Planning for College Tuition Tax Benefits

By Mark E. Riley, Cindy L. Seipel, and P. Larry Tunnell

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JANUARY 2006 - The College Board estimates that the annual cost of attending a private university during the 2003/2004 academic year, including tuition, fees, room, and board, was $26,854, while the annual cost at a public university was $10,636. Fortunately, a number of education-related tax benefits are available to help taxpayers pay for a college education. Three of these, the Hope Scholarship Credit (HSC), the Lifetime Learning Credit (LLC), and the Higher Education Expense Deduction (HEED), are based on the amount of tuition paid and are the focus of this article.

Hope Scholarship Credit (HSC)

The HSC is designed to help taxpayers afford certain costs associated with the first two years of college education. The HSC is generally available to either a qualifying student or a taxpayer who may claim a qualifying student as a dependent on her federal income tax return. The HSC is equal to 100% of the first $1,000 of qualified tuition and related expenses, and 50% of the remaining qualified tuition and related expenses, for a maximum credit of $1,500 per year per qualifying student.

To qualify for the HSC, a student must meet the following five requirements:

  • The student must not have claimed the credit, or had it claimed based on his expenses, for any two prior taxable years.
  • The student must have completed less than two years of academic credit (as determined by the student’s college) as of the beginning of the taxable year. Many students receive academic credit for advanced placement classes or exams, but this is not considered. In addition, if a student loses credit because of transferring to another college, a common occurrence, only the credit allowed by his current college counts toward the two-year limit.
  • The student must enroll at least half-time for at least one academic period that begins during the taxable year.
  • The student must be enrolled in a program of study leading to a degree, certificate, or other recognized postsecondary educational credential.
  • The student must not have been convicted of a felony offense for possession or distribution of illegal drugs.

A student who is eligible for the HSC during a tax year may compute the credit using all qualified tuition and related expenses incurred during that year, even if the expenses occurred after the end of the second year of academic credit.

The HSC is phased out for taxpayers with adjusted gross income (AGI) over a certain inflation-adjusted amount. For 2004, the phase-out range was an AGI from $42,000 to $52,000 ($85,000 to $105,000, for taxpayers married filing jointly).

Example 1. John, a dependent of his parents, enrolled at State University in the fall of 2001. He goes less than full time and completes two years of academic credit in the spring of 2004. His tuition expenses are $1,000 per semester, two semesters per year, and neither he nor his parents claimed the HSC in 2001 or 2002, because they did not owe taxes in those years. His parents claimed an HSC of $1,500 in 2003 and are also eligible to claim an HSC of $1,500 in 2004. They can base the HSC in 2004 on John’s tuition for both spring and fall, even though he completed his two years of academic credit in the spring semester. Had they claimed the HSC in 2001 and 2002, however, they could not have claimed it in 2003 or 2004, because of the two-taxable-years rule.

Lifetime Learning Credit (LLC)

The LLC equals 20% of the first $10,000 of tuition and required fees paid for either undergraduate or graduate credit. While the LLC is less generous than the HSC, the qualifications to take the LLC are less restrictive than those of the HSC. Unlike the HSC, with its restrictive first-two-years requirement, the LLC can be taken at any stage of the student’s education. The HSC requires that the student be going at least half time, but the LLC has no course-load requirement. Even a student taking only one class is eligible for the LLC.

Like the HSC, the LLC is gradually phased out for taxpayers with AGI from $42,000 to $52,000 ($85,000 to $105,000 for taxpayers married filing jointly).

Example 2. Assume the same facts as in Example 1. If John attends college in 2005, his parents will be eligible for only the LLC or HEED; because he finished his first two years of academic credit in 2004, he is no longer eligible for the HSC.

The HSC requires that the student be enrolled in a program leading to a degree or certificate, but the LLC can be based on qualified expenses incurred either as part of a postsecondary degree program (either undergraduate or graduate), or as part of a nondegree program taken to acquire or improve job skills. A taxpayer can take the HSC with respect to a particular student for only two taxable years, but the LLC can be taken for any number of years. A student with a felony drug conviction is ineligible for the HSC, but is eligible for the LLC.

The LLC limit of $2,000 ($10,000 x 20%) is applied to each taxpayer or tax return, while the HSC limit of $1,500 is applied to each student. While the LLC and the HSC cannot be taken in the same year with respect to the same student, a taxpayer can take the LLC with respect to one or more students (children, spouse, herself) and the HSC with respect to one or more other students.

Example 3. Joe and Sue have four children in college: Bill, Cathy, Diane, and Ed. They are a senior, junior, sophomore, and freshman, respectively. Each child is incurring tuition and fees of $6,000. In addition, Joe has paid tuition and fees of $5,000 for night classes. Diane and Ed qualify for the HSC, and all of the children and Joe qualify for the LLC and the HEED. Joe and Sue can claim either the HSC or the LLC for both Diane and Ed, or the HSC for one and the LLC for the other. To maximize their credits, however, they would claim an HSC of $1,500 each for Diane’s and Ed’s expenses. If the HSC is taken with respect to any of their expenses, Diane’s or Ed’s expenses that are not used for the HSC are ineligible for the LLC or the HEED. The expenses of Joe, Bill, and Cathy are eligible for either the LLC or the HEED, so the LLC could be calculated based on $10,000 of expenses associated with two of them—for example, Bill’s $6,000, and $4,000 of Joe’s tuition and fees. The HEED could be taken based on the expenses of the other—e.g., $4,000 of Cathy’s tuition.

Higher Education Expense Deduction (HEED)

If the HSC or LLC is not taken with respect to the higher education expenses of a particular student, an above-the-line HEED is allowed for payments of tuition and fees for that student. The deduction has been increased in 2004 and 2005 to a maximum of $4,000, but is less for taxpayers with AGI (before deducting the HEED) above certain levels. For a taxpayer with AGI more than $65,000 ($130,000 for a joint return), but less than $80,000 ($160,000 in the case of a joint return), the maximum HEED is $2,000. No deduction is allowed for taxpayers with AGI more than $80,000 ($160,000 for a joint return).

There is no gradual phase-out of the HEED. For taxpayers whose AGI is at the HEED cutoff points above, a $1 deduction from other sources could conceivably result in a $2,000 increase in the HEED.

Example 4. Doug and Linda (married, filing jointly) have a daughter in her senior year of college, and their AGI before the HEED is $130,001. Their LLC is completely phased out. They can take a HEED of $2,000, but if they had only one more dollar of deductions, which would have brought their AGI before the HEED down to $130,000, they could have taken a HEED of $4,000.

Because in most states and municipalities computing taxable income begins with the taxpayer’s AGI, the HEED is effectively deductible against state taxable income. In contrast, neither the HSC nor the LLC is allowed as a credit against any state or local income tax. In addition, because the HEED reduces AGI, it can also reduce a taxpayer’s phase-outs of certain tax items or put the taxpayer in a lower tax bracket.

Example 5. Randy and Teresa have a son in college, and they paid his tuition of $7,500 in 2004. At this level of tuition payments, their HSC and LLC will be equal, at $1,500. Their HEED would be preferable to the HSC and LLC if their combined state, local, and federal marginal rates total more than 37.5% ($4,000 x 0.375 = $1,500), and the HEED is deductible for state and local tax purposes where they live.

Coordinating with Other Plans and Accounts

Distributions from qualified tuition plans (QTP) or Coverdell education savings accounts (ESA) are generally not taxable to the extent they are used to pay qualified educational expenses. Qualified educational expenses for purposes of the QTP and ESA include tuition and related expenses, books, supplies, and equipment required for enrollment—a broader definition than that used for the HSC, LLC, or HEED. A taxpayer may take the QTP or ESA exclusions and also claim one of the college tuition tax benefits. However, a taxpayer who is eligible for a QTP or ESA exclusion and one of the college tuition tax benefits cannot reap a double benefit on the same expenses.

Expenses taken into account in computing the HSC, LLC, or HEED reduce the total expenses that may be taken into account in determining the portion of a QTP or ESA distribution that is excludable from a taxpayer’s income. Because the QTP and ESA distribution exclusions are not subject to any phase-out, these exclusions might be preferable to the college tuition tax benefits discussed above for taxpayers with higher AGIs.

Common Questions on College Tuition Tax Benefits

Who may take the HSC, LLC, or HEED? A taxpayer is allowed to take the credits and the deduction (hereafter referred to collectively as college tuition tax benefits) based on expenses she has paid for the education of herself, her spouse, or her dependents. With respect to the HSC and LLC, even if a dependent student pays the expenses, the taxpayer claiming the student as a dependent is treated as having paid those expenses, and may claim the credits on her own return.

Taxpayers who qualify to claim a student as a dependent and have an AGI high enough to force a phase-out of the credits should consider allowing the student to take the HSC or LLC himself. If the taxpayer does not claim the dependency exemption, the student is allowed to claim the credit. If the student takes a credit that would otherwise be phased out, the tax burden for the family as a whole would be reduced. In this case, it does not matter whether the taxpayer or the student is the one who actually pays the expenses.

Rules with respect to the HEED and dependents are more restrictive. Not just any student who qualifies as a dependent of another can claim the HEED on his tax return. To claim the HEED for the educational expenses of a dependent, the taxpayer herself must a) actually pay the related expenses for a dependent, and b) claim the dependency exemption. Neither the taxpayer nor the dependent student is allowed the deduction if the taxpayer fails to meet both conditions. If a taxpayer pays the expenses of a student who does not qualify as a dependent, the amount paid is treated as a gift to the student and a subsequent payment by the student. Only the student is allowed to claim the HEED for these expenses under such circumstances. An individual who is married and filing separately may not claim the HSC, the LLC, or the HEED.

Can more than one benefit be taken at a time? The tuition of each individual student is eligible for the full HSC, as long as they otherwise qualify for it, so one taxpayer could be eligible for more than $1,500 of HSC, provided she can claim the tuition of more than one student (e.g., a spouse or children). On the other hand, the LLC and HEED limits apply to the taxpayer, not the student, so while a taxpayer can take the LLC or the HEED with respect to more than one student, the total tuition the taxpayer claims for these benefits cannot exceed $10,000 for the LLC or $4,000 for the HEED, no matter how many students can be claimed. In addition, no two of the three benefits may be taken with respect to the same student.

Example 6. Steve and Laurie had three children in college, all of whom qualified for the HSC, LLC, and HEED, and each of whom had tuition of $7,000 in 2004. Steve and Laurie could: a) take the full HSC for each child for a total credit of $4,500; b) take the HSC for two children and either the LLC or HEED for the third; or c) take the HSC for one child and split the $10,000 LLC tuition limit or the HEED limit between the other two. In fact, they could split the LLC and HEED limits among their children however they choose, as long as no two of the three benefits are taken with respect to the same child.

When can benefits be claimed? The general rule is that the college tuition tax benefits must be taken in the tax year in which both the payment and the academic period related to the payment occur. The rules do, however, allow prepayments to be applied toward the tuition benefits in the year they are paid, as long as the related academic period begins during the first three months of the taxpayer’s next taxable year. Taxpayers might be able to use prepayments to increase the expenses in the prepayment year and take advantage of the full limits on the college tuition tax benefits in that taxable year. Under certain circumstances, a student might be better served by deferring payment until the taxable year in which the related academic period begins.

Example 7. Patty begins junior college in the fall of 2006, and her tuition is $1,000 per semester. If she prepays her spring 2007 tuition in 2005, she can claim an HSC of $1,500 based on her $1,000 of tuition for fall 2004 and her prepaid $1,000 of tuition for spring 2007. If she does not prepay her tuition, she would be eligible for only a $1,000 HSC in 2004.

What expenses qualify? The rules are the same for the HSC, LLC, and HEED. Expenses that qualify generally include all tuition and academic fees. Expenses that do not qualify include tuition for courses related to sports, games, or hobbies (unless the courses are part of the student’s degree plan), as well as books or room and board. Fees that are not related to a student’s academic course of instruction, such as student activity fees or athletic fees, do not qualify for the credits.

The college tuition tax benefits cannot be taken with respect to any expenses for which a deduction is taken under any other IRC provisions. This includes, but is not limited to, business deductions under IRC section 162 and the higher education expense deduction under IRC section 222.

Click here to see an Exhibit.

Mark E. Riley, CPA, is a graduate student of accounting at Rawls College of Business, Texas Tech University, Lubbock.
Cindy L. Seipel, PhD, CPA, and P. Larry Tunnell, PhD, CPA, are associate professors of accounting in the department of accounting and business computer systems at College of Business Administration and Economics, New Mexico State University, Las Cruces, N.M.




















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