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New Tax Provisions Help College Students And Their Families

by Steven C. Colburn, PhD, CPA

If you are like many other college students today, paying for college tuition and other expenses can be a significant burden on you and your family. Well, help has finally arrived from Uncle Sam in the form of new income tax credits and other benefits. The Taxpayer Relief Act of 1997 provides two new credits, the HOPE Scholarship Credit and the Lifetime Learning Credit, for college students and their families. In addition, taxpayers may now invest in Education Retirement Accounts for themselves or their dependents. The funds from these accounts may be withdrawn tax-free in order to pay for qualified higher education expenses.

The Hope Credit

The HOPE Scholarship Credit provides a maximum allowable credit of $1,500 per eligible student for each of the first two years of post-secondary education. A credit is a dollar-for-dollar reduction in your income tax bill. For example, if your parents' federal income tax liability for 1999 is $10,000, the Hope Scholarship Credit could reduce their taxes to as little as $8,500! However, the credit is non-refundable, so they can't get back more than they paid.
The credit may be claimed (only during the student's first two years of higher education) for 100 percent of the first $1,000 of qualified tuition and related expenses and 50 percent of the next $1,000 of qualified tuition and related expenses paid (up to a total of $1,500). For example, if you paid $900 in tuition during 1999, the credit equals 1.00 X $900 = $900. If the tuition paid is $3,000, the credit is (1.00 X $1,000) + (.50 X $1,000) = $1,500. No credit is allowed for tuition paid in excess of $2,000.
To be eligible for the HOPE credit, a student must:

  1. Not have completed the first two years of post-secondary education (generally, freshman and sophomore years) as of the beginning of the tax year. In other words, if you or your parents want to claim the HOPE credit for qualified expenses paid for you during 1999, you must not have completed your sophomore year in college as of January 1, 1999.
  2. Be enrolled in a program that leads to a degree, certificate, or other recognized educational credential.
  3. Take at least one-half the normal full-time workload for at least one academic period (semester, quarter, trimester, summer session, as defined by the school) that begins during the calendar year.
  4. Not have been convicted of any felony charge for possessing or distributing a controlled substance.
    The HOPE credit may be taken for tuition paid by the taxpayer on behalf of the taxpayer, the taxpayer's spouse, and the taxpayer's dependents. So, parents can claim credits for as many family members as are in school. For example, if you and your sister (or brother) are both in college, your parents may claim two credits for a total of up to $3,000. If Mom or Dad is also in school, the credit may go as high as $4,500 or $6,000.

Qualified Tuition And Related Expenses

Generally, tuition and other fees required for enrollment paid to an accredited post-secondary educational institution that offers credit towards an associate's, bachelor's, or other recognized post-secondary degree would qualify. Such institutions include colleges, universities, and vocational schools, among others. Also, tuition paid to institutions which are eligible to participate in student aid programs sponsored by the Department of Education generally qualifies.
As a rule, amounts paid for books, supplies, equipment, and non-academic fees do not qualify for the HOPE credit. However, such fees would qualify as "related expenses" if they must be paid directly to the educational institution as a condition of the student's enrollment. Certain expenses may not qualify for the HOPE credit. They include the costs of room and board, insurance, medical expenses (such as student health fees), transportation, student activity fees, and other personal, living, or family expenses, whether or not they are paid to the eligible educational institution.

Who May Claim The Credit

Generally, the credit may be claimed only by the taxpayer that actually pays the tuition and related fees and can claim the student as a dependent (usually, a parent). Students paying their own tuition may claim the HOPE credit for themselves if they are not claimed as dependents by someone else (e.g. their parents). If the student is claimed as a dependent by another taxpayer, amounts paid by the student for tuition and related expenses are treated as if they were paid by the other taxpayer. This results in a tax credit for the parents as long as they can claim the student as a dependent. What if a third party (someone other than you or your parents), such as a grandparent, pays your tuition and fees directly to the school? In this case, you, as the student, are treated as receiving the payment from your grandparent and then using that money to pay your tuition and fees. Again, in this case, your parents would deduct the credit on their return if they claim you as a dependent. Otherwise, you would claim the credit on your own return.

Half-Time Enrollment

As long as you are enrolled at least half-time for one academic period during the tax year, all qualified tuition and fee payments made during the tax year qualify for the credit (even if you were enrolled less than half-time for other academic periods during that same tax year). For example, assume you began college as a full-time student during the fall of 1998 by enrolling for 12 credit hours. During the spring semester of 1999, you take only 5 credit hours, which is less than half-time (half-time = 6). During the fall semester of 1999, you take at least 6 credit hours. For 1998, you would qualify for the HOPE credit because you were enrolled at least half-time. Even though you were enrolled less than half-time during the spring 1999 semester, you would qualify for the HOPE credit for all of 1999 because you were enrolled at least half-time during the fall of 1999. Students studying abroad qualify as long as the program is approved for credit by the institution in which they are enrolled.

Timing Of Payments

Generally, the credit is available only for qualified tuition and expenses that are paid in the same year as the academic period to which they relate. For example, if you pay tuition for the fall 1999 semester during 1999, you may deduct the HOPE credit on your 1999 tax return (filed by April 15, 2000). However, payments made in one year for an academic period that begins within three months of the end of the year of the payment may qualify for the credit in the year paid. So, if you prepay your spring 2000 tuition in December 1999, assuming other requirements are met, you may deduct the credit on your 1999 tax return rather than your 2000 return.

Phaseout Of Credit

The credit is reduced (phased out) for taxpayers in higher income brackets. For a single taxpayer, the credit is phased out for Adjusted Gross Income (AGI) between $40,000 and $50,000. The phaseout range for married taxpayers filing jointly is an AGI of $80,000 to $100,000. For example, Bill and Mary paid $4,000 in college tuition for their daughter Christy in 1999. Bill and Mary's AGI for 1999 is $85,000. Their tentative HOPE credit is $1,500 ($1,000 X 100%) + ($1,000 x 50%). However, the phaseout provision reduces their credit by [($5,000/$20,000) X $1,500] $375 to $1,125.
Finally, the HOPE credit is not available to married taxpayers filing separate tax returns. Married taxpayers must file jointly to obtain the benefit of the HOPE credit.

Lifetime Learning Credit

As of July 1, 1998, the lifetime learning credit equals 20 percent of the first $5,000 of qualified tuition and fees paid by the taxpayer each year, for a maximum credit of $1,000 (.20 X $5,000). Amounts paid before July 1, 1998 do not qualify for the credit. For example, if qualified expenses in 1999 equal $4,000, the credit is $800 (.20 X $4,000). If qualified expenses amount to $6,000, the credit is $1,000 (.20 X $5,000). The amount of eligible expenses increases to $10,000 beginning in 2003, increasing the maximum credit to $2,000. As with the HOPE credit, this credit is also available for taxpayers paying tuition for themselves, their spouse, or their dependents.

Differences exist between the lifetime learning credit and the HOPE credit. Unlike the HOPE credit, the lifetime learning credit is determined per taxpayer, not per student. As a result, a married couple filing jointly will be able to claim a maximum lifetime learning credit of $1,000 (.20 X $5,000) for 1999 regardless of how many family members are attending college. However, the lifetime learning credit has advantages not found in the HOPE credit. There is no limit to the number of years that the lifetime learning credit may be claimed. Therefore, the it may be claimed for graduate as well as undergraduate education expenses. The HOPE credit may only be claimed for the first two years of post-secondary education, and both credits may not be claimed with respect to the same student in the same tax year. To take maximum advantage of both credits, your parents might want to claim the HOPE credit during your first two years of college and the lifetime learning credit during the remaining years of your college education. They may claim the HOPE credit for your brother or sister if he/she is a freshman or sophomore, as well as for you if you are a junior or senior.

Another advantage of the lifetime learning credit is that students do not have to be enrolled at least half-time in a degree program to qualify for the credit. The credit may be claimed for any course at an eligible institution that helps an individual acquire or improve job skills. This provision will allow taxpayers that already have their degrees (practicing accountants, for example) to take the credit for continuing education courses and non-credit professional seminars in their fields.

Education IRAs

A new tax-favored investment vehicle called the Education Individual Retirement Account (Education IRA) was also created to help taxpayers save for the future education of their children or grandchildren. It functions similarly to a regular IRA account, except that it is designed to pay the beneficiary's college expenses rather than retirement benefits.

It works this way. Taxpayers may contribute up to $500 per year to an education IRA for each beneficiary under the age of eighteen. Anyone may contribute to a child's Education IRA, but the total contributions per year per child may not exceed $500. For example, parents may invest up to $500 per year in separate education IRAs for each of their children. Or, a grandparent or other relative or friend may contribute part (or all) of that $500. The donors (parents) get no deduction on their current income tax return, but the funds in the IRAs grow, tax deferred. Also, there is no tax on the earnings withdrawn if the entire amount is used to pay the student's qualified post-secondary education expenses. If less than the full amount withdrawn is used for qualified expenses, some or all of the earnings will be taxable to the student. There is a catch. You can't double dip! That is, earnings from an education IRA cannot be withdrawn free of tax if either the HOPE credit or lifetime learning credit is claimed in the same year for the same student. Amounts withdrawn from an education IRA must be used to pay for the beneficiary's tuition, fees, books, supplies, and equipment at an eligible educational institution. Unlike the HOPE and lifetime learning credits, the education IRA may also be used to pay room and board expenses if the student attends school at least half-time. A ten-percent penalty tax applies to amounts withdrawn but not used for qualified educational expenses of the beneficiary. If the beneficiary doesn't use up all of the funds in the IRA by his/her 30th birthday, the remaining amount may be rolled over into another IRA to benefit another member of the family.

Five hundred dollars per year may not sound like a lot of money, but it can add up to a sizeable amount over 18 years. Example: Assume that Harold and Kathy have a baby girl in 1999 named Sarah. Beginning in 1999, they put $500 per year for 18 years into an education IRA. The fund earns 8 percent per year compounded annually. By the time Sarah is ready to start college in 2017, the fund will have grown to $18,725, and the money can be withdrawn free of income tax to pay Sarah's college expenses.

As with the HOPE credit and the lifetime learning credit, phaseout rules apply to the education IRA. The $500 annual contribution is phased out for joint filers with an AGI between $150,000 and $160,000 (between $95,000 and $110,000 for single filers).
Example: Assume in the previous example that Harold and Kathy's AGI for 1999 is $153,000. This would reduce their contribution to Sarah's education IRA by 30 percent equaling $350---[$500 - (($153,000 - 150,000)/($160,000 - 150,000) X $500)].

Claiming The Credits

Taxpayers wishing to claim either credit must fill out and attach Form 8863, Education Credits (HOPE and Lifetime Learning Credits), to their tax returns. The name and taxpayer ID number (social security number) for each student must be included. Married taxpayers must file jointly to claim the credits.

Changes In Regular IRAs

In addition to the HOPE credit, the lifetime learning credit, and the education IRA, Congress also loosened the provisions on regular IRAs to help pay college expenses. Taxpayers may now make early withdrawals from regular IRAs to pay qualified higher education expenses for themselves, their spouse, a child, or a grandchild without having to pay the 10 percent tax on early withdrawals. Any earnings withdrawn will still be subject to income tax. Qualified expenses include tuition, fees, books, supplies, and equipment for graduate as well as undergraduate programs.

Deductions For Interest On Education Loans

Beginning with the 1998 tax year, taxpayers may deduct interest paid on qualified education loans for themselves, their spouse, and dependents. The maximum deduction for 1998 was $1,000, increasing to $1,500 for 1999, $2,000 for 2000, and $2,500 in 2001 and after. The expenses must be incurred for a period during which at least a half-time student is pursuing a degree, certificate, or other program at a qualified educational institution.

Qualified expenses generally include tuition, fees, room and board, and related expenses (books and supplies). These expenses must be reduced by the amount of certain adjustments including employer-provided educational assistance, U.S. savings bond interest used to pay higher education costs, education individual retirement accounts, and scholarships and other forms of tax-free educational assistance.

The deduction for interest may only be taken during the first 60 months in which interest payments are required; the months need not be consecutive. Deferral periods do not count as part of the 60 months.
Now for even better news. The interest may be deducted "above the line" for AGI. The interest deduction is not an itemized deduction. This means that taxpayers may take the interest deduction whether or not they itemize. The bad news is that you may not take the deduction if someone else may claim you as a dependent (e.g. your parents). Also, married taxpayers must file a joint return to deduct interest they paid.
As with other benefits, the deduction is phased out as income increases. For single taxpayers, the deduction is phased out at modified AGI between $40,000 and $55,000 ($60,000 to $75,000 for those married persons filing jointly).


To summarize, the 1997 tax law provided three new tax saving opportunities to help fund college costs for students. The HOPE and lifetime learning credits can help with current college expenses by providing immediate tax savings. The HOPE credit is available only for the first two years, while the lifetime learning credit can apply right through graduate school and beyond. The education IRA may be more useful in helping to pay for future education costs because of the tax-free buildup and withdrawal of earnings. In addition, early withdrawals may be made from regular IRAs to pay educational expenses without incurring the 10 percent early withdrawal penalty.

Steven C. Colburn is an associate professor of accounting in the Maine Business School at the University of Maine, Orono, Maine.

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