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Tax Newsletter
September 2001

Education Incentives - A Broad Range of Choices

The Economic Growth and Tax Relief Reconciliation Act of 2001 (Tax Act) provides new opportunities for parents to fund future education expenses for their children. Together with existing incentives, these provisions present a broad menu of opportunities and significant planning challenges to taxpayers.

Education IRAs Education IRAs may be established to fund future education expenses. Contributions to education IRAs are nondeductible, and the earnings are not currently taxable. Distributions of income are excluded from income to the extent used for educational expenses.

The Tax Act of 2001 makes several important changes to the Education IRAs, which are effective for years 2002 through 2010:

  • The annual contribution has been increased from $500 to $2,000 per student;
  • Contributions can be made to both an Education IRA and to a qualified state tuition program in a single year (previously, these were mutually exclusive);
  • Distributions can be made for elementary, secondary and postsecondary education (previously, distributions were limited to postsecondary education);
  • Entities may contribute to Education IRA accounts.

Qualified education expenses include tuition, books, fees, supplies, and equipment; for elementary and secondary education, qualified expenses may also include tutoring, certain computer technology costs, room and board, uniforms, transportation, and services such as extended day programs as required or provided by the school.

The availability of education IRAs is phased-out based on modified adjusted gross income (beginning at $95,000 for a single person; $190,000 for married persons).

Qualified Tuition Program (QTP). Federal tax law allows states to maintain QTPs that enable persons to participate in prepaid tuition programs or utilize state-sponsored higher education savings accounts. Contributions into QTP accounts are nondeductible, but the earnings are not currently taxable. With the Tax Act of 2001, distributions made during the years 2002 through 2010 that are used for the individualís qualified education expenses are excluded from income. In addition, the Tax Act expands the QTP provisions to allow eligible private institutions to offer prepaid tuition programs (but not savings accounts).

While the Tax Act has expanded the scope of uses for the Education IRAs to include elementary and secondary education expenses, the QTP remains limited to postsecondary education.

Educational Assistance Programs. Educational benefits provided by an employer to an employee may be deductible by the employer and nontaxable to the employee if the benefits qualify as working condition fringe benefits (i.e., work-related education) or are provided pursuant to an educational assistance plan. Employees may exclude up to $5,250 in educational benefits annually under an employer-sponsored educational assistance plan. The Tax Act makes this provision permanent, and extends the exclusion to cover both undergraduate and graduate education. The provisions of the Tax Act are effective for courses beginning after 2001.

Deduction for Student Loan Interest. Certain taxpayers may be eligible to claim an above-the-line deduction for interest paid on qualified student loans. The maximum deduction is $2,500. Deductibility is phased out at certain adjusted gross income levels. The Tax Act increases the phase-out ranges to $50,000-$65,000 for single taxpayers and $100,000-$130,000 for married taxpayers. In addition, the Tax Act eliminates the 60-month limitation on the deductibility of loan interest as well as the restriction on voluntary payments.

Deduction for Higher Education Expenses. For years beginning after December 31, 2001 and before January 1, 2006, the Tax Act provides an above-the-line deduction for qualified tuition and related expenses. The maximum amount deductible is $3,000 in 2002 and 2003 and $4,000 in 2004 and 2005. The availability of the deduction is phased out for individuals whose adjusted gross income exceeds certain thresholds. (In 2002 and 2003, phase-out begins at modified AGI of $50,000 for single individuals; $130,000 for joint filers.

HOPE Credit. The HOPE Credit is a credit against tax for qualified tuition and related expenses for the first two years of post-secondary education. The maximum credit is $1,500 per student; however, the credit amount is phased out for taxpayers with modified AGI above $40,000 and $80,000, single and married persons respectively.

Lifetime Learning Credit (LLC). The LLC is a credit against tax for qualified tuition and related expenses for undergraduate and graduate courses, for an unlimited number of years. The family calculated maximum credit is $1,000, through December 2002, and $2,000 for subsequent years; however, the credit amount is phased out for taxpayers with modified AGI above $40,000 and $80,000, single and married persons respectively.

Planning Challenges. The increased availability of education incentives continues to be a positive development. However, planning for the most effective use of these incentives has become exceedingly complex. Adjusted gross income phase-outs, effective-date phase-ins, sunset provisions, mutually exclusive tax provisions make planning decisions difficult.

In addition, on January 1, 2011, all of the provisions of the Tax Act expire. While it is likely that many provisions will be renewed, there is no guarantee; therefore, the future possibility of changes in taxability of the distributions and the allowable uses of funds should be factored into the planning process for education funding.

Please feel free to contact us should you have any questions regarding the foregoing.


The information contained in this newsletter is general in nature and does not constitute tax advice or opinion. Applicability to specific situations should be determined through consultation with your tax advisor.

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