NEWS AND RESOURCES

Tax and Financial News for August 2000

You Deserve a Break Today!!!
Isn't it funny how time flies? It seems like just yesterday you were young and carefree. And now, you have a child going to college and the sticker shock is worse than what you get when you look at the price tag of a Rolls-Royce. The only good news is that you, or your child, may have a way to reduce that sticker shock with a gift from Uncle Sam.

Beginning in 1998, the tax code was changed to allow for certain tax breaks on expenses associated with "higher education." That's what we are going to explore in this month's Tax and Financial News. In case you didn’t know, your trivia for the day is that parents coined the term “higher education” after tabulating costs of their child's first semester in college.

Before we discuss the common education tax breaks, we need to define the following terms:

Tax credit - Tax credits are dollar for dollar decreases in your tax bill.

Deductions - Deductions are decreases in your taxable income, which in turn reduce your tax bill based on the tax bracket you are in.

As an example of these two terms, assume you are in the 28% tax bracket and get a $1,000 tax credit. Your tax bill will be reduced by $1,000. If, on the other hand, you get a $1,000 tax deduction, your tax bill will only decrease $280 ($1,000 X 28%).

Phase-out (a/k/a Out of luck) – This is the point at which you make too much money to use any of the tax breaks we will be talking about, or at which the benefits start to go away.

Tax Credits

The tax law provides for two basic credits. One, the “Hope scholarship credit”, can be used only for the first two years of “postsecondary” education. The other, the “Lifetime learning credit” is available for the remainder of your life. You can’t use both credits for the same student in the same year.

Hope Scholarship Credit

We have already said this credit is available for the first two years of postsecondary education, but we didn’t tell you what qualifies as postsecondary education. In short, postsecondary education is a course of study – for credit – in any accredited college, university, vocational or other postsecondary institution eligible to participate in federal financial aid programs. Given that there are broad ranges of public, nonprofit and for profit proprietary schools that qualify for federal financial aid, the credit applies to a wide array of potential students.

The credit equals the first $1,000 of qualified tuition and related expenses incurred during the year, plus 50% of any excess over $1,000. However, the maximum amount you can take is limited to $1,500 per year per student. Qualified tuition and related expenses are those amounts required by the institution to enroll the student. Qualified expenses do not include books, room and board, athletic activity fees and similar items that are more in the nature of personal expenses.

Does all of this sound like a pretty good deal? It should, because it is a vast improvement over prior law that provided no tax breaks for the costs of higher education. It is even more attractive because the costs are not limited to colleges and universities. By including vocational, technical and business colleges, plus similar institutions that prepare you for specific jobs, Congress recognized the fact that not everyone should go to a four-year college and this eliminates some of the pressure otherwise talented people may feel to do something they may not be qualified for.

But, as with most items in the tax code, there are those in the Out of Luck category. If you are single, you start losing the credit when your taxable income hits $40,000 and you completely lose it when your modified adjusted gross income reaches $50,000. The numbers are doubled for married taxpayers filing jointly. Married taxpayers who file separately do not qualify for the credit.

One last thing you should know is that this credit will be adjusted for inflation after the year 2000.

Lifetime Learning Credit

If you don’t qualify for the Hope scholarship credit, you may qualify for the Lifetime learning credit. The Lifetime learning credit is available when the Hope scholarship credit is not. The types of payments eligible for the credit are the same as the Hope scholarship credit. However, instead of the credit equaling 50% of qualified expenses, the credit is equal to 20% of qualified expenses, limited to $1,000 in years beginning before January 1, 2003. After that, the maximum credit goes up to $2,000. These amounts are not adjusted for inflation – ever. That is, unless Congress changes it’s mind.

The Out of Luck categories for the Lifetime learning credit are the same as the Hope scholarship credits.

One very good planning point: If you happen to be one of those rich people who earn too much to take advantage of one of these credits, you may want to consider whether taking your child as a dependent is worthwhile. Something very important to remember is the person who gets the credit is the person who gets the dependency benefit for the student.

For instance, say you make $100,000 in 2000 and you pay $10,000 for your child to attend Weteachem University. Since you make too much money, you won’t be able to take the credit.

If, however, you give the money to your child who then pays the qualified expenses and he or she worked during the year and had a tax bill of $1,500, you can elect not to treat that child as a dependent. That would free your child to claim a $1,500 credit and eliminate his or her tax expense. They could use this to reduce what you might otherwise have paid for room, board and miscellaneous expenses.

At the same time Congress created the credits we have been discussing, it also created the “Education IRA”. This is similar in concept to a Roth IRA in that any contribution made to it is not deductible. However, any withdrawals used to pay for qualified educational expenses are not subject to income tax. This is really a great deal, except you must be careful in using it.

Just as you are limited in using the Hope scholarship credit and the Lifetime learning credit for the same student in the same year, you are limited if you use an Education IRA. Any year in which you make a withdrawal from the Education IRA and exclude that withdrawal from your income, you are not eligible for either the Hope scholarship or the Lifetime learning credit.

You are also precluded from contributing to an Education IRA if you make over $100,000.

Before you take any withdrawal to pay for education expenses out of the Education IRA, you need to take stock of 1) how much money is in the education IRA, 2) what the entire course of instruction will cost and 3) if you have any other children who may benefit from the Education IRA. Once you know this, you will be able to determine if it is best to forego the Hope credit in favor of withdrawing the funds from the Education IRA, or wait and use the Hope credit first, before withdrawing Education IRA funds.

Education Related Deductions

With the cost of higher education on the rise, many prospective students are finding it necessary to take out student loans. Until 1998, any interest paid on these loans was “personal interest.” This meant you couldn’t deduct the interest in arriving at taxable income. Beginning in 1998, a limited amount of interest paid on education related loans became deductible. The deductible amounts are $2,000 for taxable years beginning in 2000 and $2,500 for 2001 and beyond.

Congress gave everyone an incentive to pay these loans off fast by limiting the deduction to interest paid during the first 60 months in which repayment is required. So, if you started paying your student loan off 10 years ago, don’t worry about calculating the interest you paid. You won’t be able to deduct it. There are some special rules when payments are suspended for a period of time due to certain specified events, but we can help you with that when you call us.

As with anything else in the tax code, there are Out of luck categories for this deduction also. If you are married, filing jointly, the deduction phases out between $60,000 and $75,000. If you are single, the phase out is between $40,000 and $55,000. If you are married filing separate, you are just plain Out of Luck.

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