Choosing the Best Tax-Favored Education Benefit Strategy

By Nell Adkins and B. Charlene Henderson

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Current Tax Benefit Benefits

A summary of current tax benefits for short-term education planning is shown in Exhibit 1.

The Hope and LLC credits. The Hope credit is allowed for qualified education expenses (QEE) paid on behalf of an eligible student for the first two years of undergraduate education. The maximum credit is calculated by claiming 100% of the first $1,000 of QEEs, plus 50% of the second $1,000 of QEEs, for a maximum annual credit of $1,500. The maximum Lifetime Learning Credit (LLC) is calculated as 20% of the first $10,000 (previously $5,000) of total QEEs paid on behalf of all eligible students in the tax year. The LLC and Hope credits cannot be claimed for the same student in the same tax year. Typically, the Hope credit has provided greater tax savings on a per-student basis. The LLC has usually been claimed for or by eligible students who have completed their first two years of undergraduate education, or who were pursuing graduate education. Both credits are elective and nonrefundable.

These credit benefits are completely phased out for taxpayers with modified adjusted gross income (MAGI) greater than $51,000 ($102,000 married filing jointly), and may not be claimed by married taxpayers filing separately, or by a taxpayer claimed as a dependent on another’s tax return (i.e., by dependent children who are eligible students). The calculation of MAGI is consistent across both provisions, and defined generally as AGI plus certain excluded foreign income. QEEs are defined similarly for both credit provisions, except that graduate tuition and required enrollment fees also qualify for the LLC. Those QEEs paid in the current year to cover an academic period that begins in the first three months of the following tax year may be used in calculating the credit benefits for the current year.

An eligible student is defined for the LLC as the taxpayer, taxpayer’s spouse, or taxpayer’s dependent enrolled at an eligible educational institution. An eligible student for purposes of the Hope credit must also be degree-seeking, enrolled at least half-time for at least one academic term at an eligible educational institution, have no felony drug convictions, and not have completed the first two years of college before the current year.

Parents, and not their dependent eligible students, are entitled to the applicable credit when either they or the eligible student pays the QEEs. When the QEEs are paid for the eligible student through a gift or inheritance, the QEEs are treated as having been paid by the student, thus enabling the parents to claim the credit. The eligible student, who may be claimed as a dependent by the parents, is eligible for the credits only when the parents elect not to claim the dependency exemption.

Final Treasury Regulations sections 1.25A-0–A-5, issued December 24, 2002, provide some clarification on certain aspects of claiming the credits. The regulations provide that an unmarried custodial parent who claims a dependency exemption for the eligible student may claim an education tax credit for QEEs paid by the noncustodial parent on behalf of the eligible student. Otherwise, qualifying QEEs paid with loan proceeds qualify as QEEs for credit calculation. Scholarships reported as income by the student that may be applied to expenses other than QEEs (such as room and board) are not considered excludable scholarships that reduce QEEs for purposes of the credit calculation.

Tuition and fees deduction. The tuition and fees deduction (TF deduction) requirements mirror the LLC requirements in many respects, including identification of the eligible student and QEEs, but the benefit is more generous in that the MAGI phaseout is higher: $65,000 ($130,000 MFJ) for 2003, and $80,000 ($160,000 MFJ) for 2004 and 2005. The maximum above-the-line deduction is $3,000 in 2003, $4,000 in 2004 and 2005, and expires on December 31, 2005. This deduction may not be used in conjunction with either of the credits for the same eligible student. Parents who wish to claim the deduction based upon a dependent child’s QEEs should explicitly pay the QEEs themselves, rather than merely reimbursing their dependent child for the QEEs, in order to secure the deduction.

While the education credits and the TF deduction provide current tax benefits and are a valuable part of near-range planning, they are much less useful in taxpayers’ long-range planning. The quantifiable tax benefits of the credits and the TF deduction are most identifiable shortly before the higher education expenses are actually incurred, when other sources of education funding are known and the taxpayers’ AGI can be reasonably estimated. Parents with young children cannot afford to rely on the availability of tax credits and the TF deduction to meet their funding needs in the distant future.

Tax-Favored Education Savings Vehicles

A summary of tax-favored education savings vehicles appears in Exhibit 2. The options include Qualified Tuition Programs (QTP), Coverdell Education Savings Accounts (CESA, formerly Education IRAs), and Qualified U.S. Savings Bonds. As investment income is earned on these assets, it is excludable from taxable income. Distributions are tax-free to the extent that they are used to pay for QEEs.

These options are designed primarily to aid parents in saving for the future college education of their dependent children. There is no federal tax deduction for contributions to these savings vehicles, though some states allow state income tax deductions for residents whose contributions are made to that state’s QTP. On the planning end of the spectrum, the savings vehicles may be used in conjunction with each other. Contributions to both a QTP and a CESA for the same beneficiary may be made in the same year. On the distribution end, however, only one tax benefit can generally be claimed for a particular QEE.

Qualified Tuition Programs. QTPs are of two general types, prepaid programs and savings programs. Every state now offers at least one of the two types. The savings QTPs are more popular and numerous and are used for comparison here. In these plans, investment risk is assumed by the investor. Distributions are generally viewed as one part return-of-contributions and one part previously untaxed earnings. Specific plan requirements and specifications vary from state to state and from plan to plan, but neither the contributor nor the beneficiary may have any direction over the investment of the funds contributed to the QTP. In contrast to the other two savings vehicles, both credits, and the TF deduction, there is no MAGI phaseout to prevent high-income taxpayers from establishing and contributing to QTPs. The Economic Growth and Tax Relief Reconciliation Act of 2001 permits higher education institutions to offer their own QTPs. The exclusion from gross income of these plan earnings became effective January 1, 2004.

QTP plan provisions must limit QTP contributions to the amount necessary to provide for QEEs of each beneficiary. The definition of QEEs under the QTP provisions is more generous than the definition for both the Hope and LLC credits and the TF deduction. QTP QEEs include undergraduate and graduate tuition and required enrollment fees, books, supplies, equipment, room and board for students enrolled at least half-time, and certain expenses for special needs students (including those with physical, emotional, or mental conditions or learning disabilities).

QTP or CESA distributions in excess of QEEs will be partially included in the beneficiary’s taxable income, based upon the ratio of QEEs to the distribution. If withdrawn funds are not used for the intended purpose, the previously untaxed QTP or CESA earnings are subject to taxation and a 10% percent penalty. The penalty is waived in the event of a nonqualifying distribution due to a beneficiary’s death or disability, or receipt of a scholarship. Rollover distributions from one designated beneficiary to another related family member are allowed annually. Family members in this context include the usual list contained in IRC section 152(a) for purposes of claiming a dependency exemption, spouses of those identified in IRC section 152(a), and also the spouse and first cousins of the beneficiary. In addition to rollovers from one designated beneficiary to a related family member, rollovers may be made from one QTP to another QTP.

Coverdell Education Savings Accounts (CESAs). Contributions of up to $2,000 per year per beneficiary to a CESA are allowed to grow tax-free within the account, and distributions from the account to pay for the beneficiary’s QEEs will be tax-free. The maximum contribution amount is allowed only to those individuals with MAGI up to $95,000 ($190,000 MFJ), and is completely phased out at MAGI of $110,000 ($220,000 MFJ). With proper planning, these MAGI limits may be effectively circumvented, as entities other than individuals may make contributions without regard to the MAGI phaseout provisions. The beneficiary must be younger than age 18 at the time of the contribution (or have special needs). Withdrawal penalties and rollover provisions between beneficiaries mirror those for QTPs, with one notable difference: A CESA must be fully used by the beneficiary before reaching age 30, or rolled over to a CESA for the beneficiary’s family member. These age restrictions generally negate the use of a CESA to fund the taxpayer’s own future education, whereas a QTP has no such restrictions.

Another major difference in the tax benefit of QTPs and CESAs lies in the different definitions of QEEs. The CESA definition of QEEs is much broader than the QTP definition. It includes QEEs as defined for QTPs, plus payments to a QTP. This effectively facilitates a rollover to a QTP, thus allowing greater flexibility in planning. Furthermore, under IRC section 530(b)(4), the CESA QEE definition also includes a host of education expenses pertaining to students’ kindergarten, elementary, and secondary education. These include tuition and required enrollment fees, books, supplies, room and board, tutoring, uniforms, transportation, special needs, and some supplementary services. Also included are computer equipment and Internet access, if such technology is to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in school. Because contributions to CESAs and QTPs are now allowed for the same eligible student in any given year, a CESA could be used to finance the purchase of a new computer every few years, as well as Internet access, even if it were not intended as the primary funding of future college expenses.

Taxpayers evaluating QTPs versus CESAs should weigh the CESA contribution limits and age restrictions against the relatively greater investment control and more expansive QEE definition. Taxpayers qualifying for tax benefits under both the current tax benefit provisions and the education savings vehicle provisions should maximize their tax benefit by taking the immediate credit or TF deduction for payments for tuition and required enrollment fees, and using QTP/CESA distributions for payment of the additional expenses that qualify only as QEEs for QTPs and CESAs.

Qualified U.S. savings bonds. A qualified U.S. savings bond is a Series EE bond issued after 1989, or a series I bond, issued to an individual who is at least 24 years old at the time of issuance. This education provision, though the oldest of the three savings vehicles (enacted by the Technical and Miscellaneous Revenue Act of 1988), has been the least popular, for several reasons. First, the rate of return on U.S. savings bonds is lower than the rate of return on many other stable investments. Second, the MAGI phaseout is much lower than that specified for CESAs, and it is applied upon redemption of the bonds, rather than at the time of purchase. This makes it difficult for taxpayers to determine whether they will be eligible for a tax benefit. No explicit rollover provision exists in IRC section 135 (though this may not have been Congress’ intent). Finally, the definition of QEEs under this provision is far more restrictive than under analogous definitions of QEEs for QTPs and CESAs. The definition of QEEs for this provision includes only undergraduate and graduate tuition and required enrollment fees and payments to either a CESA or a QTP. Overall, this savings vehicle is much less flexible, and thus less practical in application, than CESAs or QTPs.

Other Possibilities

Traditional and Roth IRAs. Withdrawals from traditional and Roth IRAs are not subject to the 10% premature distribution penalty if the funds are used to pay QEEs of the taxpayer, spouse, child, or grandchild. QEEs are defined in this context as tuition and required enrollment fees, books, supplies, and equipment, but not room and board. Because there are no required distributions or use of funds for educational purposes, account owners maintain high levels of control and flexibility over the account assets.

Student loans. Eligible student loans covering tuition, fees, room and board, and books and supplies for the taxpayer, spouse, or dependent (at loan origination) now yield an above-the-line interest deduction of up to $2,500. AGI phaseout limits for 2003 are $50,000 ($100,000 MFJ) to $65,000 ($130,000 MFJ). A taxpayer claimed as a dependent on another’s return may not claim the deduction, and the taxpayer claiming the deduction must be legally obligated to make the interest payments. Thus, parents who wish to claim the deduction for their dependent should take out and repay the loan. Dependent students who take out and repay student loans for their own education must wait until they are no longer dependents to take the deduction.

Caveats and Considerations

Effect on financial aid eligibility. Although the impact of a QTP is somewhat less definitive, a CESA account balance is considered an asset of the student, and therefore negatively affects the student's eligibility for federal need-based financial aid. By statute, the credits—but not the TF deduction—are to have no effect on a student’s eligibility for, or level of, federal aid. Individual schools’ assessments for need- and merit-based financial aid vary widely. Many schools are only now beginning to adjust awards based upon the presence of QTP or CESA funds. The potential negative effect of CESAs on a student’s eligibility for federal aid may be somewhat mitigated through the use of rollovers to other family members, provided the likelihood of the original beneficiary’s obtaining financial aid is accurately assessed in advance and coupled with timely action.

Gift and estate taxes. CESA provisions mandate that an established account must be controlled by a designated responsible individual, usually the beneficiary’s parents or guardians, regardless of who actually established the CESA. The owner or person who established the QTP, on the other hand, controls the QTP.

Contributions to QTPs and CESAs are taxable gifts. Distributions from these accounts are not taxable gifts, except in cases of generation-skipping beneficiary changes. QTPs owned by a decedent are not included in the decedent’s gross estate, but are included in the beneficiary’s gross estate.

Many characteristics of QTPs and CESAs coordinated by the 2001 Tax Act are scheduled to terminate December 31, 2010, barring any further action by Congress. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced capital gain and dividend tax rates, decreasing the relative tax advantage of QTPs and CESAs. Parents
saving for future higher education costs may prefer to maximize their flexibility by choosing traditional investments rather than tax-favored education savings vehicles.