Article: Tax Strategies for Education Costs

December 2003

Tax strategies for education costs

The growing list of education-related tax-saving opportunities takes on special importance at year’s end

The Tax Code is loaded with tax breaks for education-related expenses. If you or members of your family are incurring these types of expenses now or in the future, it’s worth paying attention to them. Here’s a sampling of strategies to consider, especially as year-end approaches.

Consider investing in a 529 plan. Named after Internal Revenue Code Section 529, these state-sponsored plans allow parents and grandparents to establish college savings accounts for their children and grandchildren. Contributions are not deductible for federal tax purposes, but earnings are not taxed if the funds are eventually used for qualified higher education costs (e.g., tuition, fees, and room and board if attending at least half time).

Especially significant is the fact that the contributor normally retains control over the account, including the power to change beneficiaries and even take back the funds, and is not subject to income limits, so even high-income individuals can contribute to an account.

There is no requirement that you invest in your own state’s plan. However, many states—including Arizona—allow residents to claim a state income tax deduction for all or part of the contributions to their in-state 529 plan, so you’ll normally want to look first at your home state plan.

If your particular state plan meets your needs and allows a state tax deduction for contributions, you might benefit by making contributions before year-end.

Claim the tuition deduction. In 2003, taxpayers can deduct up to $3,000 of college tuition and related expenses, provided their adjusted gross income (AGI) is no more than $130,000 (for joint filers) or $65,000 (for single and head-of-household filers).

Although the deduction is available regardless of whether you itemize expenses, you cannot claim it if you claim an education credit for the same student. Unlike many other tax breaks subject to income limits, this one does not phase out over a range of income. Instead, it’s all or nothing, depending on whether your income is above or below the threshold amount. If you can benefit from this deduction, but your AGI is at or near the applicable $130,000 or $65,000 limit, monitor your AGI level between now and year end and, if possible, take steps to keep it below the limit.

Plan for education credits. If you pay college or vocational school tuition and fees for yourself, your spouse or your children, you might be eligible for either the Hope Scholarship Credit or the Lifetime Learning Credit. These credits reduce taxes dollar-for-dollar but begin to phase out when 2003 AGI exceeds $83,000 for married filers and $41,000 for other taxpayers. The credits phase out completely when AGI exceeds $103,000 and $51,000, respectively. The Hope credit is available only during a student’s first two years of college and equals 100% of the first $1,000 of tuition and 50% of the next $1,000, for a maximum annual credit of $1,500 per student.

Note: The Hope Scholarship Credit was renamed the American Opportunity education credit subsequent to the writing of this article.

The Lifetime Learning Credit, on the other hand, is available without regard to the year of study, but is a per return (rather than a per student) credit, computed at the rate of 20% on up to $10,000 of qualifying expenses, for a maximum annual credit of $2,000.

Two particularly attractive features of the education credits have to do with timing and the possibility of shifting the credit. First, the credits are allowed for tuition paid during the year for education received that year or during the first three months of the next year. Therefore, it might be beneficial from a tax standpoint to pay part of 2004 tuition at the end of 2003.

Parents also can shift an education credit from their return to the student’s by simply forgoing an exemption deduction for the student. This strategy is particularly appealing to high-income parents whose income prevents them from claiming the credit. To benefit from this strategy, however, the student must have sufficient income and, therefore, tax liability to absorb the credit. It might be necessary to shift income to the student as well, perhaps through gifts of appreciated property (that the student then sells at a gain) or employment in a family business. But be careful: Shifting income to a student can have a detrimental impact on a student receiving or being eligible for financial aid.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.