Death & Taxes

Education Deductions and Credits

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By Roy Lewis
May 17, 2002

We often talk about various education credits and deductions. But, like prescribed medication, there may be some ugly results due to uninformed interaction between some of those deductions and credits. Let's look at some of those interactions and determine strategies to avoid potentially deadly (at least financially) combinations.

Coordination of Education IRA benefits with other educational benefits
For 2002, the tax act repeals the rule disallowing any income tax credit for qualified education expenses to the extent that they are taken into account in determining the exclusion for distributions from an Education IRA. This means that in 2002 you'll be able to claim a HOPE or Lifetime Learning credit for a tax year and exclude from gross income amounts distributed from an Education IRA for the same student, as long as the distribution is not used for the same expenses for which the credit was claimed.

The new law does not change the rule disallowing any other income tax deduction for qualified education expenses to the extent they are taken into account in determining the exclusion for distributions from an Education IRA. So, you still can't double dip, claiming the tax-free treatment of an Education IRA distribution and also claiming education expenses paid with those funds as deductible education expenses of some sort.

Additionally, under the old rules, you had the option to "waive" the exclusion from income from an Education IRA, and were then able to use those funds to pay any qualified education credits, and to take any allowable deduction or credit. Beginning in 2002, the new law no longer allows you to make this waiver. So make sure that if you take a distribution from an Education IRA, you've got your facts straight regarding coordination with other credits and deductions.

Education IRAs and HOPE/Lifetime credits
For 2001 and earlier, if a beneficiary excludes from income any amount of an Education IRA distribution for a tax year, neither a HOPE credit nor a Lifetime Learning credit may be claimed for that beneficiary for that tax year. That's not the case for 2002; the new law will then permit an Education IRA distribution in conjunction with HOPE or Lifetime credits.

Example: In 2001, Vince qualifies for the Lifetime credit. He also has an Education IRA account. His qualified education expenses amount to $2,500. He wants to pay for these education expenses using $300 from his Education IRA account (tax-free), and the balance out of his own pocket.

In this example, Vince would not be able to claim the Lifetime credit. Why? Because he excluded $300 from his income via the Education IRA. So, Vince loses the benefit of the Lifetime credit just to save the taxes on the income from the Education IRA. If Vince is in the 27% bracket, his tax savings would amount to only $81 on his tax-free Education IRA distribution. Not a very good trade-off.

But Vince might be pleased to know that for Roth IRA distributions in 2002 and later, he would be able to take a tax-free Education IRA distribution and claim a HOPE/Lifetime credit for the same tax year.

Education IRAs and qualified tuition programs
In 2001 and prior years, a contribution made to a qualified tuition program to allow a person to purchase tuition credits or otherwise pay for higher education for a beneficiary may cause any amount contributed to an Education IRA for that beneficiary to be subject to a 6% penalty excise tax.  But that is no longer the case in 2002 and beyond. The new law allows for a distribution from an Education IRA to a qualified tuition program without the burden of the 6% penalty tax. Sweet.

Qualified tuition program distributions and other credits
As you know, you may claim a HOPE or Lifetime Learning credit for certain qualified higher education expenses. But what if those higher education expenses are paid with tax-free proceeds from a qualified tuition program (QTP)? As long as the distribution isn't used for the same expenses for which a credit was claimed, it's all good. Under the new law, the general rule is that as long as you don't "double dip" credits and/or deductions with tax-free distributions from QTPs, you're fine. No longer is it imperative that taking a QTP distribution automatically disqualifies the use of the HOPE or Lifetime Learning credit for the same student.

Example: Marti is a first-year college student. Her qualified higher education expenses amount to $10,000. She receives a $6,000 tax-free distribution from a QTP to pay a portion of those expenses. She also takes a $2,500 tax-free distribution from an Education IRA to pay part of those expenses. Marti directly pays the remaining $1,500 of those expenses. She will still be able to use the $1,500 worth of qualified higher education expenses in order to compute her HOPE credit.

HOPE/Lifetime credits and education deductions
Remember that the HOPE or Lifetime credit cannot be claimed for any education expenses that are otherwise claimed as a business expense.

Example: Diane is qualified to claim the HOPE/Lifetime credit. She pays $1,750 in qualified education expenses that maintain or improve her current job skills. Diane can either claim a deduction for these expenses (as an itemized deduction), or she can take the HOPE/Lifetime credit. But she can't claim both the deduction and the credit.

What should Diane do? She must closely review her tax situation and take the largest tax benefit available to her. Generally, a credit is much more valuable than a deduction. In addition, the education deduction would be subject to the 2% AGI limitation for miscellaneous itemized deductions. So, it is very likely that Diane would benefit most from foregoing the education deduction and claiming the HOPE/Lifetime credit instead. But only Diane (or her hired tax pro), after a close review of her personal tax situation, will be able to make that determination.

HOPE and Lifetime credits for the same student
Remember that the HOPE and Lifetime credits can't be claimed in the same tax year for the same student. But claiming the HOPE credit in one year doesn't prevent a taxpayer from claiming the Lifetime credit for qualifying expenses of that same year in other tax years. In addition, if there are two students involved, there is no restriction from claiming the HOPE credit for the first student and claiming the Lifetime credit for the second student.

Example: Dick and Sharon have two children in college. Graham is a freshman and Haley is a junior. Assuming that all of the other requirements have been met for each credit, Dick and Sharon may claim the HOPE credit for Graham's expenses and the Lifetime credit for Haley's expenses.

Note that until 2003 (when the maximum Lifetime credit increases to $2,000), the HOPE credit will always produce the larger credit. In 2003, the Lifetime credit will produce a larger credit than the HOPE if qualified tuition and expenses for the tax year exceed $7,500. So, plan the use of your credits accordingly.

HOPE/Lifetime credits and drug problems
Here we are, back to talking about drug interactions. Remember that while the HOPE credit is not allowed for a student who has been convicted of a federal or state drug felony, there is no such restriction for the Lifetime credit. So, even if the HOPE credit is not available to a student because of drug problems, he or she may still qualify for the Lifetime credit.

While there are other twists and turns regarding the interaction between the various education credits and deductions, these are the major issues that will affect most people. The key to claiming any education credits or deductions is understanding the law and making the best choices available and allowable.

By the way, if you're looking for more information on saving for a college education, check out our new Saving for College Center.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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