Tax Tips
College Expenses - How to Pay For Part I - October 2002
Richard Scrivanich - Partner
Last month we took a look at several tax-favored ways to build up a college fund for your children. This month and next, we'll look at a variety of ways of paying for your children's college expenses.
Paying college expenses.
You may be able to take a credit for some of your child's tuition expenses, or write off some of the interest on education loans. You may also be able to take a deduction for some of those expenses that you pay in 2002-2005. There are also tax-advantaged ways of getting your child's college expenses paid by others.
Tuition tax credits.
You can take a Hope tax credit of up to $1,500 a year (for 2002) per student for the first two years of college (a 100% credit for the first $1,000 in tuition and a 50% credit for the second $1,000). You can take a Lifetime Learning credit of up to $1,000 per family for every additional year of college or graduate school (a 20% credit for up to $5,000 in tuition). Both credits are phased out for 2002 for couples with incomes between $82,000 and $102,000 (or singles with income between $41,000 and $51,000). (The Hope credit amount and the phase-out ranges for both credits are adjusted annually for inflation.) Only one credit can be claimed for the same student in any given year. But, beginning in 2002, a taxpayer is allowed to claim a Hope or a Lifetime Learning credit for a tax year and to exclude from gross income amounts distributed (both the principal and the earnings portions) from a Coverdell education savings account for the same student, as long as the distribution is not used for the same educational expenses for which a credit was claimed.
Deduction for college costs (available 2002-2005).
Starting this year (and only through 2005), certain taxpayers are permitted to take an above-the-line deduction for college tuition and related expenses that they pay. (An above-the-line deduction is more favorable that a below-the-line deduction because it may be taken regardless of whether the taxpayer elects to take the standard deduction or to itemize deductions, and it's not subject to the overall limitation on itemized deductions or to the 2% floor on miscellaneous itemized deductions.) In 2002 and 2003, for taxpayers with AGI of up to $65,000 for singles and $130,000 for joint return filers, the maximum deduction will be $3,000. The deduction can't be taken in the same year that a Hope or Lifetime Learning credit is claimed for the same student. However, it can be claimed in the same year as an exclusion is available for distributions from a Coverdell education savings account or qualified tuition plan or for interest on education savings bonds, as long as the deduction and exclusion aren't claimed for the same expenses.
Scholarships.
Scholarships (if your child qualifies for any) are exempt from income tax. For this exemption to apply, certain conditions must be satisfied. The most important are that the scholarship must not be compensation for services, and it must be used for tuition, fees, books, supplies and similar items (and not for room and board). (Although a scholarship is tax-free, it will reduce the amount of expenses that may be taken into account in computing the Hope and Lifetime Learning credits, above, and may therefore reduce or eliminate those credits). Note also that, beginning in 2002, in an exception to the rule that a scholarship must not be compensation for services, a scholarship received under a health professions scholarship program may be tax-free even if the recipient is required to provide medical services as a condition for the award.
Employer educational assistance programs.
If your employer pays your child's college expenses, the payment is a fringe benefit to you, and is taxable to you as compensation, unless the payment is part of a scholarship program that's "outside of the pattern of employment." Then the payment will be treated as a scholarship (if the other requirements for scholarships are satisfied).
Tuition reduction plans for employees of educational institutions.
Tax-exempt educational institutions sometimes provide tuition reduction plans for the children of their employees-tuition reductions for those children who attend that educational institution, or cash tuition payments for children who attend other educational institutions. If certain requirements are satisfied, these tuition reductions are exempt from income tax.
College expense payments by grandparents and others.
If someone other than you pays your child's college expenses, the person making the payments is generally subject to the gift tax, to the extent the payments and other gifts to the child by that person exceed the regular annual (per donee) gift tax exclusion of $11,000 ($22,000 in the case of married donors who consent to split gifts) (for 2002). If the other person pays your child's school tuition directly to an educational institution, however, there's an unlimited exclusion from the gift tax for the payment. The relationship between the person paying the tuition and the person on whose behalf the payments are made is irrelevant, but the payer would typically be a grandparent. The unlimited gift tax exclusion applies only to direct tuition costs. There's no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc. Prepaid tuition payments may qualify for the unlimited gift tax exclusion under certain circumstances.
Next month we'll conclude our discussion on this topic with three other methods of paying for your children's college expenses. Meanwhile, if you have any questions, please give me a call at (562) 698-9891.
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