Education Tax and Saving Incentives

The Act provides roughly $29 billion in direct tax and saving incentives to help towards funding education. For parents and grandparents who are saving or currently paying for children's educational expenses (either college or, as of 2002, secondary or primary school educational expenses), there are new and quite beneficial privileges for you in the bill as well. 

The educational IRAs was something I have never been excited about because the previous limit was only 500. Effective 2002, the annual limit has increase to $2,000 making it now an effective savings vehicle. 

For the first time ever, starting in 2002, contributions and earnings can be used to pay for educational expenses for grades K-12 as well as for college expenses. Qualified educational expenses now include: tuition, academic tutoring, special needs services, books, supplies, room and board, uniforms, transportation, supplementary items or service (such as extended day programs), and the purchase of any computer technology, equipment, or internet access. (Computer software primarily involving sports, games, or hobbies is not considered a qualified school expense unless it is educational in nature). Although the money you contribute to an Education IRA is still not tax deductible, as of 2002 the earnings will be tax free if spent on qualified educational expenses. 

Furthermore, as of 2002, using money from an Education IRA no longer disqualifies you from taking a Hope Scholarship or Lifetime Learning Credit in the same year (as long as the Education IRA money and the tax credits are not used for the same expenses). 

Also, starting in 2002, the income cap to qualify for an Education IRA will go up to $110,000 for single filers and to $220,000 for married filers (from $95,000 and $150,000, respectively, in 2001). 

The tax relief act now allows contributions to be made up until April 15th of the year following the year for which the contribution would be designated (instead of December 31 of the taxable year under the old law). Contributions to accounts after the beneficiary reaches age 18 is allowed in the case of a special needs beneficiary. The Tax Relief Act also clarifies that corporations and other entities (including tax-exempt organizations) would be permitted to make contributions to Education IRAs, regardless of the income of the corporation entity during the year of the contribution. 

The Tax Relief Act now allows contribution to an Education IRA in the same year that a contribution is made to a qualified state tuition program for the benefit of the same beneficiary. Please keep in mind, distributions from an educational IRA and a qualified tuition program can not exceed the beneficiary's qualified higher education expenses for any year. Any distribution in excess of expenses needs to returned by May 31 of the following tax year or taxes will be imposed.

The following example show then impact investing 2,000 a year (starting with the beneficiaries birth),and the account provides a 7% annual rate of return:

Under the new law, starting in 2002, any earnings that accumulate in any section 529 college-savings plan will be income-tax free when used to pay qualified expenses for a child's higher education, including payments for tuition, fees, room and board, and books. You can still participate in a 529 plan no matter your household income. Programs allow funding ranging from $15 per month to a total of $250,000, over time or at once. Up to $50,000 by singles or $100,000 married, filed jointly may be contributed at once without a gift tax (assuming no other gifts to same beneficiary within 5 years) for use at the college or grad school of your choice (private or public; in state or out-of state). The account is controlled by the individual whom set up the plan and not the beneficiary, but is generally not included in the owner's estate for estate tax purposes. Some states also allow residents to deduct their contribution on their state-tax returns. In addition, distributions are excluded from gross income if used to pay for qualified higher education expenses. 

You have the ability to spread your investment over several state plans and with the new tax law you can roll money from one state-sponsored savings plan to another, as often as once a year. 

The new law even allows you to now transfer the beneficiary to a first cousin rather than just immediate family members. The new law eliminated the rule that requires 529 plans to impose a penalty on withdrawals and replaces it with a 10% tax penalty on withdrawals not used for qualified education expenses. 

The Tax Relief Act expands the scope of qualified higher education expenses to include actual living expenses and necessary expenses incurred by special needs students in connection with enrollment or attendance. 

As with educational IRAs, taxpayers receiving qualified tuition plan distributions also will be eligible to claim either the HOPE or Lifetime Learning credit for a taxable year as long as the distributions are not used for the same expenses for which a credit is claimed. 

The law has been modified to allow "qualified" tuition program to include prepaid tuition programs established and maintained by private institutions, although tax-free withdrawals from a private prepaid plan won't begin until 2004. Please keep in mind that private educational institutions must first receive a favorable IRS ruling or determination, and program assets must be held in a trust. Contributors can now purchase tuition credits or certificates for beneficiaries from private educational institutions. 

There are two general types of 529 plans: prepaid tuition plans and college savings plans. With both plans you are no longer limited to use the money for just state schools or schools in the state plan. The states offering prepaid tuition contracts covering in-state tuition will allow you to transfer the value of your contract to private and out-of state schools (although you may not get the full value depending on the particular state. If you decide to use a college savings plan, the full value of your account can be used at any accredited college or university in the country (along with some foreign institutions). 

For the most information on Section 529 plans and the new tax bill's effect on them, please see Joe Hurley's Web site,

By the way, given this new tax advantage for Section 529 plans, there is now no reason whatever to save for college via a Uniform Gifts to Minors (UGMA) or a Uniform Transfer to Minors (UTMA) account. In my opinion, these accounts are now obsolete.

Effective in 2002, the Tax Relief Act extends the employee exclusion from income of employers-provided educational assistance. The education assistance amount is up to $5,250 annual and can cover tuition, fees, books, supplies, but not room and board. The education does not have to be work related for the exclusion to qualify but the employer must maintain the program. This provision was expiring at the end of 2001 but is now permanent and expanded to cover graduate studies which have not qualified for the exclusion since June 30, 1996.

The Tax Relief Act allows student loan interest on qualified educational or refinanced loans -- deducted from filers taxable income. The maximum allowable annual deduction is $2,500. No deduction is allowed to an individual if that individual is claimed as a dependent on another taxpayer's return for that taxable year. There is no longer a limit on the term of the loan (old law was first sixty months) or restrictions for voluntary payments while the loan is deferred or forbearance. If your adjusted gross income is $100,000 for married, joint filers or $50,000 for single filers you can deduct the full amount of interest paid each year (not to exceed $2,500) Taxpayers with adjusted gross income between $100,00 - $130,000 for married, joint filers and $50,000 - $65,000 for single filers are able to deduct a portion of the interest paid. Income levels will be adjusted annually for inflation.

Beginning in 2002, for the first time, up to $3,000 annually (rising up to $4,000 annually in 2004) of any money you spend directly on qualified higher education expenses will be deductible from your income on your tax return, if your are income eligible. 

For 2002 and 2003

The maximum deduction would be $3,000 for:

Single filers whose adjusted gross income is $65,000 or less

Joint filers whose adjusted gross income is $130,000 or less 

For 2004 and 2005

A maximum deduction would be $4,000 for:

Single filers whose adjusted gross income is $65,000 or less

Joint filers whose adjusted gross income is $130,000 or less 

A maximum deduction would be $2,000 for:

Single filers whose AGI is between $65,000 and $80,000

Joint filers whose AGI is between $130,000 and $160,000 

Taxpayers would NOT be eligible to claim the Hope or Lifetime Learning credits and this deduction in the same year. In some circumstance, a higher education deduction may provide a greater tax relief than a HOPE or Lifetime Learning credit. This will occur if the taxpayer's income is above the income phase-out for the HOPE and Lifetime Learning credits. Even credit-eligible taxpayers may find the deduction more advantageous than the Lifetime Leaning credit, if their income is taxable above the 15 percent bracket. Taxpayers need to evaluate which benefit is most appropriate. 

Let me stress once again that these new education benefits are set to expire in 2011 and may be repealed at any time before them. So please, please, please learn about them now and act on them immediately. 

People First. Then Money. Then Things.
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