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Family Tax Planning - Education Credits

To help families (largely low- and middle-income) and students pay for the costs of post-secondary education, the tax law provides a number of tax benefits for education, including the Hope scholarship credit, the lifetime-learning credit, two forms of tax-favored savings accounts, a deduction for tuition, and a deduction for student loan interest. There are, however, limitations and restrictions on using all of these benefits. As a result, it's important to consider strategies that maximize a taxpayer's use of all the benefits available.

EDUCATION CREDITS -- GENERAL PLANNING CONSIDERATIONS

The Hope credit is a per student credit, and can be claimed for each student. Thus, a taxpayer can claim this credit for more than one family member in the same year.

EXAMPLE: A taxpayer pays $2,000 in qualified education expenses for his dependent daughter and $2,000 in qualified education expenses for his dependent son. The taxpayer can claim a Hope Scholarship credit for the year of $3,000 ($1,500 credit for his daughter's expenses plus a $1,500 credit for his son's expenses), provided that all other requirements relating to the credit are satisfied.

A taxpayer cannot claim both the Hope Scholarship Credit and the Lifetime Learning Credit in a single tax year with respect to one student. However, a taxpayer is not prohibited from claiming the Hope Scholarship Credit for one family member and the Lifetime Learning Credit for another family member in the same year.

EXAMPLE: A taxpayer has two sons who are in college -- one who is a freshman and one who is a junior. The taxpayer can claim the Hope Scholarship Credit with respect to the son who is a freshman, and can also claim the Lifetime Learning Credit with respect to the son who is a junior (provided that all other requirements relating to the credits are satisfied).

Education tax credits are non-refundable, and no carryforward of an unused education tax credit or carryforward of excess qualified tuition or other education expenses is allowed. Thus, the education tax credit should be claimed in a year in which the taxpayer's tax liability exceeds the amount of the credit. Otherwise, some or all of the credit will be lost.

Taxpayers must be careful in regards to claiming an education tax credit in the case of a dependent. If a student is claimed as a dependent on a parent's tax return, only the parents may claim the education tax credit for the student's qualified education expenses—even if the student files his own tax return. On the other hand, if a taxpayer is eligible to claim the student as a dependent, but does not do so, only the student may claim the education credit for the qualified education expenses. Higher income taxpayers who are prohibited from claiming the education tax credits due to the level of their income should compare (1) the tax savings results of treating the student as a dependent while forgoing the education tax credits to (2) the tax savings results of not claiming the student as a dependent so that the student can claim the benefits of the education tax credits.

Because qualified education expenses are treated as paid by the taxpayer who claims the student as a dependent, a situation can occur where a taxpayer who would otherwise be entitled to claim an education tax credit cannot because the education expenses are deemed paid by another person. For example, where a divorced taxpayer claims an individual as a dependent, but the ex-spouse pays for the individual's qualified education expenses, the ex-spouse who makes the payment is not allowed to claim an education tax credit with respect to the individual (because the ex-spouse cannot claim the individual as a dependent on his or her return). Instead, the individual student is treated as receiving the money from the ex- spouse and, in turn, paying his qualified tuition and related expenses. The taxpayer who claims this individual as a dependent is then entitled to claim the education credit.

To avoid this situation, a divorced taxpayer who is paying qualified education expenses for a child, and wants to enjoy the benefit of an education tax credit, should also be able to claim the child as a dependent for the year or years for which the education tax credits are available.

Planning for optimum use of these education credits in conjunction with planning for distributions from a Coverdell education savings account (education IRA) is further complicated by changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001. Certain planning strategies that were applicable for tax years through 2001, no longer apply for tax years after 2001. To make the most of the education tax credits, taxpayers must understand how these credits are used in conjunction with each other, as well as how these credits are used in conjunction with Coverdell education savings accounts. For example, for tax years before 2002, if a student made a withdrawal from a Coverdell education savings account (an education IRA until 2001) in a particular year, he could treat the withdrawal in one of two ways:

(1) the student could treat the withdrawal as a tax-free distribution, but was prohibited from using any education expense incurred in the year of the withdrawal as the basis for claiming either of the two available education credits for the same year (that is, neither of the education credits could be claimed because of the tax-free withdrawal), or (2) the student could elect to treat the withdrawal as taxable and then use his incurred education expense as the basis for claiming either the Hope Scholarship Credit or the Lifetime Learning Credit for the year of the taxable withdrawal.

In a pre-2002 situation where a withdrawal was made, and one of the two education credits was otherwise available, the student could compare the tax savings generated by each option in order to determine whether the withdrawal was taxable or tax-free.

After 2001, a new set of rules came into effect. Under the new rules, qualifying education expenses incurred by a student are first used to calculate the Hope Scholarship Credit or Lifetime Learning Credit allowed to the student. The student's total qualifying education expenses are then reduced by the amount of education expense tied to one of the two available education credits. If the student's Coverdell education savings account withdrawals for the year do not exceed the amount of total education expenses incurred for the year (after reduction for education expense tied to the two available education credits), then the withdrawals are tax-free. If the student's withdrawals for the year exceed the amount of the total education expenses incurred for the year (after reduction for education expense tied to the two available education credits), then a portion of the withdrawals are subject to tax.

For tax years before 2002, to maximize the benefits of the education tax incentives with respect to a single student, a taxpayer would first claim the Hope Scholarship Credit for the first two years of that student's higher education since this credit is only available for the first two years of post-secondary education. In the year following the year in which the Hope Scholarship Credit had been completely used, the Lifetime Learning Credit would be used. In any years following the complete use of both credits, tax-free withdrawals from an education IRA would be made. This generally maximized a taxpayer's education tax savings.

For tax years after 2001, Coverdell education savings account withdrawals can be made in the same year as one of the two available education credits is claimed; however, the taxpayer must be careful to incur sufficient education expense to both exhaust the available education credit and exhaust the entire amount of any withdrawals. If not, a portion of the education IRA withdrawals for the year will be treated as taxable income.

EDUCATION CREDITS WITH LOAN PROCEEDS AND DEDUCTING STUDENT LOAN INTEREST

Education expenses paid with loan proceeds can be used to claim the Hope Scholarship Credit or the Lifetime Learning Credit in the year the education expenses are paid—not in the year the loan is repaid. 3 Thus, taxpayers who borrow money to finance a dependent's college education are able to claim the available education credits for the earlier years in which the borrowed funds are used to pay qualified education expenses—rather than during the later years when the borrowed funds are repaid.

Student loan interest is also deductible up to certain annual limits (for 2002 and 2003 the annual deductible student loan interest limit is $2,500). However, the deduction for student loan interest expense is phased out for higher-income taxpayers. For 2002 and 2003, the student loan interest deduction is phased out for individual taxpayers with modified adjusted gross income of $50,000 to $65,000 and married taxpayers with modified adjusted gross income of $100,000 to $130,000.

Since higher-income taxpayers (individual taxpayers with modified adjusted gross income in excess of $65,000 and married taxpayers filing jointly with modified adjusted gross income in excess of $130,000) are not allowed to deduct student loan interest, and since the deduction for student loan interest is an "above-the-line" deduction (the deduction can be taken if the taxpayer does not itemize deductions), higher income taxpayers who plan to borrow to help finance a child's college education should consider having the child take out the student loan and electing to not claim the child as a dependent on their own tax return. By proceeding in this manner, the following results can occur:

(1) Since the benefit of claiming education credits is phased out for high-income taxpayers (for individual taxpayers between $41,000 and $51,000 for 2002 and 2003 and married taxpayers filing jointly between $82,000 and $102,000 for 2002 and $83,000 and $103,000 for 2003), electing not to claim their child as a dependent can result in the child claiming the available education tax credits. (2) Since the child takes out the student loan, it is more likely that the child will be able to deduct all or a portion of the future student loan interest paid (assuming the child's initial post-college income does not exceed the phase-out income levels for deducting student loan interest). (3) If the child is not able to itemize deductions after leaving college, the child's student loan interest payments is still deductible as an above-the-line tax deduction.
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