Above-The-Line Education Deduction

Through 2016, Taxpayers are allowed an above-the-line deduction for qualified tuition and related expenses for the year, to the extent the expenses are in connection with enrollment at an institution of higher education during that tax year, or if those expenses are in connection with an academic term beginning during that tax year or during the first 3 months of the next tax year. 

The deduction is limited both by filing status and Adjusted Gross Income (AGI). Unlike the other education tax incentives where the deduction is slowly phased out, this deduction is not allowed once the AGI limit is reached. Married individuals who file separately and taxpayers who are claimed as a dependent of another are not allowed to take this deduction. 


Filing Status
AGI Limit
Max Deduction
Joint
130,000
4,000
Joint
160,000
2,000
Others
65,000
4,000
Others
80,000
2,000


Since the expenses that qualify for this deduction are the same as those that qualify for the education credits, taxpayers may qualify for both and will be required to choose between the two. Each taxpayer's individual circumstances must be taken into consideration before making the most beneficial decision. This office can assist you in making an informed choice.

Education Credits Can Be Claimed On An Amended Return

Individuals who could have claimed an education credit but failed to do so on their original returns, may claim the credit on an amended return. In general, an amended return may be filed within three years from the date your return was filed or within two years from the time the tax was paid, whichever is later. 

This rule creates a refund opportunity for those who filed their returns without claiming an education credit that they were entitled to. If you can benefit from this rule, please call for further details.

Coverdell Education Savings Accounts

Coverdell accounts are education trusts that allow funds to be put away for a child's education. Tax on earnings from these accounts is deferred until the funds are withdrawn, and if used for qualified education purposes, the entire withdrawal can be tax-free.These accounts have seen limited use, due in part to small dollar amounts that can be deposited and many limitations imposed both on the contributor and beneficiary of the accounts.

The annual contribution is limited to $2,000 for each beneficiary. Therefore, contributors must be careful that their combined contributions do not exceed the annual limitation. The contribution is further limited for higher income taxpayers. The contribution limit begins to phase out when the taxpayer’s Adjusted Gross Income (AGI) exceeds $95,000 and is fully phased-out when it reaches $110,000. The phase out range for married taxpayers filing jointly is $190,000 to $220,000.

The qualified use of these funds includes kindergarten through post-secondary (college) education expenses.  Education credits (Hope/American Opportunity and Lifetime) and tax-free Coverdell withdrawals are allowed in the same year, provided that they are for different qualified expenses.

Example: A single taxpayer establishes a Coverdell Account for a grandson. By the time the grandson reached 18, the taxpayer had contributed $4,500 to the account. Assuming the account earned $1,500 interest, the total account value will be $6,000. When the grandson enters college, he withdraws the entire account balance and uses $4,000 of the funds for tuition and $2,000 for non-qualified expenses. Since some of the fund's use is non-qualified, a pro-rata share of the earnings must be reported as income by the grandson - in this case $500 is taxable ($1,500 x $2,000/$6,000). In addition to the regular tax, the grandson will also be assessed a 10% tax penalty on the taxable portion. 

Each beneficiary under the age of 18 is allowed to have an amount up to the annual limit deposited into their Coverdell Account each year. The contributions made by the contributing taxpayer are nondeductible and care should be exercised so that the combined total of contributions does not exceed the annual contribution limit for the year. This is especially important when more than one individual is making contributions and not sharing that information with others.  To escape penalty, any excess contributions must be withdrawn before the sixth month, usually June 1, of the year following the year in which the contribution was made, and the beneficiary must include the distributed earnings in gross income for the year in which the contribution was made.

Contributions to Coverdell Accounts can be delayed to as late as the due date of the contributor's tax return (generally April 15) allowing them the opportunity to determine if their AGI is within limits so they can make the contribution. 

Coverdell or Section 529 Plan - Frequently, the question arises: is it better to contribute to a Coverdell Account or to a Section 529 Plan?  Generally, unless the contribution is limited by the AGI phase-out, the Coverdell Account provides more advantages than the Section 529 plans.  Here are the strategic differences:

• Coverdell funds can be used for kindergarten and up, while Section 529 plans only apply to post-secondary education. 

• Coverdell accounts lack control, since the beneficiaries actually own the accounts and can raid them for other than education purposes once they reach maturity. 

• The advantages of a Section 529 plan are control retention by the contributor, larger contributions permitted, and no AGI phase-out limiting contributions.

Strategy – Other than lack of control, it may be to a taxpayer’s advantage to place the first $2,000 contributed toward a student’s education fund in a Coverdell and then any additional amount can be set aside in a Section 529 plan.

Additional rules apply for dealing with rollovers, mandatory distributions, changes in designated beneficiaries, death of taxpayer or beneficiary, and unauthorized use of distributions. Please call this office for additional information.

Deduction for Higher Education Interest

Generally, taxpayers can only deduct home mortgage interest, investment interest, and business interest. However, interest paid on student loans used to pay tuition, room and board and related expenses for qualified higher education is an above-the-line deduction. The deduction is limited to $2,500.

The deduction for student loan interest is allowed whether or not a taxpayer itemizes deductions. Qualifying loans can include government student loans, consumer loans, and loans by unrelated third parties.
 

The annual deduction begins to phase out when a taxpayer's modified AGI reaches the lower end of the phase out range and is completely phased out at the top of the range. The phase-out range is adjusted annually for inflation. The table below indicates the phase out ranges for each filing status. Married individuals who file separately and taxpayers who are claimed as a dependent of another are not allowed to take this deduction. The phase-outs are inflation adjusted in some years. 

Phase-Out AGI
Filing Status
2004 - 2016
2017
Unmarried Filing Status
65,000 - 80,000
65,000 - 80,000
Joint Filing Status
130,000 - 160,000
135,000 - 165,000
Married Separate
No Deduction Allowed
Dependent of Another
No Deduction Allowed


If you overlooked this deduction in a prior year, it is not too late. We can assist you in amending your prior year's returns to take advantage of this deduction.

Education Credits: Who Gets the Benefit?

When it comes to who gets the benefit of the education credits, it might not be who you would expect. The IRS has provided clarification as to who can claim the education credits. These are credits allowed for qualifying higher education costs for yourself, your spouse, or your dependents. Under the latest rules, if a third party—i.e., someone other than you, your spouse or claimed dependents—pays tuition and related fees directly to a college, the student is treated as having made the payment directly. To further confuse you, expenses made by a student are treated as made by the taxpayer who claims the student as a dependent. Thus, if a divorced parent pays tuition on behalf of a child but the other parent has custody of the child and is eligible to claim the child as a dependent, the custodial parent is treated as paying the tuition directly to the college. Thus, the custodial parent could claim the credit.

Another added complexity:
For purposes of claiming education credits, taxpayers can choose not to claim dependency exemptions for their student children. Then the student can claim the education credit on his/her own return. This could be beneficial, for example, if the parents have a gross income too high to actually get a tax break from the credit. A BIG drawback to this approach: Neither the student nor the parents can claim a dependency exemption for the student.

Educational Tax Credits

The law currently provides for two tax credits, the American Opportunity and the Lifetime Learning Credits. Both credits will reduce a taxpayer's tax liability dollar for dollar until the tax reaches zero. Any Lifetime credit in excess of the tax liability is lost. The American Opportunity credit provides for a partial excess credit refund.  The credit is not allowed for taxpayers who file married separate returns. The credits are elective and the taxpayer must choose between the two credits for each student.

AMERICAN OPPORTUNITY CREDIT

The American Opportunity credit is available for the first four years of post secondary education, and the maximum credit per student is $2,500.  The credit is based on 100% of the first $2,000, and 25% of the next $2,000, of tuition, fees and course material (including books) expenses paid during the tax year.  40% of the credit is refundable, provided the taxpayer is not: (1) a child under the age of 18 or (2) under the age of 24, a full-time student and is not self-supporting.  The credit is available for students enrolled on at least a half-time basis.

For higher-income taxpayers, this credit begins to phase out for AGI in excess of $80,000 ($160,000 for married couples filing jointly). Annual inflation adjustment does not apply to these amounts.

LIFETIME LEARNING CREDIT

The Lifetime Learning Credit is a credit of up to 20% of the first $10,000 of qualifying educational expenses for (1) undergraduate, graduate, or certificate level courses for a student attending classes on at least a half-time basis, or (2) any course at an eligible institution to acquire or improve job skills of the student (no attendance time requirements).

For 2016, the allowable credit phases out when a taxpayer’s modified AGI is between $55,000 and $65,000 for single taxpayers and between $111,000 and $131,000 for joint return filers. These phase-out levels are annually adjusted for inflation. Please call this office for the phase-out AGI for other years.

Lifetime Learning Credit Example: A taxpayer, whose AGI is under the phase-out threshold, has two children attending college on a full-time basis. The taxpayer pays qualified tuition expenses for the two children in the amount of $12,500, and there is no reimbursement or other tax benefit claimed for the tuition expense. The taxpayer is entitled to a tax credit of $2,000 (20% of the first $10,000) for the tax year. 

Qualifying expenses...for both credits include tuition and fees but generally not expenses for room, board, equipment*,materials*, books* and other nonacademic fees such as student activity, athletic, insurance, etc. Also excluded are expenses for courses that involve sports, games or hobbies that are not part of a degree program. Tax-free scholarships or fellowships and other tax-free educational benefits must reduce expenses qualifying for the credit. *However books and certain other materials that are provided by the school and included in the tuition and fees may also be deductible.

Qualifying students...must attend a qualified educational institution (one that is eligible to participate in U.S. Dept. of Education student aid programs). The student must be the taxpayer, spouse, or someone who is a dependent of the taxpayer. In addition, in the case of the American Opportunity Credit, the student must have no federal or state felony drug convictions for the academic period to which the credit would apply.

Who claims the credit? The taxpayer who claims the Lifetime Learning or American Opportunity credit is not necessarily the one who pays the tuition.

Home Equity Can Provide Funds for Children's Education

Many parents of college age children would like to utilize the equity in their home to help pay for college expenses. When considering this course of action, there are two issues: (1) Should the first trust deed be refinanced, or should a second trust deed line of credit be secured? and (2) Will the interest be deductible?

The decision whether to refinance the first trust deed or to obtain a second trust deed will depend on several factors, including how favorable the interest rate is on your current mortgage, how much it will cost to refinance, how much you need to borrow and how long you will remain in the home. Generally, if your interest rate is near the prevailing rate for new mortgages, it will be better to obtain a second loan or a line of credit. The line of credit has the added advantage that you can draw on it as needed, rather than trying to estimate your needs in advance and borrowing a lump sum. If you are planning to sell your home within the near future, the cost of refinancing the first mortgage is probably not warranted. On the other hand, if your current mortgage is more than 2 points higher than the prevailing mortgage rates and you plan to remain in the current home for the foreseeable future, it is probably better to refinance the first mortgage anyway.

The tax laws associated with deducting home mortgage interest can be tricky if you have previously refinanced or have mortgages in excess of one million dollars. However, if your current mortgage is less than $1 million and you have never previously taken any equity out of the home, you can borrow up to an additional $100,000 and still deduct all of the interest as home mortgage interest.

CAUTION: The limitations associated with the deduction for home mortgage interest are complex and tax strategies involving home mortgages often require the services of a professional advisor. Please call this office for assistance.

Penalty-Free IRA Withdrawals

Generally, when funds are withdrawn from an IRA before a taxpayer reaches age 59-1/2, a 10% early withdrawal penalty applies to the distribution. However, penalty-free withdrawals are permitted if the funds are used to pay qualified higher education expenses. The withdrawals will still be subject to regular income tax.

Qualified "higher education expenses" include tuition at a qualified educational institution, as well as related room, board, fees, books, supplies and equipment. The expenses can be for the taxpayer, spouse, taxpayer's or spouse's children and grandchildren.

If you overlooked this exception and paid the early withdrawal penalty, on a prior year's return, the oversight may be corrected by amending the prior year's tax return. Call this office for assistance.

Qualified Tuition Programs - Section 529 Plans

Section 529 Plans (named after the section of the IRS Code that created them) are plans established to help families save and pay for college in a tax-advantaged way and are available to everyone, regardless of income. These state-sponsored plans allow you to gift large sums of money for a family member’s college education, while you maintain control of the funds. The earnings from these accounts grow tax-deferred and are tax-free if used to pay for qualified higher education expenses. They can be used as an estate-planning tool as well, providing a means to transfer large amounts of money without gift tax. With all these tax benefits, 529 plans are an excellent vehicle for college funding.

Types of Plans


Section 529 Plans come in two types, allowing you to either save funds in a tax-free account to be used later for higher education costs, or to prepay tuition for qualified universities.
  • College Savings Plans – These allow you to contribute after-tax dollars that are invested in some sort of savings vehicle. Many of these plans offer more aggressive investments when a child is quite young, which will then be transferred to more conservative investments as the child gets closer to college age. As with any investment, there are no guarantees of growth, and the plans are subject to the normal investment risks, even though state governments sponsor them. A big plus for these plans is that they are not geared towards in-state schools but are meant to be applied to whichever school your child chooses to attend.

  • Prepaid Tuition Plans – As the name implies, a Prepaid Tuition Plan allows parents to pay for college education at today’s tuition rates. By locking in your tuition payments, worries about the increase of tuition costs in the future can be set aside. This gives the assurance that the child will have the money to attend college when that time comes. These plans sound very attractive; however, most of these plans guarantee that you will be covered only if your child chooses to go to a public in-state college or university. Therefore, if your child decides to attend an out-of-state school, you won’t be fully covered, simply because these plans are not meant to fund the higher costs of private or out-of-state education.

Control

If you make sacrifices to save for a child’s college education, you certainly want to make sure those savings end up being used for college and not some other purpose. 529 Plans allow you to keep control of the account. If you save money for college in a UGMA or UTMA (the name depends on the state in which you live and are essentially custodial accounts, set up for minors), the account becomes the child's property once he or she reaches the age of maturity – usually 18 or 21 and you lose control. Unlike UGMA/UTMAs, Section 529 plans are not irrevocable gifts and you retain control. Control stays in the hands of the adult responsible for the account. Generally, this is the same person who contributed the money, but it doesn't have to be the case. Someone else, for example a grandparent, could make the donation but name the child’s parent as the account owner. Money does not come out of the account without permission from the account owner. If the designated beneficiary of the plan decides not to go to school, then the account owner can simply change the beneficiary to someone else in the family.

Tax Benefits

There is no federal tax deduction for making contributions, but taxes on the earnings within a 529 plan are not only tax-deferred while they are held in the account, but are tax-free when withdrawn to pay for qualified education expenses. This allows you to accumulate money for college at a much faster rate than you can in an account where you had to pay tax on the investment gains and earnings.

How Much Can Be Contributed?

Unlike the Coverdell Education Savings Accounts that limit the annual contribution to $2,000, Sec 529 Plans allow you to put away larger amounts of money. There are no income or age limitations for the Sec 529 Plans. The maximum amount that can be contributed per beneficiary is based on the projected cost of a college education and will vary between state plans. Some states base their maximum on an in-state four-year education, while others use the cost of the most expensive schools in the U.S., including graduate studies. Most have limits in excess of $200,000. Generally, once an account reaches that level, additional contributions cannot be made, but that doesn’t prevent the account from continuing to grow.

Contributions to a 529 college savings plan must, by Federal law, be made in cash and always consist of after-tax money. Most programs also have a minimum contribution that is within everyone’s budget. Many have payroll or automatic withdrawal programs

Penalties

If the earnings from the 529 Plan are withdrawn and not used for higher-education expenses, the earnings withdrawn will be subject to both regular taxes and a 10% penalty. Before you become concerned, consider this: Had you not utilized the tax deferral benefits of the Sec 529 Plan, you would have accumulated significantly less in the account (because you would have paid tax on the earnings), which will generally more than offset the 10% penalty. You can avoid penalties by making a tax and penalty-free rollover from one 529 Plan to another, and remember that you are able to change beneficiaries to a 529 Plan without penalty.

Impact on Financial Aid

Predicting financial aid eligibility is no easy task, since it’s based on a myriad of factors, including income, the age of the parents, and the methodology used. A question that always arises when discussing the benefits of saving for college is the impact those savings will have on future financial aid. Investing in a college savings plan could affect your financial aid eligibility but are typically viewed as a parental asset, rather than a child’s, and that means that a financial aid officer would count only a small portion of the assets toward the financial aid eligibility.

However, don't let the fear of hurting your child's eligibility for financial aid deter you from developing a sound savings strategy. Keep in mind that a lot of financial aid comes in the form of student loans, which means you'll save yourself (or your child) some money by planning ahead.

Gift and Estate Tax Considerations

Contributions to Section 529 Plans are considered completed gifts and are subject to the gift tax rules. Under these rules, individuals can annually give away (gift) money up to the annual limit to another individual (double for a married couple) without triggering gift taxes or reducing their lifetime gift and estate tax exclusion. The annual gift exclusion amount is $14,000 for 2017 (same as 2013 through 2016) and is periodically adjusted for inflation. Please call this office for the limits for other years.

In addition, individuals are allowed to make five years’ worth of gifts to a Section 529 Plan in one year. That means an individual can contribute $70,000 in 2016 or 2017 and a couple $140,000.

Section 529 Plans are increasingly being promoted as an estate-planning device for wealthy grandparents, since making a large contribution to a 529 Plan reduces your taxable estate much quicker than the current annual gift exclusion. But while the assets leave your estate, they don't leave your control.

Please Note: Transfers and change of beneficiaries can trigger gift and generation-skipping taxes if not planned correctly. If you are contemplating a change in beneficiary or transferring an account to another beneficiary, you are cautioned to call this office in advance. We can plan the change or transfer in such a way to avoid or minimize any potential gift or generation-skipping taxes.

Plan Sponsors

Section 529 Plans are state-sponsored programs. You are actually investing in a program authorized by the Federal government and run by the various states. To attract their own residents, some states offer tax deductions for contributions, while others will disregard the account balances when calculating state financial aid. It is important to understand that you are not limited to establishing a plan with your resident state. You should investigate the various state plans available and evaluate their performance, expenses, and investment options before making your selection.

Getting Started

Evaluating the various plans available, selecting one that meets your needs, and deciding on the amount of money to contribute to the fund can be time-consuming and complex. If you need professional assistance, please call this office.

Use Appreciated Stock to Fund Obligations

You might want to consider gifting stock that has appreciated in value to your children (over age 23) to help pay for their education or to purchase a home, or to parents to help pay for their eldercare. By doing this, you shift the tax liability for the gain from selling the stock to the child or parent, who with proper planning, may pay a lower tax on the profits than you would. In 2013 through 2017, each taxpayer can gift up to $14,000.

This strategy cannot be used for children under the age of 19 or by children who are under the age of 24 and are full-time students.

Everyone's situation is different and what works for one may not work for another. Please call this office for information pertaining to your particular circumstances.

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