New tax law reduces education costs

While much of the attention on the new tax law has focused on income tax rate reductions and the eventual elimination of the estate tax, the law contains several important education-related provisions.

However, as often occurs with tax changes, federal workers need to be aware of expiration dates and weigh conflicting options in some cases.

This is a brand-new provision in the tax code. It allows for an "above-the-line" deduction for higher education expenses up to $3,000 annually for single taxpayers who have adjusted gross incomes (AGI) below $65,000 ($130,000 for married, filing jointly). The $3,000 maximum applies to tax years 2002 and 2003, then jumps to $4,000 for 2004 and 2005. Single taxpayers with AGIs from $65,000 to $80,000 (married, from $130,000 to $160,000) can claim up to $2,000 in 2004 and 2005.

The advantage of the above-the-line deduction, which means you deduct it from your gross income to arrive at your AGI, is that all feds can use it, whether you itemize or not.

However, Louis Stanasolovich, a certified financial planner, observed that there are two major catches in this provision beyond the income limitations. First, the deduction cannot be claimed if you claim the existing Hope Scholarship or Lifetime Learning tax credits in the same year for the same student. These tax credits have tighter income restrictions, but if you qualify, you may need to calculate your tax both ways to see whether the new deduction or the old credit saves you more money. Second, the new expense deduction expires after 2005.

Congress has quadrupled the maximum annual contribution you can make to an education IRA per child (under age 18) from $500 to $2,000, beginning in 2002. Moreover, the contributions can now be made even if the family contributes to a state prepaid tuition plan in the same tax year.

Withdrawals from education IRAs remain tax-free even if claimed in the same year the Hope Scholarship or Lifetime Learning credits are claimed, as long as the withdrawals are not used for the same qualified educational expenses for which a credit is claimed. Furthermore, those withdrawals may now be used for such expenses as tuition and room and board for elementary and secondary schools, public and private.

Taxpayers have not been able to contribute to education IRAs if their modified AGIs exceeded certain thresholds. Congress raised the phase-out thresholds for joint filers from $150,000-$160,000 to $190,000-$220,000, beginning in 2002. Contributions also can be made as late as April 15 for the previous tax year.

In addition to individuals, the law now allows corporations, tax-exempt organizations and other entities to contribute to education IRAs, regardless of the donor's income.

These dramatic changes in education IRAs undoubtedly will make these vehicles more attractive. However, keep in mind that money in education IRAs may reduce financial aid more than money not saved in a child's name, so lower-income families counting on aid may not find these changes as useful.

Beginning in 2002, distributions from state-sponsored, pre-paid tuition plans and savings plans (known as 529 plans) used for education expenses will be free of tax. Before, earnings were taxed at the student's rate. This same benefit extends to private college and university plans beginning in 2004.

Savings plan assets also may be rolled over tax-free into a new plan for the same beneficiary once every 12 months.

The new law eliminates the $2,500 limit on student-loan interest that may be deducted in a year, as well as the restriction that the deduction must apply only to interest payments made in the first 60 months of repayment. In addition, Congress boosted the AGI phase-out thresholds to $50,000-$65,000 for singles and $100,000-$130,000 for joint filers. This becomes effective in 2002 and is adjusted annually for inflation.

The law permanently allows taxpayers to exclude from income up to $5,000 a year in employer-provided education assistance. It also now applies to graduate as well as undergraduate education. This popular provision has been subject to annual elimination and renewal.

While these provisions are designed to reduce the cost of higher education, they are complicated and sometimes require trade-off decisions. In some cases, Stanasolovich said, families with college-bound children may want to delay certain decisions or withdrawals until provisions become effective, or be sure to use the provisions during windows of opportunity.

Zall, Bureaucratus columnist and a retired federal employee, is a freelance writer based in Silver Spring, Md. He specializes in taxes, investing, business and government workplace issues. He is a certified internal auditor and a registered investment adviser. He can be reached at miltzall@starpower.net.