Plans so these research notes were gathered to help answer questions. Most of what I know was written more than 10 years ago prior to the much publicized 2010 review of these plans by the Department of Treasury. The IRS Web site addresses most questions. A few recent publications for CPA expand the planning opportunities and some less considered uses.
Key points:
1) Section 529 plans generally do not interfere with other federal tax benefits for education as long as the underlying expenses are different.
2) There is no federal tax deduction. There is no income “phase out” that would limit use of 529 plans therefore these plans are more attractive to higher income individuals who fail to qualify for other common tax breaks.
3) UTMAs are still better (fewer restrictions and more flexibility) for modest account sizes up to about $20,000.
4) Pennsylvania allows a $12,000 per year income tax deduction for state tax purposes. Keep in mind that a state tax deduction is worth only a fraction of a federal tax deduction.
5) There is little reference comparing the benefits of pre-paid tuition plans to savings account plans. What is published is out-of-date and likely irrelevant.
6) Protection of assets from creditors is likely a significant planning trigger for using these Section 529 plans when the parent or grand parent is in a high risk business or an “upside down” net worth position due to collapse of real estate or investment values.
Treasury:
Tax Topic 313 – Qualified Tuition Programs (QTPs)
A Qualified Tuition Program (QTP) also called “529 plan”, formerly called a Qualified State Tuition Program (QSTP), is a program established and maintained by a state, or agency or instrumentality of a state, to allow either prepaying, or contributing to an account established for paying a student’s qualified higher education expenses at an eligible educational institution. Eligible educational institutions can establish and maintain QTP(s) to allow prepaying a student’s qualified higher education expenses.
An eligible educational institution is generally any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education.
Contributions to a QTP on behalf of any beneficiary cannot be more than the amount necessary to provide for the qualified higher education expenses of the beneficiary. Contributions made to a QTP are not deductible on your Federal tax return.
The benefits of establishing a QTP are; earnings accumulate tax free while in the account, and no tax is due on a distribution that is used to pay qualified higher education expenses. The beneficiary generally does not have to include in income any of the earnings from a QTP unless the amount distributed is greater than the beneficiary’s qualified higher education expenses.
For additional information, refer to Chapter 8 of Publication 970, Tax Benefits for Education.
Publication 970, Tax Benefits for Education
http://www.irs.gov/publications/p970/index.html
Qualified Tuition Program (QTP)
Table of Contents
Introduction
Qualified tuition programs (QTPs) are also called “529 plans.”
States may establish and maintain programs that allow you to either prepay or contribute to an account for paying a student’s qualified education expenses at a postsecondary institution. Eligible educational institutions may establish and maintain programs that allow you to prepay a student’s qualified education expenses. If you prepay tuition, the student (designated beneficiary) will be entitled to a waiver or a payment of qualified education expenses. You cannot deduct either payments or contributions to a QTP. For information on a specific QTP, you will need to contact the state agency or eligible educational institution that established and maintains it.
What is the tax benefit of a QTP. No tax is due on a distribution from a QTP unless the amount distributed is greater than the beneficiary’s adjusted qualified education expenses. See Are Distributions Taxable , later, for more information.
Even if a QTP is used to finance a student’s education, the student or the student’s parents still may be eligible to claim the American opportunity credit or the lifetime learning credit. See Coordination With American Opportunity and Lifetime Learning Credits, later.
What Is a Qualified Tuition Program
A qualified tuition program is a program set up to allow you to either prepay, or contribute to an account established for paying, a student’s qualified education expenses at an eligible educational institution. QTPs can be established and maintained by states (or agencies or instrumentalities of a state) and eligible educational institutions. The program must meet certain requirements. Your state government or the eligible educational institution in which you are interested can tell you whether or not they participate in a QTP.
Qualified education expenses. These are expenses related to enrollment or attendance at an Eligible educational institution (defined later). As shown in the following list, to be qualified, some of the expenses must be required by the institution and some must be incurred by students who are enrolled at least half-time. See Half-time student , later.
- The following expenses must be required for enrollment or attendance of a Designated beneficiary (defined later) at an eligible educational institution.
- Tuition and fees.
- Books, supplies, and equipment.
- Expenses for special needs services needed by a special needs beneficiary must be incurred in connection with enrollment or attendance at an eligible educational institution.
- Expenses for room and board must be incurred by students who are enrolled at least half-time. The expense for room and board qualifies only to the extent that it is not more than the greater of the following two amounts.
- The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.
- The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.
You will need to contact the eligible educational institution for qualified room and board costs.
Designated beneficiary. The designated beneficiary is generally the student (or future student) for whom the QTP is intended to provide benefits. The designated beneficiary can be changed after participation in the QTP begins. If a state or local government or certain tax-exempt organizations purchase an interest in a QTP as part of a scholarship program, the designated beneficiary is the person who receives the interest as a scholarship.
Half-time student. A student is enrolled “at least half-time” if he or she is enrolled for at least half the full-time academic workload for the course of study the student is pursuing, as determined under the standards of the school where the student is enrolled.
Eligible educational institution. For purposes of a QTP, this is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.
Certain educational institutions located outside the United States also participate in the U.S. Department of Education’s Federal Student Aid (FSA) programs.
How Much Can You Contribute
Contributions to a QTP on behalf of any beneficiary cannot be more than the amount necessary to provide for the qualified education expenses of the beneficiary. There are no income restrictions on the individual contributors.
You can contribute to both a QTP and a Coverdell ESA in the same year for the same designated beneficiary.
Are Distributions Taxable
The part of a distribution representing the amount paid or contributed to a QTP does not have to be included in income. This is a return of the investment in the plan.
The designated beneficiary generally does not have to include in income any earnings distributed from a QTP if the total distribution is less than or equal to adjusted qualified education expenses (defined under Figuring the Taxable Portion of a Distribution , later).
Earnings and return of investment. You will receive a Form 1099-Q, from each of the programs from which you received a QTP distribution in 2011. The amount of your gross distribution (box 1) shown on each form will be divided between your earnings (box 2) and your basis, or return of investment (box 3). Form 1099-Q should be sent to you by January 31, 2012.
Figuring the Taxable Portion of a Distribution
To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses.
Adjusted qualified education expenses. This amount is the total qualified education expenses reduced by any tax-free educational assistance. Tax-free educational assistance includes:
- The tax-free part of scholarships and fellowships (see Tax-Free Scholarships and Fellowships in chapter 1, Scholarships, Fellowships, Grants, and Tuition Reductions),
- Veterans’ educational assistance (see Veterans’ Benefits in chapter 1, Scholarships, Fellowships, Grants, and Tuition Reductions),
- Pell grants (see Pell Grants and Other Title IV Need-Based Education Grants in chapter 1, Scholarships, Fellowships, Grants, and Tuition Reductions),
- Employer-provided educational assistance (see chapter 11, Employer-Provided Educational Assistance ), and
- Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
Taxable earnings. Use the following steps to figure the taxable part.
- Multiply the total distributed earnings shown in box 2 of Form 1099-Q by a fraction. The numerator is the adjusted qualified education expenses paid during the year and the denominator is the total amount distributed during the year.
- Subtract the amount figured in (1) from the total distributed earnings. The result is the amount the beneficiary must include in income. Report it on Form 1040 or Form 1040NR, line 21.
Example 1.
In 2005, Sara Clarke’s parents opened a savings account for her with a QTP maintained by their state government. Over the years they contributed $18,000 to the account. The total balance in the account was $27,000 on the date the distribution was made. In the summer of 2011, Sara enrolled in college and had $8,300 of qualified education expenses for the rest of the year. She paid her college expenses from the following sources.
Gift from parents
$1,600
Partial tuition scholarship (tax-free)
3,100
QTP distribution
5,300
Before Sara can determine the taxable part of her QTP distribution, she must reduce her total qualified education expenses by any tax-free educational assistance.
Total qualified education expenses
$8,300
Minus: Tax-free educational assistance
−3,100
Equals: Adjusted qualified
education expenses (AQEE)
$5,200
Since the remaining expenses ($5,200) are less than the QTP distribution, part of the earnings will be taxable.
Sara’s Form 1099-Q shows that $950 of the QTP distribution is earnings. Sara figures the taxable part of the distributed earnings as follows.
1.
$950 (earnings)
×
$5,200 AQEE
$5,300 distribution
=$932 (tax-free earnings)
2.
$950 (earnings)−$932 (tax-free earnings)
=$18 (taxable earnings)
Sara must include $18 in income (Form 1040, line 21) as distributed QTP earnings not used for adjusted qualified education expenses.
Coordination With American Opportunity and Lifetime Learning Credits
An American opportunity or lifetime learning credit (education credit) can be claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses are not used for both benefits. This means that after the beneficiary reduces qualified education expenses by tax-free educational assistance, he or she must further reduce them by the expenses taken into account in determining the credit.
Example 2.
Assume the same facts as in Example 1 , except that Sara’s parents claimed an American opportunity credit of $2,500 (based on $4,000 expenses).
Total qualified education expenses
$8,300
Minus: Tax-free educational assistance
−3,100
Minus: Expenses taken into account
in figuring American opportunity credit
−4,000
Equals: Adjusted qualified
education expenses (AQEE)
$1,200
The taxable part of the distribution is figured as follows.
1.
$950 (earnings)
×
$1,200 AQEE
$5,300 distribution
=$215 (tax-free earnings)
2.
$950 (earnings)−$215 (tax-free earnings)
=$735 (taxable earnings)
Sara must include $735 in income (Form 1040, line 21). This represents distributed earnings not used for adjusted qualified education expenses.
Coordination With Coverdell ESA Distributions
If a designated beneficiary receives distributions from both a QTP and a Coverdell ESA in the same year, and the total of these distributions is more than the beneficiary’s adjusted qualified higher education expenses, the expenses must be allocated between the distributions. For purposes of this allocation, disregard any qualified elementary and secondary education expenses.
Example 3.
Assume the same facts as in Example 2 , except that instead of receiving a $5,300 distribution from her QTP, Sara received $4,600 from that account and $700 from her Coverdell ESA. In this case, Sara must allocate her $1,200 of adjusted qualified higher education expenses (AQHEE) between the two distributions.
$1,200 AQHEE
×
$700 ESA distribution
$5,300 total distribution
=
$158
AQHEE (ESA)
$1,200 AQHEE
×
$4,600 QTP distribution
$5,300 total distribution
=
$1,042
AQHEE (QTP)
Sara then figures the taxable portion of her Coverdell ESA distribution based on qualified higher education expenses of $158, and the taxable portion of her QTP distribution based on the other $1,042.
Note.
If you are required to allocate your expenses between Coverdell ESA and QTP distributions, and you have adjusted qualified elementary and secondary education expenses, see the examples in chapter 7, Coverdell Education Savings Account under Coordination With Qualified Tuition Program (QTP) Distributions .
Coordination With Tuition and Fees Deduction
A tuition and fees deduction can be claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses are not used for both benefits. This means that after the beneficiary reduces qualified education expenses by tax-free educational assistance, he or she must further reduce them by the expenses taken into account in determining the deduction.
Example 4.
In 2006, Devin Smith’s parents opened a savings account for him with a QTP maintained by their state government. Over the years they contributed $30,000 to the account. The total balance in the account was $35,000 on the date the distribution was made. In the summer of 2011, Devin enrolled in college and had $6,000 of qualified education expenses ($2,000 room and board and $4,000 tuition and fees) for the rest of the year. He paid his college expenses from a $6,000 QTP distribution, $1,000 of which is earnings.
The Smiths claim a $4,000 tuition and fees deduction based on the $4,000 tuition expense, and used the $2,000 room and board expenses to reduce the taxable amount of distributed earnings from the QTP.
Total qualified education expenses
$6,000
Minus: Expenses taken into account in figuring
tuition and fees deduction
−4,000
Equals: Adjusted qualified
education expenses (AQEE)
$2,000
They have taxable earnings of $667. This is figured as follows.
1.
$1,000 (earnings)
×
$2,000 AQEE
$6,000 distribution
=$333 (tax-free earnings)
2.
$1,000 (earnings)−$333 (tax-free earnings)
=$667 (taxable earnings)
Losses on QTP Investments
If you have a loss on your investment in a QTP account, you may be able to take the loss on your income tax return. You can take the loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of contributions to that QTP account. You claim the loss as a miscellaneous itemized deduction on Schedule A (Form 1040), line 23 (Schedule A (Form 1040NR), line 9), subject to the 2%-of-adjusted- gross-income limit.
If you have distributions from more than one QTP account during a year, you must combine the information (amount of distribution, basis, etc.) from all such accounts in order to determine your taxable earnings for the year. By doing this, the loss from one QTP account reduces the distributed earnings (if any) from any other QTP accounts.
Example 1.
In 2011, Taylor received a final distribution of $1,000 from QTP #1. His unrecovered basis in that account before the distribution was $3,000. If Taylor itemizes his deductions, he can claim the $2,000 loss on Schedule A (Form 1040).
Example 2.
Assume the same facts as in Example 1 , except that Taylor also had a distribution of $9,000 from QTP #2, giving him total distributions for 2011 of $10,000. His total basis in these distributions was $4,500 ($3,000 for QTP #1 and $1,500 for QTP #2). Taylor’s adjusted qualified education expenses for 2011 totaled $6,000. In order to figure his taxable earnings, Taylor combines the two accounts and determines his taxable earnings as follows.
1.
$10,000 (total distribution)−$4,500 (basis portion of distribution)
= $5,500 (earnings included in distribution)
2.
$5,500 (earnings)
x
$6,000 AQEE
$10,000 distribution
=$3,300 (tax-free earnings)
3.
$5,500 (earnings)−$3,300 (tax-free earnings)
=$2,200 (taxable earnings)
Taylor must include $2,200 in income on Form 1040, line 21. Because Taylor’s accounts must be combined, he cannot deduct his $2,000 loss (QTP #1) on Schedule A (Form 1040). Instead, the $2,000 loss reduces the total earnings that were distributed, thereby reducing his taxable earnings.
Additional Tax on Taxable Distributions
Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income.
Exceptions. The 10% additional tax does not apply to distributions:
- Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
- Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration.
- Included in income because the designated beneficiary received:
- A tax-free scholarship or fellowship (see Tax-Free Scholarships and Fellowships in chapter 1, Scholarships, Fellowships, Grants, and Tuition Reductions),
- Veterans’ educational assistance (see Veterans’ Benefits in chapter 1, Scholarships, Fellowships, Grants, and Tuition Reductions),
- Employer-provided educational assistance (see chapter 11, Employer-Provided Educational Assistance ), or
- Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
- Made on account of the attendance of the designated beneficiary at a U.S. military academy (such as the USNA at Annapolis). This exception applies only to the extent that the amount of the distribution does not exceed the costs of advanced education (as defined in section 2005(d)(3) of title 10 of the U.S. Code) attributable to such attendance.
- Included in income only because the qualified education expenses were taken into account in determining the American opportunity or lifetime learning credit (see Coordination With American Opportunity and Lifetime Learning Credits , earlier.)
Exception (3) applies only to the extent the distribution is not more than the scholarship, allowance, or payment.
Figuring the additional tax. Use Part II of Form 5329, to figure any additional tax. Report the amount on Form 1040, line 58, or Form 1040NR, line 56.
Rollovers and Other Transfers
Assets can be rolled over or transferred from one QTP to another. In addition, the designated beneficiary can be changed without transferring accounts.
Rollovers
Any amount distributed from a QTP is not taxable if it is rolled over to another QTP for the benefit of the same beneficiary or for the benefit of a member of the beneficiary’s family (including the beneficiary’s spouse). An amount is rolled over if it is paid to another QTP within 60 days after the date of the distribution.
Do not report qualifying rollovers (those that meet the above criteria) anywhere on Form 1040 or 1040NR. These are not taxable distributions.
Members of the beneficiary’s family. For these purposes, the beneficiary’s family includes the beneficiary’s spouse and the following other relatives of the beneficiary.
- Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them.
- Brother, sister, stepbrother, or stepsister.
- Father or mother or ancestor of either.
- Stepfather or stepmother.
- Son or daughter of a brother or sister.
- Brother or sister of father or mother.
- Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.
- The spouse of any individual listed above.
- First cousin.
Example.
When Aaron graduated from college last year he had $5,000 left in his QTP. He wanted to give this money to his younger brother, who was in junior high school. In order to avoid paying tax on the distribution of the amount remaining in his account, Aaron contributed the same amount to his brother’s QTP within 60 days of the distribution.
If the rollover is to another QTP for the same beneficiary, only one rollover is allowed within 12 months of a previous transfer to any QTP for that designated beneficiary.
Changing the Designated Beneficiary
There are no income tax consequences if the designated beneficiary of an account is changed to a member of the beneficiary’s family. See Members of the beneficiary’s family , earlier.
Example.
Assume the same situation as in the last example. Instead of closing his QTP and paying the distribution into his brother’s QTP, Aaron could have instructed the trustee of his account to simply change the name of the beneficiary on his account to that of his brother.
Pasted from <http://www.irs.gov/publications/p970/ch08.html>
Pennsylvania Law:
Pennsylvania now allows contributions to Section 529 Qualified Tuition Programs to be deducted for Personal Income Tax purposes. The annual deductible contribution limit per beneficiary is $12,000.00 per year. These plans provide an excellent opportunity to invest on a tax-free basis for your children/grandchildren’s education. In addition, these plans may also provide significant estate tax benefits.
Recent publications about Section 529 plans:
Section 529 Qualified Tuition Programs
by Lucido, Peter D
The CPA Journal 80. 4 (Apr 2010): 48-51.
Abstract
Recent events have focused a spotlight on IRC section 529 qualified tuition programs, one of the most popular ways to save for college. On Sep 9, 2009, the US Treasury Department issued a report, “An Analysis of Section 529 College Savings and Prepaid Tuition Plans,” that examined these plans. It is expected that Congress will soon evaluate whether the rules governing these plans should be changed and whether their current tax benefits should continue to be available to all taxpayers. There are two types of section 529 plans: prepaid tuition plans and college savings plans. The Treasury found section 529 plans to be “an attractive and convenient means of saving for college.” As a result of the substantial tax benefits that section 529 plans offer, the Treasury found that the use of these plans increased the effectiveness of saving by between 6% and 39%. Low- and middle-income taxpayers may benefit in the near future from changes in US and state laws that could increase the benefits of section 529 plans.
Unconventional Uses of 529 Plans Should Not Be Ignored by Taxpayers and Their Advisors
By Koche, David L, Esq; Gassman, Alan S, Esq; Denicolo, Christopher J, Esq. Tax Management Estates, Gifts and Trusts Journal35. 2 (Mar 11, 2010): 130-134.
Abstract
IRC § 529 enables taxpayers to establish ” 529 plans,” which may be immune from federal and state income taxes, creditor-protected, and absorbent of losses that have been sustained within them. Many taxpayers may (after consulting with their financial advisors) consider abandoning the original plan to use a 529 plan to pay for college expenses when it becomes apparent that “an upside down 529 plan” is an income tax savings vehicle, without regard to where the plan assets are spent to pay for college. Also, clients may be best served by starting new 529 plans to pay for college expenses, while using existing upside down 529 plans as income savings vehicles. This article will investigate these strategies and questions that arise therefrom after providing a basic background on 529 plan investment rules.
Website of the Month: Savingforcollege.com
by Anders, Susan B
The CPA Journal 80. 1 (Jan 2010): 73.
Abstract
Savingforcollege.com bills itself as “Your Guide to Saving for College.” Its mission is to help individuals and professional advisors understand IRC section 529 qualified tuition programs, as well as other options to cover the costs of higher education. Although Savingforcollege.com is now owned by Bankrate.com, its founder, Upstate New York CPA Joe Hurley, is still involved, and the professionalism of the Web site should appeal to many practicing tax and financial advisors. The “529 plans” main page presents planning tools for every state and allows users to compare the important features of different states’ 529 plans. The Web site provides a collection of useful information on financial aid. Brief discussions on eligibility, what savings are needed, and some advice on financial aid considerations are reproduced from Family Guide to College Savings.
Tax Benefits for Higher Education
by Galletta, Patricia Z.
The CPA Journal 81. 10 (Oct 2011): 48-53.
Abstract
With annual college expenses running as high as $50,000, CPAs should be aware of the opportunities the IRS offers taxpayers for 2011. Although, dollar for dollar, credits are usually the preferred choice, CPAs should help taxpayers review the requirements and limitations of both credits and deductions and choose the method that will best minimize their tax liabilities. Under IRC section 529, individuals may contribute to a qualified tuition program (QTP) on behalf of any beneficiary. Contributions made to a QTP are not deductible on the federal tax return, but the investment grows tax-free and the distributions to pay for the beneficiaries’ qualified education expenses are tax-free to the beneficiary, as long as the distribution is not more than the beneficiary’s qualified higher education expenses. While the American Opportunity Tax Credit allows a credit for qualified education expenses for the first four years of college, the Lifetime Learning Credit allows a credit for undergraduate, graduate, and job skills courses.
Full text
Headnote
A Planning Toolbox for CPAs
With annual college expenses running as high as $50,000, CPAs should be aware of the opportunities the IRS offers taxpayers for 2011. Although, dollar for dollar, credits are usually the preferred choice, CPAs should help taxpayers review the requirements and limitations of both credits and deductions and choose the method that will best minimize their tax liabilities.
Tax Benefits for Saving for Higher Education
IRC section S29 plans. Under IRC section 529, individuals may contribute to a qualified tuition program (QTP) on behalf of any beneficiary. Contributions made to a QTP are not deductible on the federal tax return, but the investment grows tax-free and the distributions to pay for the beneficiaries’ qualified education expenses are tax-free to the beneficiary, as long as the distribution is not more than the beneficiary’s qualified higher education expenses. This tax-free treatment was made permanent with the Pension Protection Act of 2006 signed by President George W. Bush.
Tuition and other expenses required to be paid to the educational institution for enrollment or a course – such as required student activity fees, special needs services, books, supplies, and equipment – are considered to be qualified education expenses. For 2009 and 2010, qualified higher education expenses also included expenses for computer technology and equipment or Internet access and related services. As of January 1, 2011, however, 529 plan withdrawals are not tax-free when paying for these technology costs. Expenses for room and board incurred by students who are enrolled at least half-time are considered a qualified education expense. But the amount of the room and board cannot be greater than the allowance for room and board, as determined by the educational institution, or the actual amount charged, if the student is residing in housing owned or operated by the educational institution. Insurance, medical, and other personal expenses are not considered qualified education expenses. Education credits or tuition deductions can be claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses are not used in the tax calculations for the credits or deductions. If a beneficiary receives taxable distributions from both a QTP and a Coverdell Education Savings Account (ESA) in the same year, as discussed below, the postsecondary expenses must be allocated between the distributions.
Where is the income claimed? If any of the 529 plan distribution is taxable due to its being greater than qualified education expenses, the excess would be included as “other income” on Form 1040.
Who can claim the income? If any of the 529 plan distribution is taxable, the taxable portion would be reported on the beneficiary’s tax return.
What expenses are eligible? Undergraduate and graduate studies qualify.
Exclusion of interest earned on education savings bonds. Under IRC section 135, a taxpayer may be able to cash qualified U.S. savings bonds and not include all or some of the interest earned on the bonds if the proceeds are used to pay qualified education expenses for the taxpayer and the taxpayer’s spouse or dependent, and the taxpayer’s modified adjusted gross income (AGI) is less than $85,100 (if single or head of household) or $135,100 (if married filing jointly or a qualifying widow). Qualified education expenses are tuition and fees paid to attend an eligible educational institution, including payments to a qualified tuition plan (529 plan) or to a Coverdell ESA. Education credits or tuition deductions can be claimed in the same year the beneficiary uses the qualified U.S. savings bonds to pay tuition expenses, as long as the same expenses are not used in the tax calculations for the credits or deductions.
Where is the exclusion taken? Form 8815, Exclusion of Interest from Series EE and I U.S. Savings Bonds Issued After 1989, is used to calculate the education savings bond interest exclusion.
Who can claim the exclusion? Any taxpayer paying qualified higher education expenses during the current tax year for himself, his spouse, or dependent can claim the exclusion. However, the taxpayer’s filing status cannot be married filing separately.
What expenses are eligible? Undergraduate and graduate studies are eligible.
Coverdell ESA. Similar to an IRC section 529 plan, contributions made to a Coverdell ESA (IRC section 530) are not deductible on the federal tax return, but the investment grows tax-free and the distributions to pay for the beneficiaries’ qualified education expenses are tax-free to the beneficiary, as long as the distribution is not more than the qualified higher education expenses. Postsecondary tuition and other related expenses such as student activity fees required for college enrollment, qualified room and board (see above), books, special needs services, supplies, and equipment are considered qualified education expenses. For an eligible elementary or secondary school, tuition and other related expenses such as books, special needs services, supplies, academic tutoring, and equipment are qualified expenses. Room and board, uniforms, transportation costs, and supplementary expenses required by the elementary or secondary school also qualify. Compared to a 529 plan, the Coverdell ESA has lower maximum contribution limits and more investment choices. It also has an age limit on distributions, can be used for qualified elementary and secondary school expenses, and contributions may be restricted based on the income level of the donor. Education credits or tuition deductions can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses are not used in the tax calculations for the credits or deductions. If a beneficiary receives taxable distributions from both a QTP and a Coverdell ESA in the same year, the postsecondary expenses must be allocated between the distributions.
Where is the income claimed? If any of the ESA plan distribution is taxable (due to its being greater than qualified education expenses), this excess amount would be included as “other income” on Form 1040.
WJto can claim the income? If any of the ESA plan distribution is taxable, this portion would be reported on the beneficiary’s tax return as “other income” on Form 1040.
What expenses are eligible? Undergraduate and graduate studies are eligible, as are grades kindergarten through 12.
Status. The Coverdell ESA was scheduled to expire at the end of 2010. In December 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, signed into law by President Obama, extended this benefit for two more years.
Uniform Transfers to Minors Act (UTTMA). Created in 1986 by the U.S. Uniform Law Commission, the UTTMA allows taxpayers to create bank or brokerage accounts in trust for a minor without going to the expense of creating a formal trust. A custodian manages the account until the minor reaches 18 or 21, depending upon the state, but the income earned on the account is credited to the minor’s Social Security number. Proceeds from the account can be – but are not required to be – used for education expenses. There are no special tax considerations related to the use of monies in a UTTMA account to pay for education expenses.
Tax Benefits for Current Expenses
American Opportunity Tax Credit. The American Recovery and Reinvestment Act (ARRA) was enacted in 2009 to stimulate jobs and promote investment and spending, and section 1004 of the act created a partially refundable American Opportunity Tax Credit under IRC section 25 A, aimed at helping parents and students pay part of the cost of the first four years of college. Applicable for tax years 2009 and 2010, the amount deductible is 100% of qualified tuition, fees, and course materials paid by the taxpayer during the taxable year, not to exceed $2,000, plus 25% of the next $2,000 in qualified tuition, fees, and course materials. The total credit cannot exceed $2,500 per year and per student, but if the credit is more than the calculated tax liability, the taxpayer may be entitled to a refund of 40% of the amount of the credit, up to $1,000. The credit cannot be claimed if the taxpayer’s modified AGI is $90,000 or more ($180,000 for married couples filing jointly). In addition, the American Opportunity Tax Credit can only be claimed for the same student for a total of four years.
ARRA section 1004 modified the Hope Scholarship Credit for 2009 and 2010 by allowing an increase in the amount that can be deducted from $1,800 to $2,500, revising the definition of qualified education expenses to include course materials, and expanding eligible expenses from the first two years of college to the first four years. Now, in addition to tuition and other related expenses such as student activity fees required for college enrollment, books, supplies, and equipment purchased for a course may be deductible even if they were not purchased from the educational institution. Costs such as room and board, insurance, medical, and other personal expenses are not considered qualified education expenses.
Where is the credit claimed? The credit is claimed using Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits), attached to Form 1040 or 1040A.
Who can claim the credit? The credit is applicable to qualified education expenses paid on behalf of the taxpayer, the taxpayer’s spouse, or a dependent, as long as an exemption is claimed for the dependent by the taxpayer and is available on a per-student basis. However, the taxpayer’s filing status cannot be married filing separately. The student must be pursuing a degree or a recognized education credential and must be enrolled at least halftime for at least one academic period during the year.
What expenses are eligible? The first four years of undergraduate studies per eligible student qualify for the credit.
Status. The American Opportunity Tax Credit was scheduled to expire at the end of 2010, but was extended for two years by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010.
Lifetime Learning Credit. While the American Opportunity Tax Credit allows a credit for qualified education expenses for the first four years of college, the Lifetime Learning Credit (under IRC section 25A) allows a credit for undergraduate, graduate, and job skills courses. The nonrefundable Lifetime Learning Credit is equal to 20% of the taxpayer’s out-of-pocket expenses, up to a maximum of $10,000 in qualified expenses; therefore, the maximum Lifetime Learning Credit a taxpayer may claim per family each year is $2,000 ($10,000 ? .20). The Lifetime Learning Credit cannot be claimed, however, if the taxpayer’s modified AGI is $60,000 or more ($120,000 for married couples filing jointly). While the American Opportunity Tax Credit can be claimed for the same student for no more than four years, the Lifetime Learning Credit is available for an unlimited number of years. Tuition and other related expenses (such as student activity fees) required as a condition of enrollment, as well as books, supplies, and equipment required to be paid to the educational institution for a course are considered qualified education expenses. Costs such as room and board, insurance, medical, and other personal expenses are not considered qualified education expenses.
Where is the credit claimed? The credit is claimed using Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits), attached to Form 1040 or 1040A.
Who can claim the credit? The credit is applicable to qualified education expenses paid on behalf of the taxpayer, taxpayer’s spouse, or a dependent, as long as an exemption is claimed for the dependent by the taxpayer. However, the taxpayer’s filing status cannot be married filing separately. The student does not need to be pursuing a degree or a recognized education credential, and the credit is available for one or more courses.
What expenses are eligible? Undergraduate and graduate studies qualify for the credit, as well as courses aimed at acquiring or improving job skills.
If a taxpayer pays qualified education expenses for more than one student in the same year, the taxpayer can claim the American Opportunity Tax Credit for one student and the Lifetime Learning Credit for another student in the same year. A taxpayer cannot, however, claim the American Opportunity Tax Credit, the Lifetime Learning Credit, and a tuition and fees deduction for the same student in a single year.
Qualified education expense above-the line deduction – tuition and fees deduction. The American Opportunity Tax Credit and the Lifetime Learning Credit reduce the federal income taxes paid dollar for dollar, but the tuition and fees deduction is a deduction from income in order to arrive at AGI. Under the provisions of IRC section 222, if a taxpayer does not take the credits on his tax return, he may be able to deduct up to $4,000 per year (for 2011) of qualified college tuition and expenses related to undergraduate and graduate courses. The tuition and fees deduction is subject to a phase-out for taxpayers with AGI in excess of $80,000 ($160,000 for married couples filing jointly).
Tuition and other related expenses (such as student activity fees) paid as part of the enrollment, as well as books, supplies, and equipment required to be paid to the educational institution for a course are considered qualified education expenses. Costs such as room and board, insurance, medical, and other personal expenses are not considered qualified education expenses.
Where is the deduction claimed? This adjustment to income is claimed using Form 8917, Tuition and Fees Deduction, attached to Form 1040 or 1040A.
Who can claim the deduction? The deduction is applicable to qualified education expenses paid on behalf of the taxpayer, the taxpayer’s spouse, or a dependent, as long as an exemption is claimed for the dependent by the taxpayer. However, the taxpayer’s filing status cannot be married filing separately. In addition, a taxpayer cannot take an education credit from Form 8863, a business deduction for work-related education expenses (see below), and the tuition and fees deduction from Form 8917 for the same student for the same tax year. Taxpayers should consider all of the available options and choose the one resulting in the lowest overall amount of taxes due.
What expenses are eligible? Undergraduate and graduate studies qualify for this deduction.
Business deduction for work-related education. If a taxpayer itemizes her deductions and is working, she can deduct the costs of qualifying work-related education as a business expense. These are expenses required by an employer or the law to keep a current job, salary, or status or to improve or maintain skills needed for a present position. An education expense is not a qualifying deductible education expense if the education is needed to meet the minimum qualifications of the job or will qualify the worker for a new position. Tuition and other related expenses (such as student activity fees) required to be paid for college enrollment, as well as books, supplies, and equipment required to be paid to the educational institution for a course are considered qualified education expenses. The cost of transportation from work to school is also a qualified education expense. The cost of transportation from school to home may be a qualified education expense if the worker is regularly employed and goes to school on a temporary basis (i.e., if the schooling is expected to last one year or less). Costs such as room and board, insurance, medical, and other personal expenses are not considered qualified education expenses. The IRS allows several different education benefits, but the same education expenses cannot be used to claim multiple credits or deductions.
Where is the deduction claimed? The deduction is claimed on Schedule A (subject to the 2% of AGI rule), or Schedule C, if a taxpayer is self-employed.
Who can claim the deduction? Any taxpayer who is working and itemizes (or files Schedule C if self-employed) and has qualifying work-related education expenses can claim the deduction.
What expenses are eligible? Classes taken to keep a taxpayer’s present salary, status, or job, or taken to maintain or improve skills needed in present work, are eligible.
Education exception to additional tax on early IRA distribution. Normally, if a taxpayer withdraws funds from an IRA before reaching age 59*/2, he must pay an additional 10% penalty on the early distribution. If a taxpayer decides to withdraw money from an IRA to pay for education expenses, and the taxable part of the distribution is less than or equal to the adjusted qualified education expense, the additional 10% penalty is waived. Tuition and other related expenses (such as student activity fees) required to be paid for college enrollment, as well as books, supplies, special needs services, and equipment required to be paid to the educational institution for a course are considered qualified education expenses. If the student is at least a half-time student, room and board is also considered a qualified expense. The amount of the room and board cannot be greater than the allowance for room and board as determined by the educational institution or the actual amount charged if the student is residing in housing owned or operated by the educational institution.
Where is the benefit claimed? The benefit is claimed on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.
Who can claim this benefit? The deduction is applicable to qualified education expenses paid on behalf of the taxpayer, the taxpayer’s spouse, and the taxpayer’s or spouse’s child (or descendant).
What expenses are eligible? Payment is made for qualified education expenses and, in some cases, room and board.
Employer-provided educational assistance. If a taxpayer receives educational assistance benefits for either undergraduate or graduate-level courses from an employer under an educational assistance program, benefits up to $5,250 do not need to be included on her tax return, under the provisions of IRC section 127. Amounts greater than $5250 are taxable and should be included in the W-2, Box 1 (Wages, Tips, and Other Compensation). Qualified education expenses include tuition, fees, books, supplies, and equipment. Meals, lodging, transportation, tools, or supplies that can be kept after completing the course, and courses involving sports, games, or hobbies (unless they are business-related or are required to earn a degree) are not eligible under IRC section 127.
What expenses are eligible? Undergraduate and graduate expenses are eligible for this exclusion.
Status. The employer-provided education assistance benefit was scheduled to expire at the end of 2010, but was extended for two years by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.
Tax Benefits Relating to Past Expenses
Student loan interest deduction. If a student, spouse, or dependent is pursuing a degree or a recognized education credential and is enrolled at least half-time for at least one academic period beginning during the current year, the interest paid on any loans associated with that education may be deductible under IRC section 221. The maximum deduction for interest on loans taken to pay tuition, room and board (see above), and other related expenses of attending an eligible educational institution (including graduate school) is $2,500 per year for taxpayers with modified AGI of less than $75,000 ($150,000 for married couples filing jointly).
Where is the deduction claimed? The deduction is claimed on Form 1040 or 1040A as an adjustment to gross income.
Who can claim the deduction? A taxpayer can deduct interest on a loan used to pay qualified education expenses on behalf of the taxpayer, the taxpayer’s spouse, or a dependent. However, the taxpayer’s filing status cannot be married filing separately.
Status. The student loan interest deduction was scheduled to expire at the end of 2010, but was extended for two years by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.
Money Available Through Grants
The federal Pell Grant, as described in Title IV of the Higher Education Act of 1965 and sponsored by the U.S. Department of Education, is based on financial need. Recipients are not required to repay the grant. The Federal Supplemental Educational Opportunity Grant (FSEOG) works similarly to the Pell Grant. Generally, grants are tax-free when the proceeds are used to pay qualified education expenses during the period the grant is awarded. (See www.grants.gov for more information on Pell Grants and www. fseog.com for more on FSEOG grants.)
Where to Go from Here?
Many taxpayers struggle to save enough to pay for their children’s college tuition. If a child does not qualify for free tuition, taxpayers first need to decide if they can afford higher education on their current income or if they need to finance the amount through an educational loan. The feasibility of other methods of financing a taxpayer’s education not discussed in this article (such as a home equity loan) should also be considered. If a taxpayer determines that an outside loan is necessary, federal Stafford loans (www.staffordloan.com) usually have a lower interest rate than comparable private loans, and federal Perkins loans (www2.ed.gov/programs/fpl/index. html) may also be available.
Once taxpayers start making tuition payments, their tax advisor should look at the various credits and deductions allowed to determine which will best minimize any taxes due. Some of the more popular education tax credits and deductions are described above. Taxpayers should also always be aware that a high modified AGI will affect the availability of the education credits and deductions.
Author Affiliation
Patricia Z. Galletta, MBA, CPA, is an assistant professor of accounting at the College of Staten island, Staten Island, N.Y.
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