Education Planning

American Opportunity Tax Credit

The American Opportunity Tax Credit is a credit for qualified education expenses paid for an eligible student for the first four years of higher education.  You can get a maximum annual credit of $2,500 per eligible student.  If the credit brings the amount of tax you owe to $0, you can have 40% of any remaining amount of the credit (up to $1,000) refunded to you.

The amount of the credit is 100% of the first $2,000 of qualified education expenses you paid for each eligible student and 25% of the next $2,000 of qualified education expenses you paid for that student.

To claim the full credit, your modified adjusted gross income must be $80,000 or less ($160,000 or less for married filing jointly).  You cannot claim the credit if your modified adjusted gross income is over $90,000 ($180,000 for joint filers).

Lifetime Learning Credit

The lifetime learning credit helps parents and students pay for post-secondary education.

For the tax year, you may be able to claim a lifetime learning credit of up to $2,000 for qualified education expenses paid for all students enrolled in eligible educational institutions.  There is no limit on the number of years the lifetime learning credit can be claimed for each student. However, a taxpayer cannot claim both the American opportunity credit and lifetime learning credits for the same student in one year.  Thus, the lifetime learning credit may be particularly helpful to graduate students, students who are only taking one course and those who are not pursuing a degree.

Generally, you can claim the lifetime learning credit if all three of the following requirements are met:

• You pay qualified education expenses of higher education.
• You pay the education expenses for an eligible student.
• The eligible student is either yourself, your spouse or a dependent for whom you claim an exemption on your tax return.

If you’re eligible to claim the lifetime learning credit and are also eligible to claim the American opportunity credit for the same student in the same year, you can choose to claim either credit, but not both.

If you pay qualified education expenses for more than one student in the same year, you can choose to take credits on a per-student, per-year basis.  This means that, for example, you can claim the American opportunity credit for one student and the lifetime learning credit for another student in the same year.  The 2020 income phaseout begins at $59,000 for single taxpayers and at $118,000 for married filing jointly.

Above-the-Line Deduction for Higher Education Expenses Retroactively Extended Through 2020

Eligible individuals could, for tax years beginning before January 1, 2015, deduct higher education expenses (i.e., “qualified tuition and related expenses” of the taxpayer, his spouse, or dependents) as an adjustment to gross income to arrive at AGI.  The maximum deduction was $4,000 for an individual whose AGI for the tax year does not exceed $65,000 ($130,000 in the case of a joint return), or $2,000 for individuals who do not meet the above AGI limit, but whose AGI does not exceed $80,000 ($160,000 in the case of a joint return).  No deduction was allowed for an individual whose adjusted gross income exceeds the relevant adjusted gross income limitations, for a married individual who does not file a joint return, or for an individual for whom a personal exemption deduction may be claimed by another taxpayer for the tax year.

Under pre-Act law, this deduction was not available for tax years beginning after December 31, 2014.

Effective for tax years beginning after December 31, 2014, the Act retroactively extends through 2017 above-the-line deduction for qualified tuition and related expenses for higher education.

EGTRRA Changes to Student Loan Deduction Rules are Made Permanent

Individuals can deduct a maximum of $2,500 annually for interest paid on qualified higher education loans.  The deduction is claimed as an adjustment to gross income to arrive at adjusted gross income (AGI).  For 2021 the deduction phases out ratably for single taxpayers with modified AGI between $70,000 and $85,000 and between $140,000 and $170,000 for married filing jointly.  The phaseout amounts and ranges are indexed for inflation.

The Economic Growth and Tax Relief Reconciliation Act amended the rules for deducting interest on student loans, effective generally for tax years beginning after 2001, by:

• eliminating the 60-month limit on the deduction for interest paid on a qualified education loan, and
• increasing the pre-2001 EGTRRA AGI phaseout ranges ($70,000 to $85,000 for taxpayers other than joint filers; $140,000 to $165,000 for a married couple filing jointly) applicable to the student loan interest deduction. The phaseout ranges, as amended by 2001 EGTRRA, were indexed for inflation.

Increased $2,000 Contribution Limit and Other EGTRRA Enhancements to Coverdell ESAs are Made Permanent

An individual can make a nondeductible cash contribution to a Coverdell education savings account (“Coverdell ESA”, or “CESA”, formerly called an “education IRA”) for qualified education expenses of a beneficiary under the age of 18.  A specified aggregate amount can be contributed each year by all contributors for one beneficiary.  The amount an individual contributor can contribute is phased out as the contributor’s modified adjusted gross income (MAGI) exceeds specified levels.  A 6% excise tax applies to excess contributions.

Earnings on the contributions made to a CESA are subject to tax when withdrawn.  But distributions from a CESA are excludible from the distributee’s (i.e., the student’s) gross income to the extent the distributions do not exceed the qualified education expenses incurred by the beneficiary during the tax year the distributions are made.  The earnings portion of a CESA distribution not used to pay qualified education expense is includible in a distributee’s income, and that amount is subject to a 10% tax that applies in addition to the regular tax.

Tax-free (including free of the 10% tax described above) transfers or rollovers of CESA account balances from a CESA benefiting one beneficiary to a CESA benefitting another beneficiary (and resignations of named beneficiaries) are permitted if the new beneficiary is a family member of the previous beneficiary and is under age 30.  Generally, a balance remaining in a CESA is deemed to be distributed within 30 days after the beneficiary turns 30.

Under the Economic Growth and Tax Relief Reconciliation Act of 2001, the CESA rules were modified to:

• increase the limit on CESA aggregate annual contributions (from $500) to $2,000 per beneficiary;
• permit corporations and other entities (in addition to individuals) to make contributions to a CESA, regardless of the corporation’s or entity’s income;
• increase the MAGI phaseout range for joint filers (from $150,000 – $160,000) to $190,000 – $220,000 to equal twice the range for single filers (i.e., $95,000 – $110,000), and so eliminate any “marriage penalty;”
• permit contributions to a CESA for a tax year to be made until April 15^th of the following year;
• modify the definition of excess contribution to a CESA for purposes of the 6% excise tax on excess contributions to reflect various other EGTRRA changes;
• extend the time (to before June 1^st of the following tax year) for taxpayers to withdraw excess contributions (and the earnings on them) to avoid imposition of the 6% excise tax;
• expand the definition of education expenses that can be paid by CESAs to include elementary and secondary school expenses (in addition to qualified higher education expenses);
• provide for coordination of the Hope and Lifetime Learning credits with the CESA rules to permit a Hope or Lifetime Learning credit to be taken in the same year as a tax-free distribution is taken from a CESA for a designated beneficiary (but for different expenses);
• provide rules coordinating distributions from both a qualified tuition program (QTP, or “529 plan”) and a CESA for the same beneficiary for the same tax year (but for different expenses);
• eliminate the age limitations described above for acceptance of CESA contributions, deemed balance distributions, tax-free rollovers to other family-member-beneficiaries, and tax-free change of beneficiaries, for “special needs beneficiaries;”
• provide that the 10% additional tax on taxable distributions from a CESA does not apply to distributions of contributions to a CESA made by June 1^st of the tax year following the tax year in which the contribution was made.

Specifically, as a result of the above extension, the following rules apply on a permanent basis:

• the limit on CESA aggregate annual contributions is $2,000 per beneficiary (and is not decreased to $500 per beneficiary);
• corporations and other entities (not just individuals) can make contributions to a CESA, and the corporations and other entities can do so regardless of their income;
• the MAGI phaseout range for joint filers is $190,000 – $220,000 (and does not decrease to $150,000 – $160,000);
• CESA contributions for a tax year can be made until April 15^th of the following year;
• the definition of CESA excess contribution reflects the various other EGTRRA changes to the CESA rules;
• taxpayers have until June 1^st of the following tax year to withdraw excess contributions (and the earnings on them) to avoid imposition of the 6% excise tax;
• education expenses that can be paid by CESAs include elementary and secondary school expenses and qualified higher education expenses (rather than only qualified higher education expenses);
• a Hope or Lifetime Learning credit can be taken in the same year as a tax-free distribution is taken from a CESA for a designated beneficiary (but for different expenses);
• the rule coordinating distributions being made from both a QTP and a CESA for the same beneficiary for the same tax year (but for different expenses) applies;
• special needs beneficiaries are exempted from the age limitations for a CESA’s acceptance of contributions, deemed balance distributions, tax-free rollovers to other family-member-beneficiaries, and tax-free change of beneficiaries; and
• the 10% additional tax on taxable distributions from a CESA is inapplicable to distributions of contributions to a CESA made by June 1st of the tax year following the tax year in which the contribution was made.

Exclusion for Employer-Provided Educational Assistance, and Restoration of the Exclusion for Graduate-Level Courses, Made Permanent

Under Code Sec. 127, an employee’s gross income does not include amounts paid or expenses incurred (up to $5,250 annually) by the employer in providing educational assistance to employees under an educational assistance program.  An educational assistance program is a separate written plan of the employer for the exclusive benefit of its employees, having the purpose of providing the employees with educational assistance.  The courses taken need not be related to the employee’s job for the exclusion to apply.  To be qualified, the program must not discriminate in favor of highly compensated employees, nor may more than 5% of the amounts paid or incurred by the employer for educational assistance during the year be provided for individuals (and their spouses and dependents) owning more than 5% of the employer.  Further, the program cannot provide employees with a choice between educational assistance and other remuneration that would be includible in their gross income.  Finally, reasonable notification of the program’s availability and terms must be provided to employees.

Before the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), Congress had periodically waited until the educational assistance exclusion was set to expire before renewing it, and had sometimes allowed it to expire, and then extended it retroactively.  The exclusion was set to expire for courses beginning after December 31, 2001.  Under EGTRRA, the exclusion was extended “permanently” subject to the EGTRRA sunset.

Also, EGTRRA restored the exclusion for graduate level courses, which had earlier been eliminated.  This was also subject to the EGTRRA sunset.

Income Exclusion for Awards Under the National Health Service Corps and Armed Forces Health Professions Programs Made Permanent

Gross income does not include (i) any amount received as a “qualified scholarship” by an individual who is a candidate for a degree at a primary, secondary, or post-secondary educational institution, or (ii) qualified tuition reductions for certain education provided to employees (and their spouses and dependents) of those educational institutions.  But these exclusions do not apply to any amount that a student receives that represents payment for teaching, research, or other services provided by the student, required as a condition for receiving the scholarship or tuition reduction.

Thus, before enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001, there was no exclusion from gross income for health profession scholarship programs which required scholarship recipients to provide medical services as a condition for their awards.

EGTRRA provided that education awards received under specified health scholarship programs may be tax-free qualified scholarships, without regard to any service obligation on the part of the recipient.  Specifically, the rule that the exclusions for qualified scholarships and qualified tuition do not apply to amounts received which represent compensation does not apply to any amount received by an individual under the following programs:

• The National Health Service Corps Scholarship Program (the “NHSC Scholarship Program,” under Sec. 338A(g)(1)(A) of the Public Health Services Act), and
• The F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance program (the “Armed Forces Scholarship Program,” under Subchapter 1 of Chapter 105 of Title 10 of the United States Code).

Interest Exclusion for Higher Education

The interest on U.S. Savings Bonds redeemed to pay qualified higher education expenses may be tax-free.  The exclusion is phased out at certain income levels, which are adjusted annually for cost-of-living increases. The phaseout for 2020 will begin at modified adjusted gross income above $82,350 for single taxpayers, and $123,550 for joint filers.

Scholarships and Fellowships

A scholarship is generally an amount paid or allowed to, or for the benefit of, a student at an educational institution to aid in the pursuit of studies.  The student may be either an undergraduate or a graduate.  A fellowship is generally an amount paid for the benefit of an individual to aid in the pursuit of study or research.  Generally, whether the amount is tax free or taxable depends on the expense paid with the amount and whether you are a degree candidate.

A scholarship or fellowship is tax free only if you meet the following conditions:

• You are a candidate for a degree at an eligible educational institution.
• You use the scholarship or fellowship to pay qualified education expenses.

Qualified Education Expenses

For purpose of tax-free scholarships and fellowships, these are expenses for:

• Tuition and fees required to enroll at or attend an eligible educational institution.
• Course-related expenses, such as fees, books, supplies, and equipment that are required for the courses at the eligible educational institution. These items must be required of all students in your course of instruction.

However, in order for these to be qualified education expenses, the terms of the scholarship or fellowship cannot require that it be used for other purposes, such as room and board, or specify that it cannot be used for tuition or course-related expenses.

Expenses that Do Not Qualify

Qualified education expenses do not include the cost of:

• Room and board.
• Travel.
• Research.
• Clerical help.
• Equipment and other expenses that are not required for enrollment in or attendance at an eligible educational institution.

This is true even if the fee must be paid to the institution as a condition of enrollment or attendance.  Scholarship or fellowship amounts used to pay these costs are taxable.

Illinois “Bright Start” College Savings Plan

The Illinois “Bright Start” college savings plan is being offered under provisions of Section 529 of the Internal Revenue code.  Bright Start works by investing in mutual funds.  Illinois has contracted with Oppenheimer Funds to manage the investment trust.  Portfolios are managed by OFI Private Investments, Inc., a subsidiary of Oppenheimer Funds, Inc. and Illinois Investments managed by Oppenheimer Funds, Inc. and its affiliates, as well as the Vanguard Group and American Century Investments.

Illinois also has “College Illinois” which has been around for a few years.  Prepaid tuition through the college Illinois plan is a less aggressive investment, a defined benefit plan that acts as a hedge against tuition inflation by allowing parents and grandparents to lock in current tuition rates for state schools.

Section 529 college savings plans offer contribution advantages over another option called Coverdell Education Savings Accounts with their low annual deposit limits of $2,000.

Contributions of up to $15,000 a year and $350,000 over the life of the account are permitted in Bright Start.

Provisions for lump sum contributions as large as $75,000 ($150,000 for married couples) without gift tax penalties are also included in the tax code, in case grandma and grandpa want some of their nest egg to go toward educating their grandchildren.

Private institutions may be sponsors of prepaid tuition programs.  The definition of a “Qualified Tuition Program” will include certain prepaid tuition programs established and maintained by eligible educational institutions (including private institutions) that satisfy the requirements under code section 529.

Exclusion for qualifying payouts.  Distributions will be excluded from gross income to the extent they are used to pay for qualified higher education expenses.  The exclusion will apply to payouts from qualified state tuition programs, and to payouts from qualified tuition programs established and maintained by entities other than a state.  Starting January 1, 2018, the definition of qualified higher education expenses is expanded to include tuition for K-12 schools, as a result of the 2017 Tax Cuts and Jobs Act.  However, the new law limits qualified 529 withdrawals for eligible K-12 tuition to $10,000 ($20,000 for married filing jointly) per beneficiary per year.

Qualified higher education expenses will include special needs services for special needs beneficiaries.

For the exclusion for distributions from qualified tuition plans to pay for qualified higher educational expenses, including room and board, the maximum room and board allowance will be the actual amount charged by the educational institution for room and board.

During the same tax year, taxpayers will be able to claim the American Opportunity Credit or Lifetime Learning Credit and exclude amounts distributed from a qualified tuition program for the same student as long as the distribution is not used for the same expenses as which a credit will be claimed.

The definition of a family member for purposes of beneficiary changes and rollovers will include first cousins of the original beneficiary.

Coverdell ESAs and Qualified Tuition Programs offer essentially the same income tax benefit, namely tax-free earnings if payouts are made for qualified educational purposes.  However, each offers a unique combination of benefits and limitations.  For example, a Coverdell ESA can be used for elementary and secondary school expenses or college costs, but annual contributions are limited $2,000 per beneficiary and an individual’s contributions are subject to AGI phase outs.  The qualified tuition program, on the other hand, does not restrict contributions, but must be used for higher education.  The best savings vehicle ultimately will depend on the needs of the donor and the beneficiary who will receive the education.

Unlike custodial mutual funds in his name that become his property at age 18, college savings plans like Bright Start remain in the name of the adult who opened the account.  The beneficiary may be changed to another family member, including adults who may want to pursue an advanced degree.

The account is also not included as part of the owner’s taxable estate.

However, withdrawals for nonqualified education expenses incur a federally mandated 10% penalty on top of the income being taxed at the owner’s higher rate.

Most Section 529 savings plans offered by other states are open to out-of-state residents.

Bright Start applications and other information are available at 877-43-BRIGHT or online at www.brightstartsavings.com.