Death & Taxes

New Education Tax Savings Options

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By Roy Lewis
July 19, 2002

Just a few years back, there were virtually no provisions in the tax code that would allow for deductions and/or credits for education expenses unless those expenses were job- or business-related. That's all over now. The Tax Relief Act of 1997 cracked the door open for various education deductions and credits. The changes brought about by the new Economic Growth and Tax Relief Reconciliation Act of 2001 kicked the door in and knocked it off of its hinges.

You now have more options (and combinations of options) than ever to pay for primary, secondary, and higher-education expenses for yourself and your family members. It's now possible that the same education expense might qualify for any number of deductions or credits. It'll be more important than ever to determine what is best for you. Let's take a look at some of the major changes on the education credit and deduction front.

Education IRA
In 2002, the contribution to an Education IRA increased from $500 per child per year to $2,000. That's a substantial increase, and may quiet those who have been claiming that the $500 contribution is so insignificant as to render the Education IRA worthless. But that's not all: Also in 2002, adjusted gross income limits were raised to allow more folks to make Ed IRA contributions. The income limit for singles is $110,000, and $220,000 for married folk.

Still hate the Ed IRA? Well, try this on for size: Effective in 2002, Ed IRA distributions can be made for qualified primary and secondary (kindergarten through 12th grade) education expenses. That includes distributions made to public, private, and/or religious schools. Heck, in the new law, you're even allowed to use Ed IRA distributions to purchase computers or computer-related equipment if that equipment is required for specific course work. So these changes allow for even more options for either establishing or ridding yourself of an Ed IRA.

Student-loan interest deduction
Big changes here also. Many of you were unable to deduct your student-loan interest because the loan exceeded the 60-month limitation. You'll recall that only the interest on the first 60 months' worth of student-loan payments was deductible. No longer. In 2002, the 60-month rule is eliminated. If you have older student loans -- stuff that you've been making payments on for longer than 60 months -- you may have an additional deduction now.

One of the other restrictions to this deduction in the past was the income limitation. If your income was above certain limits, you couldn't claim the deduction. But the new Tax Act has raised those income limits to $65,000 for single taxpayers and $130,000 for married folks. So now even more of you are eligible for the student-loan deduction in 2002.

Don't forget -- this deduction is an "above the line" deduction, i.e., you don't have to itemize your deductions in order to take a deduction for student-loan interest paid. So, if you otherwise qualify, you can claim the student-loan interest deduction even if you use the standard deduction.

Higher-education expense deduction
This is a brand-new provision in the law. It allows for a deduction of up to $3,000 for qualified higher-education expenses that you pay for yourself, your spouse, or your family members. This $3,000 deduction comes into play in 2002 and 2003. In 2004 and 2005, the deduction is increased to $4,000. But, as with virtually all of the other education provisions, there are income limitations. You can kiss this deduction goodbye if your income exceeds $65,000 ($130,000 for marrieds) in 2002 and 2003. Those income limitations increase to $80,000 ($160,000 for marrieds) in 2004 and 2005.

What happens in 2006? Unless legislation is passed that would make this provision in the law permanent, it will be automatically repealed at the end of the 2005 tax year.

You'll have to be careful if you plan to use this new deduction, since there are restrictive provisions that will not allow for the deduction if you also claim a HOPE or Lifetime Learning Credit in the same year for the same student. There are also restrictions if you take distributions from a Qualified Tuition Plan. So make sure that you clearly understand the rules and don't trip yourself up.

HOPE and Lifetime Learning credits
While there were no drastic changes to either of these credits, there was one very important clarification. Under the old law, you were not able to claim a HOPE or Lifetime credit in any year that you received an Ed IRA distribution or a distribution from a Qualified Tuition Program. That restriction has been lifted. Of course, you can't claim a credit for the same expenses that were paid with Ed IRA or Tuition Program funds. But at least you are now free to use Ed IRA or Tuition Program funds on some of the expenses, and claim the HOPE or Lifetime credit on other education expenses that you paid out of pocket.

Qualified Tuition Plans
Prior to the 2001 Tax Act, earnings in Qualified Tuition Plans were tax-deferred and were then taxable (usually to the student) when distributions were used to pay higher-education expenses. But not anymore. The earnings from a Qualified Tuition Plan are now tax-free if they are used to pay qualified education expenses. This change has made a great way to save for college even better. Here's the cherry on the sundae: You are allowed to transfer credits (or other amounts) from one Qualified Tuition Plan to another. In effect, the new law created Qualified Tuition Plan rollovers! You are only allowed one rollover per 12-month period, and there is a lifetime limit of three rollovers. But these changes have made Qualified Tuition Plans even more responsive as a college saving tool.

Employer-provided education assistance
The 2001 Tax Act made permanent this fringe benefit. Your employer can pay for up to $5,250 of your qualified education expenses (undergraduate OR post-graduate education), and you don't have to treat any of those payments as compensation or taxable income. This fringe benefit was scheduled to "sunset" at the end of 2001, but the new law has made it permanent.

Those are the highlights. There are many other technical issues embedded within each of the headings above, so if there is something you read that perks up your ears, make sure to get even more information on those specific changes and how they will affect you and your family.  

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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