Education Credits

  • There are two logical ways that I can arrange this information:
    1. There is a spectrum of education credits:
      1. Straightforward credits for expenses the taxpayer "had no choice but to spend." For example, if the taxpayer has a student loan, he had no choice but to pay student loan interest.
      2. Credits also for expenses for which the taxpayer "had no choice but to spend," but which credits the tax preparer must compare to each other to see which is the most advantageous.
      3. Credits that the taxpayer creates himself by taking some action. For example, the taxpayer may decide to put money into an "education IRA."
    2. I have chosen to present this information in the above order because it is more similar to the order of discussion in the tax preparation interview.

  • Student Loan Interest Deduction
    1. IRS Tax Topics: Topic 456-Student Loan Interest Deduction.
    2. The student will get Form 1098-E if he paid more than $600 student loan interest.
    3. The amount on Form 1098-E may be entered direction into the Adjustments Section of Form 1040.
    4. The limit per person in 2003 was $2,500.
    5. The deduction is available to a taxpayer for a 1098-E issued to:
      1. Taxpayer
      2. Spouse
      3. Any dependent
    6. A person who is a dependent of another person cannot take the credit.
    7. Unfortunately, the deduction must be reduced by:
      1. employer-provided education benefits
      2. distributions that year from an education IRA
      3. U.S.Savings bond interest that is non-taxable because you paid qualified higher education expense
    8. The student must
      1. be enrolled in an educational institution leading toward a certificate or degree, which includes:
        1. High school
        2. Trade school with a recognized certificate program
        3. College
      2. have carried at least half of a full-time student work-load
    9. There is no special form to fill out for this deduction.
      1. However there is a special worksheet incorporated into the 1040 instructions.
      2. This worksheet does not accomodate the reductions listed above.

  • Educator Expense Deduction
    1. IRS Tax Topics: Topic 458-Educator Expense Deduction
    2. This deduction is for elementary or secondary and not college.
      1. Teacher
      2. Instructor
      3. Counselor
      4. Principal
      5. Aide
    3. The person claiming the deduction must work at least 900 hours a year as one of the above.
    4. These expenses typically include:
      1. books
      2. supplies
      3. computer equipment
    5. This deduction is limited to $250.
      1. Since most of these taxpayers are in the 15% bracket, the maximum credit is about $37. Big deal.
      2. Although they do not seem to be related, the educator expense deduction is reduced by
        1. U.S. savings bond interest that the taxpayer excluded from income because of the higher education expenses,
        2. withdrawals from a Coverdell Education Savings Account.
      3. There is no special form for this deduction.

  • Tuition and Fees Deduction, Hope Credit, and Lifetime Learning Credit

    1. Background.
      1. For years quite a few states have had some sort of "higher education" credit with no corresponding credits on the federal returns.
      2. Finally Congress authorized substantial "higher education" credits in the Taxpayer Relief Act of 1997.
      3. However, instead of one all-encompassing credit, the Act followed a the recent tendency in recent tax acts to provide an array of choices.
      4. There are two pick-and-choose education credits.
      5. The Hope Scholarship Credit is designed for freshmen and sophmores.
      6. The Lifetime Learning Credit is designed for both undergraduate and graduate students.
      7. However, the credits do overlap so that a prudent tax return preparer must compare the two to find out which works best for the particular student in a particular year.
      8. However, the best of these two credits must further be compared to the Tuition and Fees Deduction (which is really an Adjustment).
      9. It is as though Congress said to the college student, "We are going to give you a variety of deductions and credits to choose from. But you are going to have to have that college education in order to figure out which one works best for you!"

    2. Getting started with the comparison of the Tuition and Fees Deduction, the Hope Credit, and the Lifetime Learning Credit
      1. First determine the dollar amount of the qualified expenses.
      2. The qualified expenses for the Tuition and Fees Deduction, the Hope Credit, and the Lifetime Learning Credit are the same.
      3. Qualified expenses are tuition and fees (such as lab fees) only for higher education (colleges and universities, trade schools, private military academies, etc).
      4. Books, supplies, room and board are not qualified expenses.
      5. Books do qualify if the educational institution requires that the books may be bought only from the institution.
      6. Once you have determined the dollar amount of the qualified expenses, then you must test each of these three credits and see how it affects the bottom-line refund or balance due.
      7. This implies that before you can intelligently make this comparison, you must complete the rest of the tax return.
      8. Point of clarification: you may already have taken the Student Loan Interest Deduction in addition to one of these three.
      9. Some tax return softward have a module similar to the approach taken here. The module first asks you for the information. Then you select one of the three methods at a time. You check the results and make the comparison.
      10. Otherwise you must do it "manually" (although you might be using a computer program.
      11. See worksheet to help record the differences.

    3. Tuition and Fees Deduction
      1. IRS Publication 970 Chatper 6. Tuition and Fees Deduction
      2. The student will get Form 1098-T.
      3. The deduction is available to a taxpayer for a 1098-T issued to:
        1. Taxpayer
        2. Spouse
        3. Any dependent under the age of 24
      4. Try this deduction first.
      5. Compare the Tuition and Fees Deduction to the Hope Credit and the Lifetime Learning Credit.
      6. The Tuition and Fees Deduction is available only for years 2002 through 2005 unless Congress in its infinite wisdom extends the availability period.
      7. The taxpayer will usually get Form 1098-T giving the qualified expense.
      8. The maximum amount of the deduction is $3,000 for 2003 and $4,000 for 2004.
      9. There is no form for the Tuition and Fees Deduction, but there is a Tuition and Fees Deductions Worksheet within the Form 1040 instructions.

    4. Hope Scholarship Credit
      1. IRS Notice 97-60 Hope Scholarship Credit
      2. The Hope Scholarship Credit became available on the 1998 tax returns.
      3. Compare the Hope Scholarship Credit to the Tuition Fees Deduction and the Lifetime Learning Credit.
      4. If the taxpayer does not qualify for the Hope Scholarship Credit, still compare the Tuition Fees Deduction and the Lifetime Learning Credit.
      5. The student will get Form 1098-T.
      6. The deduction is available to a taxpayer for a 1098-T issued to:
        1. Taxpayer
        2. Spouse
        3. Any dependent under the age of 24
      7. Use Form 8863 for both the Hope Scholarship Credit and the Lifetime Learning Credit.
      8. Limitations are written into Form 8863.
      9. The 2003 limit of qualified expenses is $1,500 multiplied by the number of students.
      10. Freshman and Sophmore Years only. There is some discussion about what exactly are the two years limitation. Notice 97-60 is very clear that the credit is available for a student "one of the first two years of postsecondary education who is enrolled in a program leading to a degree, certificate, or other recognized educational credential."

    5. Lifetime Learning Credit
      1. IRS Notice 97-60 Lifetime Learning Credit
      2. The Lifetime Learning Credit became available on the 1998 tax returns.
      3. Compare the Lifetime Learning Credit to the Tuition Fees Deduction and the Hope Scholarship Credit.
      4. The student will get Form 1098-T.
      5. The deduction is available to a taxpayer for a 1098-T issued to:
        1. Taxpayer
        2. Spouse
        3. Any dependent under the age of 24
      6. Use Form 8863 for both the Hope Scholarship Credit and the Lifetime Learning Credit.
      7. Limitations are written into Form 8863.
      8. Use this imaginary Congressional debate as a way to understand why there is both a Hope Scholarship Credit and a Lifetime Learning Credit.
        • Congressman A: I think I'll create a credit for college freshmen and sophmores. I'm going to call it the Hope Scholarship Credit.
        • Congressman B: Why not make it for all college students?
        • Congressman A: Nope, just freshmen and sophmores. If you want to make a credit for all college students, make your own law!
        • Congressman B: OK, I will. And I'll call my law the Lifetime Learning Credit.
        • Congressman C: Gentlemen, that is great! I represent the Tax Return Preparers of America. Let's make this whole thing rather complicated by passing both laws and tell taxpayers they have to figure out which one is better.
        • IRS: Well, Congressman C, it's even better than that! Taxpayers will have to compare the Hope Credit and the Lifetime Learning Credit to the Tuition and Fees Deduction.

    6. The Duh's of the Tuition and Fees Deduction, Hope Scholarship Credit, and Lifetime Learning Credit.
      1. There is too much discussion about not being able to use both the Hope Scholarship Credit and Lifetime Learning Credit on the same expenses. Has there ever been a deduction that a taxpayer could deduct one and then again on the same tax return?
      2. There is too much discussion about whether a person can claim graduate education expenses for the Hope Scholarship Credit. The words freshman and sophmore have already been established.
      3. The "under 24-year old dependent" rule is not a new rule. A person can not be a dependent if he's not under 24-years old and a full-time student. Just saying "dependent" automatically includes the "under 24-year old rule."
      4. Parents and their children do not have the right to decide who's going to claim the education credits. Either a person is or is not a dependent. A person who is a dependent of another person cannot claim any of the education credits and deductions discussed above.

      Now we move to the credits and deductions that the taxpayer creates himself by taking some action.

    7. Coverdell Education Savings Account
      1. IRS Publication 970, 7. Coverdell Education Savings Account (ESA)
      2. The name "Coverdell Education Savings Account" is generally shortened to "Coverdell ESA" or simply "ESA."
      3. "Until July 26, 2001, this type of account was called an education individual retirement arrangement (or Education IRA)."
      4. There is no line on Form 1040 to report a Coverdell ESA transaction. The IRS web site leads one to Form 8606, but reading Form 8606 line-by-line, one does not find where to report taxable Coverdell ESA distributions.
      5. General idea of a Coverdell ESA:
        1. A taxpayer puts $2,000 into a Coverdell ESA for 7-year old son Harmon.
        2. In 12 years the $2,000 becomes $3,591.
        3. The taxpayer withdraws the $3,591 and spends the money on tuition, books bought off-campus, books bought on campus, supplies, and some equipment.
        4. None of the $3,591 is taxable or reportable.
      6. Age limitations.
        1. The Coverdell ESA must be created for a designated beneficiary before the beneficiary becomes 18 years old.
        2. Whatever amount that is in the account on the day the beneficiary becomes 30 must be distributed within the next 30 days.
      7. Any amounts taken out and not used for educational expense is reportable as ordinary income and must be reported on Form 5329, Part II.
      8. Form 5329 computes an additional 10% penalty tax on the portion of the distributions for the year that were not used on education expenses.
      9. The taxpayer is on the "honor system" to report these taxable distributions.
      10. Qualifying expenses include:
        1. Tuition and fees
        2. books, supplies, equipment
        3. room and board
        4. transportation
      11. Contributions are limited to MFJ taxpayers with gross incomes of less than $220,000.
      12. There is another rule about the Coverdell contributions which may require knowledge about other family member's tax returns.
        1. The rule is that contributions for any one child may not exceed $2,000 (year 2003) in any one year.
        2. The child's parents put $1,000 into a Coverdell.
        3. The child's grandparents put in $1,000 into a Coverdell for the same child but at their bank in their state.
        4. The child's single aunt puts in $1,000 into a Coverdell for the same child but at her bank in her state.
          1. Anyone may put money into a Coverdell for a child under the age of 18 and as long as the MFJ AGI of the contributor is less than $220,000 ($95,000 for a single filer).
          2. This means that not only the parents, but grandparents, uncles, aunts, older siblings, non-related persons can open a Coverdell ESA for the beneficiary.
          3. But remember the $2,000-per-year rule.
        5. EXAMPLE: $3,000 has been put into Coverdell accounts for the same child in the same year.
        6. Someone or some combination of the three must take money out of the COverdell until the total is $2,000 or less.
        7. Extreme example: ten strangers (such as church members or free-lance philanthopists) can together open ten Coverdell ESA's for the very same unrelated person and each put $200 into his Coverdell ESA.

    8. Education Savings Bond Program
      1. Overview example:
        1. A taxpayer cashes in $2,000 in U.S. savings bonds.
        2. He spends $1,800 in tuition.
        3. He reports the $2,000 as interest income on Schedule B as expected.
        4. He fills out Form 8815 to figure how much of the $2,000 interest is deductible. In this case it is the $1,800.
        5. He reports the deductible education interest on Schedule B, line 3.
        6. The deduction is available to a taxpayer for:
          1. himself
          2. his spouse
          3. Any dependent under the age of 24
        7. The taxpayer may have already had the savings bonds.
        8. Only tuition and fees qualify for this exclusion.
        9. Books, supplies, and room and board do not qualify.
        10. He does not have to have made a decision when he bought the savings bonds that they would be for education expenses.
        11. But I put this in the "credits and deductions that the taxpayer creates himself by taking some action" section because this is a decision the taxpayer can make.

    9. Employer-Provided Educational Assistance
      1. IRS Publication 970, 11. Employer-Provided Educational Assistance
      2. First let's look at this from the employee's point of view.
        1. The employer may offer a benefit to employees to pay up to $5,250 in 2003 which is not reported on the employee's W-2.
        2. The employee does not have to do anything. The Employer-Provided Educational Assistance is already "deducted" from the W-2.
        3. The qualifying costs include:
          1. tuition and fees
          2. Books
          3. Supplies
          4. Equipment
        4. The following costs do not qualify:
          1. Meals
          2. Lodging
          3. Transportation
          4. Portion of supplies and equipment that the employee can keep and use after the course
        5. Surprisingly, the courses do not have to be employment-related.
        6. Courses may be either graduate or undergraduate courses.
      3. Now let's look at it from the employer's point of view.
        1. Consider this scheme:
          1. Taxpayer owns a corporation.
          2. Taxpayer also has a child at college.
          3. Why not let the corporation pay the college expenses and deduct it?
        2. It will not work:
          1. There must be an established plan available to most employees.
          2. No more than 5% of the benefits may be paid to an owner.

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