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Education Savings Incentives – Tax Act 2001
by Jacqueline Ellisor Wiggins, JD, LLM, CLU, ChFC

Overview: Many strategies are available to meet a family’s education planning objectives. Savings options include Education IRAs and Qualified State Tuition Programs (Section 529 Plans); tax incentives include education tax credits and deductions. Traditional family investment strategies can also be used to fund education objectives. The specific strategy or combination of strategies selected depends largely on the family’s income and financial position and also on the family’s broader tax and financial objectives.

This article will discuss those educational initiatives that have been impacted by the 2001 Tax Act. Other strategies, including UGMA/UTMA, minor’s trusts and irrevocable trusts may also be utilized, particularly where the objective is to provide a broader financial foundation for children and grandchildren. See The Advanced Underwriter, Transfers to Minors, Fourth Quarter 1999.

Unless otherwise specified, these provisions will be effective for tax years after December 31, 2001 and without further legislative action the impacted provisions will expire December 31, 2010.
I/R Code: 2300.02

Education IRA
An Education IRA is a tax-exempt trust or custodial account created to encourage savings on a tax-favored basis to pay education expenses of the designated beneficiary. However, the minimal contribution limits and low-income eligibility under the pre-2001 Tax Act rules did not create wide appeal and eligibility under the pre-2001 Tax Act rules did not create wide appeal and eligibility for the Education IRA. The Tax Act of 2001 has made changes that should increase the attractiveness and effectiveness of the Education IRA as an educational savings tool.

Contribution Limit Increased
First, the 2001 Tax Act increased the allowable cash contribution a taxpayer can make from $500 to $2,000 a year per beneficiary for a child under the age of 18. Internal Revenue Code Section 530(b)(1)(A)(iii). More than one taxpayer can establish an Education IRA for one beneficiary. Parents and grandparents can each set up an Education IRA for a child. However, the total contribution to all accounts cannot exceed the $2,000 annual limit per child. IRC Sec. 530(b)(1)(E).

Example: Assume parents have a 3-year-old for whom they have begun education planning. Under the old law assume a parent contributes the maximum $500 annual contribution to an Education IRA until the child’s age is 18 (15 years). Assuming an 8% return, that annual investment will be worth $14,662. That is barely adequate to pay for one year at a public college. However, under the new contribution limitation, the $2,000 annual contribution for 15 years (assuming an 8% return) will be worth $58,649. An amount that will allow the parents (or other donor) to make a substantial tax advantaged contribution to the child’s education.

Special Needs Beneficiary Age Exception
The age limitations for contributions to and distributions from an Education IRA for a designated beneficiary with special needs will not apply. Therefore, parents and grandparents of special needs students may continue to make contributions to an Education IRA after age 18; and age 30 will not trigger a deemed distribution of the IRA account. IRC Sec. 530(b)(1).

Income Eligibility Expanded
A second change that will broaden the interest in the Education IRA is the increase in the income eligibility range. A taxpayer’s eligibility to use Education IRAs, like traditional IRAs, is subject to adjusted gross income (AGI) phase-outs. An individual may make the maximum contribution to an Education IRA if his or her adjusted gross income is $95,000 and $110,000. The 2001 Tax Act has increased the phase-out range for married taxpayers filing a joint return to twice the range for single taxpayers. Married taxpayers filing a joint return may contribute the maximum $2,000 per year to an Education IRA if their adjusted gross income is $190,000 or less. If their combined AGI is $220,000, they could not contribute to an Education IRA. However, if their AGI fell between $190,000 and $220,000, a married joint filer could make a partial contribution. IRC Sec. 530(c)(1).

Example: If Marge and John file a joint return and their combined AGI is $195,000 their maximum contribution would be $1,666.67. Individuals now have until April 15 of the year following the taxable year (instead of December 31) to make contributions for the taxable year. IRC Sec. 530(b)(5).

Contributions by Business Entities
In addition to IRAs funded with personal dollars, IRC Sec. 530(c)(1) clarifies that contributions can be made to Education IRAs by corporations and other entities (including nonprofits). As a part of an attractive compensation package, employers can fund Education IRAs for the benefit of their employee’s children. The Education IRA annual contributions by these entities would not be subject to income limitations. Contributions made by an employer would be treated as taxable income to the employee.

Qualified Education Expenses
For an Education IRA distribution to receive tax-free treatment, such distribution must be used to pay qualified education expenses. In what is arguably a very significant policy statement, the 2001 tax law, qualified distributions only included expenses for higher education. For tax years beginning January 1, 2002, qualified education expenses will include both qualified higher education expenses and qualified elementary and secondary education expenses.

Taxpayers who are supportive of school choice may find the liberalization of the qualified education expense definition a significant step in providing tax advantaged funding for private elementary and secondary education. From an accumulation perspective, an Education IRA might not have accumulated sufficient assets to meet private primary school expenses. However, the account might have accumulated a sufficient amount to fund private secondary education for the account beneficiary.

Qualified elementary and secondary expenses include expenses for tuition, fees, tutoring, special needs services for a special needs beneficiary, books, supplies, room and board, uniforms, transportation and computer equipment at an eligible educational institution. Room and board is part of the allowable expenses. Effective in tax years beginning after December 31, 2001, the dollar limitations on room and board expenses have been relaxed to reflect the room and board allowance applicable to the student as determined by the eligible institution or the amount actually charged by the eligible institution.

Qualified education expenses also include any contribution to a qualified state tuition program on behalf of a designated beneficiary. The 2001 Act also repeals the 6% excise tax on contributions to Education IRAs for any year in which a contribution is made to qualified tuition program on behalf of the same beneficiary. IRC Sec. 4973(e)(1)(B).

Taxation
Contributions are not deductible and earnings on contributions accumulate on a tax-free basis. The contributor can access the assets at any time and for any reason. Distributions that are used for and do not exceed qualified education expenses are received federal income tax free. If the distributions exceed the amount required for qualified education expenses, the taxable portion is included ratably in income under IRC Sec. 72 annuity rules. IRC Sec. 530(d)(1)(2).

Penalty Tax
Any earnings on distributions that are not used for higher education expenses are subject to federal income tax and an additional penalty tax is imposed equal to 10% of the includible amount. The distribution will avoid a penalty if the distribution meets one of the following exceptions: Assets remaining after the designated beneficiary has completed his or her postsecondary education can be withdrawn and be subject to both federal income tax and the additional 10% penalty.

Rollovers
The beneficiary of an Education IRA can be changed to another eligible family member without triggering a tax. The amount in the designated beneficiary’s Education IRA may be rolled over to another Education IRA for the benefit of the same beneficiary or a member of the designated beneficiary’s family who has not reached age 30. Also, a distribution from an Education IRA can be transferred to another Education IRA within 60 days of the distribution without triggering a tax. Only one tax-free rollover of a particular Education IRA is allowed in a 12-month period. IRC Sec. 530(d)(5).

Coordination with Other Education Incentives
A taxpayer can claim a HOPE credit or a Lifetime Learning credit and also exclude Education IRA distributions for the same student as long as the distribution is not used for the same education expenses for which a credit was claimed. The prohibition against claiming HOPE or Lifetime Learning credits and taking distributions from Education IRAs have been repealed. The taxpayer, however, cannot claim any other income tax deduction for qualified education expenses if those expenses were used to determine the exclusion for distributions from an Education IRA.

Qualified Tuition Program (Section 529 Plan)
A Qualified Tuition Program, also referred to as a Section 529 Plan, is a program established and maintained by a State, state agency or state instrumentality under which a person may purchase either 1) tuition credits on behalf of a designated beneficiary (prepaid educational services account); or 2) make contributions to an account, which is established for the purpose of meeting the qualified higher education expenses of the designated beneficiary of the account (education savings account).

The 2001 Tax Act now allows private institutions to establish qualified tuition plans. However, private institutions can only provide prepaid educational service accounts and individuals contributing to these prepaid accounts cannot also take advantage of a State sponsored education savings account. IRC Sec. 529(b)(1)(A).

Contributions
Like the Education IRA, contributions to a Qualified State Plan must be in cash. However, unlike the Education IRA, there is no specific maximum contribution prescribed by the Internal Revenue Code. A requirement addressed to the qualification of the actual program under IRC Sec. 529(b)(6) is that the plan must limit contributions to an amount reasonably needed for higher education. Therefore, the determination of this limitation is generally made by the specific plan and, therefore, will vary between plans. Some states may have high lifetime account balance limits. Other states may have substantial contribution limits. Taxpayers should review different state plans in order to identify a plan that best meets their objectives.

Taxation
In-kind distributions and cash distributions, including earnings, will now be federal income tax-free when used to pay qualified higher education expenses beginning in tax year 2002 for state plans and 2004 for private institution plans. IRC Secs.529(c)(1), 529(c)(3)(B)(iii). Any distribution that is not a qualified distribution will be taxed under IRC Sec. 72 annuity rules. IRC Sec. 529(b)(c)(3)(A).

An additional 10% tax penalty will apply to any payment or distribution from a qualified tuition program that is includible in gross income. IRC Secs. 529(c)(6), 530(d)(4). The penalty will not apply to distributions: The 10% penalty, however, will not apply to any distribution before tax year 2004 that is includible in gross income but is used for qualified higher education expenses of the designated beneficiary. IRC Sec. 529(c)(6).

Gift Taxation
A contribution to a qualified tuition program is treated as a completed gift, which qualifies for the annual exclusion for federal gift tax purposes. Contributors can contribute up to $10,000 ($20,000 for married couples) annually per beneficiary. IRC Sec. 529(c)(2)(A). However, if the donor’s contribution exceeds the annual gift-tax exclusion, the donor may elect to take the excess into account ratably over five years. IRC 529(c)(2)(B).

Taxpayers facing estate tax liability can remove a large amount of money from their estates by acceleration the contribution to a Section 529 program. For example, assume married grandparents with a taxable estate have 4 grandchildren. Grandparents can establish a Section 529 Qualified Tuition Plan for each grandchild and fund each with $100,000. By accelerating the funding of the Qualified Tuition Plan, grandparents have removed a total of $400,000 from their estate without a gift tax impact.

The contributor cannot exceed $50,000 ($100,000 if spouse joins in) per beneficiary in the first year of this five-year period and can make no additional annual exclusion gifts to the same beneficiary during this period. Grandparents or other account owner have the added advantage of retaining control over the account. They can access the funds, if needed (of course they would have to pay tax and penalty). Alternatively, the grandparents can change the beneficiary if they find that a grandchild is not continuing his or her education or if a grandchild receives scholarships. A grandparent-owned account should also totally remove the account from impacting the student’s financial aid.

Designation of a new beneficiary will not be treated as a taxable gift, unless the new beneficiary is a generation below the generation of the original beneficiary. IRC Sec. 529(c)(5).

Estate Taxation
No part of the contributed amount is included in the donor’s estate for federal estate tax purposes unless the donor dies during the five-year period in which excess contributions to a qualified state tuition program are being ratably taken into account. Only the excess portion allocable to calendar years beginning after the donor’s death is includible in the donor’s gross estate. The account values are not included in the estate.

Coordination
Taxpayers can receive both qualified tuition distributions and will also be eligible to claim either the HOPE or Lifetime Learning credits for a taxable year as long as the distributions are not used for the same expenses for which a credit is claimed. The taxpayer can also utilize distributions from the Education IRA and qualified tuition program as long as the same expenses are not used. IRC Secs. 529(c)(3)(B)(v), 529(c)(3)(B)(v) (I)(II). If distributions from both the Education IRA and Qualified Tuition Plan exceed qualified education expenses, the expenses must be allocated between the distributions IRC Sec. 529(c)(3)(B).

Rollovers
For purposes of tax-free rollovers and changes of designated beneficiaries, first cousins are included as eligible designated beneficiaries. IRC Sec. 529(e)(2)(D)

Hope Scholarship Credit and Lifetime Credit
Another category of education tax incentives is the Education Credit, which includes the Hope Scholarship Credit and Lifetime Learning Credit. Under the credit system, subject to applicable requirements, the parents pay tuition and fees. The taxpayers can then reduce their federal income tax by an amount based on the maximum credit, their income tax bill and their income eligibility status. These credits are probably of greater usefulness to middle income parents because of the income eligibility requirements and the fact that a family must owe taxes to take advantage of them.

Hope Scholarship Credit
The Hope Credit governed by IRC Sec. 25(a)(1) allows a taxpayer to claim a maximum $1,500 credit for qualified tuition and related expenses paid by the taxpayer during each tax year for each eligible student. The Hope Credit covers 100% of the first $1,000 in expenses. This means a taxpayer will need at least $2,000 in eligible expenses to claim the full $1,500 credit. The credit is available for the educational expenses of the taxpayer, the taxpayer’s spouse, and the taxpayer’s dependent. The taxpayer qualifies for the maximum benefit with an Adjusted Gross Income (AGI) of up to $40,000 for a single taxpayer ($80,000 for married taxpayers). The credit amount is phased out between $40,000 and $50,000 for single taxpayers ($80,000 and $100,000 for married taxpayers).

To receive the credit, the student must be at least a half-time student in a program leading to a degree, certificate, or other recognized credential at an eligible school and must not have completed the first two years of undergraduate study. IRC Sec. 25A(b)(2)(A); Proposed Regulation 1.25 A3(c). These amounts are indexed for inflation beginning after 2001. IRC Sec. 25A(h)(1); Proposed Reg. Sec. 1.25A3(a)(2). The HOPE Credit is not allowed for a student convicted of a felony drug charge.

Lifetime Learning Credit
The Lifetime Learning Credit allows a taxpayer to claim a credit of up to $1,000 per tax year through year 2002 (20% of the first $5,000 of qualified tuition expenses). For tax years beginning January 1, 2003, a taxpayer can claim a maximum credit of $2,000 (20% of expenses up to $10,000) per tax year. The credit is available for the educational expenses of the taxpayer, the taxpayer’s spouse, and the taxpayer’s dependents. However, it is not a per student credit but is per family, regardless of the number of eligible students in the household. There is no limit on the number of years the credit may be claimed for an individual. The Lifetime Learning Credit is available for degree and non-degree post-secondary education, including undergraduate, graduate, technical or remedial training (as long as the training is to acquire or improve the job skills of the individual). Only tuition and related fees are covered expenses.

The credit amount is phased out between $40,000 and $50,000 for single taxpayers ($80,000 and $100,000 for married taxpayers filing jointly).

Coordination
Taxpayers cannot claim both a HOPE Credit and a Lifetime Learning Credit for the same student in the same year. For the current tax year, a taxpayer must elect between the Hope Credit, the Lifetime Learning Credit or the Education IRA. However, for tax years beginning January 1, 2002, the taxpayer must select between the two credits with respect to the eligible student, but the taxpayer can also claim an exclusion from an Education IRA distribution for other qualified expenses in the same tax year. IRC Sec. 530(d)(2)(C). Remember, these changes do not apply to tax years beginning after December 31, 2010 without further Congressional action.

Taxpayers can also claim a HOPE credit or Lifetime Learning Credit for a tax year and exclude from gross income amounts distributed from a qualified tuition program on behalf of the same student, as long as the distribution is not used for the same expenses for which a credit was claimed.

Example: Assume Matt and Melanie Miser (parents of Maggie) have adjusted gross income of $80,000. In tax year X, Mr. and Mrs. Miser paid the following for Maggie’s enrollment in State University, an eligible institution:
Tuition and fees - $4,000
Books and Supplies - $800
Room and Board - $4,600
Maggie is also the beneficiary of an Education IRA that was established by Melanie’s employer, as part of a customized employee compensation benefit package created to retain Melanie. Maggie is also a beneficiary of a Qualified Tuition Plan (a Section 529 Plan) established by her grandparents. Maggie received no grants or scholarships in year X.

Maggie is in her third semester of college and she has not completed her second year in college. Mr. and Mrs. Miser can take a $1,500 Hope Credit on their income tax return. If the Hope Credit is used, the Lifetime Learning Credit cannot be used with respect to Maggie. After allocating $2,000 in expenses to the Hope Credit (100% of the first $1,000 and 50% of the next $1,000), the balance of tuition and fees; room and board expenses can be allocated between tax free withdrawals from Maggie’s Education IRA or her Section 529 Qualified Tuition savings account. Another option is to use withdrawals from the Education IRA for the balance of her expenses and save the Qualified Tuition savings account for Maggie’s graduate school. Maggie does not have any brothers or sisters. However, she has a number of first cousins that will be attending college in a few years. Should she not need the funds in the Qualified Tuition savings account established by her grandparents, the designated beneficiary could be changed to one of Maggie’s first cousins. There are a combination of education planning strategies that can be used based on the family and student’s prior planning and current tax and financial situation.

Miscellaneous Education Provisions

Employer-Provided Educational Assistance
IRC Sec. 127 permits employees to exclude from income tax up to $5,250 of employer-provided educational assistance. Companies and employees have had to endure the on again, off again nature of this exclusion which was slated to end December 31, 2001. The 2001 Tax Act provides a permanent extension of income exclusion for employer-provided educational assistance. The exclusion now extends to both undergraduate courses and graduate courses effective for tax years beginning after December 31, 2001. IRC Sec. 127.

Student Loan Interest Deduction
Under the pre-2001 Tax Act, the student loan interest deduction could be claimed only during the first 60 months in which interest payments are required on the loan. The new law will repeal the 60-month limit as of January 1, 2002. The income-eligibility limits for the deduction have also been raised. Beginning in 2002, eligibility begins to phase out for single taxpayers with adjusted gross income between $50,000 and $75,000 and for joint filers with adjusted gross income between $100,000 and $130,000. The maximum allowable deduction would also be reduced ratably. The deduction is an above the line deduction and the income eligibility amounts are adjusted for inflation after 2002. The student loan deduction provisions are effective for interest paid on qualified education loans after December 31, 2001. IRC Sec. 221.

Qualified Higher Education Deduction
For tax years beginning January 1, 2002, eligible taxpayers (see chart below) can take an above the line deduction for qualified higher education expenses paid during the tax year. These expenses include tuition and fees. This deduction cannot be taken with the HOPE or Lifetime Learning Credits in the same year and for the same student. The deduction is subject to a phase-out and expires for tax years after December 31, 2005. IRC Sec. 222.

Eligibility Requirements
Adjusted Gross Income Limitations (single filer) Adjusted Gross Income Limitations (joint filer) 2002 and 2003 Maximum Deduction 2004 and 2005 Maximum Deduction
Not more than $65,000Not more than $130,000$3,000$4,000
More than $65,000More than $130,000$0N/A
More than $65,000 but not more than $80,000More than $130,000 but not more than $160,000N/A$2,000
More than $80,000More than $160,000N/A$0


Summary
The Education provisions of the 2001 Tax Act has a “little something”, savings options and tax incentives, for taxpayers in a range of income levels. The most promising for long term planning is the Education IRA and the Qualified Tuition Program (Section 529 Plan). These programs will be good financial tools for clients with educational savings objectives and can also be funded by business dollars as part of an attractive compensation package for select employees. The various strategies available and the combination of strategies used must be based on the client’s specific financial situation and the applicable requirements of the strategy.

It should be noted that the majority of these provisions are subject to the sunset rules. Like Cinderella at the Ball, when the clock strikes midnight, December 31, 2010 the provisions will revert back to their original pre-2001 Tax Act status unless Congress takes additional legislative action.



Last Updated: 9/23/2012 10:05:00 PM