Paying for College Without Going Broke, 2017 Edition - Princeton Review, Kalman Chany (2016)
Part IV. The Offer & Other Financial Matters
Chapter 10. Less Taxing Matters
The Good News
The Taxpayer Relief Act of 1997 and The Economic Growth and Tax Relief Reconciliation Act of 2001 have given middle-income families some much-needed help in raising their children and paying for the costs of higher education. Unfortunately, the regulations are truly complex and some of the goodies are mutually exclusive. While many provisions did not lapse on January 1, 2013 when they were scheduled to expire, some of these provisions still have not been made permanent. So if they expire in the future, then the old rules prior to 2002 will go back into effect. The purpose of this section is to provide you with basic information regarding some of the benefits now available for education and raising children. For more details, we recommend that you refer to the appropriate IRS publications or consult with a competent professional.
✵ Coverdell ESAs (formerly called Education IRAs) received an added boost under the 2001 law. Previously, the annual contribution per beneficiary (under the age of 18) was $500 from all sources. Starting in 2002, the annual limit has been increased to $2,000. Though no tax deduction will be granted for these contributions (which must be made in cash), the funds will grow tax-deferred and there will be no taxes owed on withdrawals used to pay for qualified higher education expenses. (The IRS definition of qualified expenses differs for each of the various federal tax benefits and can change from year to year, so be sure to read the fine print.) Withdrawals from Coverdells can also be made tax-free if the funds are used to pay for qualified private elementary and secondary school expenses. Prior to 2002, they could only be used for college or graduate school. The definition of “education” expenses has also been liberalized, so that since 2002 funds can be withdrawn to cover computers, internet access, and some other related expenses. While there are income limits as to who can contribute to a Coverdell, parents with higher incomes may be able to take advantage of a loophole in the law. Since the tax code states that the income limits apply to the “contributor” and does not state that the parent must be the contributor, families may be able to get someone else (whose income is below the limits) to fund the account. Prior to 2002, this benefit phased out between $150,000 and $160,000 for married couples filing jointly, and between $95,000 and $110,000 for others. Starting in 2002, the phase-out range for couples filing jointly increased to $190,000-$220,000. (The phase-out range stayed the same for others.)
✵ Starting in 2002, withdrawals from qualified state tuition programs (i.e., Section 529 plans which include both pre-paid plans and tuition savings accounts run by state governments) are now tax-free if the funds are used for qualified higher education expenses. This is great news! Prior to January 1, 2002, the increase in value of the plan from the time of the original contribution was subject to federal income taxes at the beneficiary’s rate. The 2001 tax law also eliminates one of the major drawbacks of the old 529 plans: namely, the lack of control over how the funds were managed after you contributed to the account. Prior to 2002, once you’d set up an account, the only way to avoid early-withdrawal penalties if you wanted out of the plan was to transfer the funds to another plan AND simultaneously change the beneficiary. You can now switch to another plan once in every 12-month period.
✵ Since 2003, the annual tax credit parents can receive for each child under the age of 17 is $1,000. This benefit phases out gradually for single parents with an Adjusted Gross Income (AGI) above $75,000 or for married parents filing jointly with an AGI above $110,000. (For married filing separately, the threshold is $55,000.) Currently this is a “refundable credit”, so you may be able to claim this benefit even if you have no federal income tax liability.
✵ Since 2009, parents have been eligible for a federal tax credit up to $2,500 per student per calendar year that is known as the American Opportunity (Tax) Credit or AOTC. (This credit is an expanded and renamed version of the Hope Credit which had been in existence for many years prior to 2009.) To qualify for the maximum AOTC, one must pay at least $4,000 towards qualified expenses as the credit is based on 100% of the first $2,000 in expenses paid during the tax year plus 25% of the next $2,000 in expenses paid. Up to $1,000 of the AOTC per student per year can be refundable. The income phase out ranges for the AOTC are higher than with the prior Hope Credit. For married couples filing jointly, the AOTC begins to phase out once the “Modified Adjusted Gross income” crosses the $160,000 threshold and completely phases out at $180,000. For others, the corresponding income amounts are $80,000 and $90,000 respectively. (Modified AGI is a taxpayer’s AGI increased by any foreign income that was excluded.) Be aware that married parents who file separately are not eligible to claim any of the federal education tax credits which include the AOTC and the Hope Credit as well as the Lifetime Learning Credit which will be discussed shortly. The American Opportunity Credit is available for only the first four years of undergraduate postsecondary education for a given student (including any years the Hope Credit was claimed for that same student.) A student who pays for her own educational expenses may also be eligible for this credit, provided she is not claimed as a dependent on someone else’s tax return. However, whether you or the student will be able to claim this credit beyond 2017 will depend if this provision of the tax code is extended.
✵ In addition to the AOTC, there is currently another education tax credit known as the Lifetime Learning Credit or LLC. Starting in 2003, the amount of this non-refundable credit is equal to 20% of the first $10,000 of qualified expenses paid each tax year. (Prior to 2003, the Lifetime Learning Credit was limited to 20% of the first $5,000 of educational expenses paid each tax year.) For 2016, the LLC phases out gradually for married parents filing jointly with Modified AGIs between $110,000 and $130,000, and for others with Modified AGIs between $55,000 and $65,000. (These income numbers are adjusted annually for inflation.) Unlike the 4-year American Opportunity Credit, the Lifetime Learning Credit can be claimed for an unlimited number of tax years provided one meets all the other criteria. It is therefore possible for a parent to take this credit for a few years, provided he claims the child as a dependent on his tax return. Years later, the student herself could claim the Lifetime Learning Credit on her own tax return if she goes back to school and meets the other criteria for the credit. In contrast to the AOTC, the Lifetime Learning Credit can also be used for graduate studies.
Note: For most (but not all) taxpayers, claiming the American Opportunity Credit will result in a larger tax benefit than claiming the Lifetime Learning Credit. However, given the fine print and differing eligibility criteria, you (or your tax preparer) should still do the math and compare the results just to be sure.
✵ It is important to note that the above two tax benefits involve tax credits and not merely deductions against your taxable income. As such, they are much more valuable since they reduce your tax liability dollar-for-dollar. While the American Opportunity Credit can be claimed for each qualifying child in the same tax year, the maximum amount of the Lifetime Learning Credit you can take each year will not vary based upon the number of students in college. In determining the size of the credit, qualifying educational expenses will only represent “out-of-pocket” costs paid. So, for example, scholarships and grants that are awarded will reduce the amount of educational expenses used to determine the size of the credit. In many cases however, expenses paid from the proceeds of a loan will qualify as out-of-pocket expenses. This is true even if the expenses were “paid” with a student loan as the regulations focus on the amount of expenses paid but not necessarily who paid them. Unlike the LLC in which expenses are limited to tuition and mandatory fees as a condition of enrollment, for the AOTC expenses can include required “course materials” (i.e. books, supplies, and equipment) and possibly even a computer if the computer is needed as a condition of enrollment.
✵ There is also a waiver of the 10% penalty on withdrawals from regular IRAs and Roth IRAs prior to age 59 1/2, provided the withdrawals are used to pay qualified post-secondary education expenses. Withdrawals can cover your own educational expenses (including grad school) as well as those of your spouse, child, or grandchild. Withdrawals from traditional IRAs will, of course, still be considered part of your taxable income. The section of the tax code pertaining to withdrawals from Roth IRAs is more complicated. While there are no special provisions regarding higher education expenses, distributions of the original contributions to Roth IRAs are not subject to tax or penalty. Distributions involving the earnings in a Roth IRA are, however, subject to taxes unless other criteria are met. (For example, the distribution is made five years after the initial contribution and the taxpayer is at least 59 1/2 years of age.) It is assumed that the first dollars distributed represent the initial contribution to the Roth IRA. Because the rules regarding IRAs and Roth IRAs contain so much fine print, you should consult the appropriate IRS publications or a professional tax advisor if you are contemplating any distributions from these plans. And remember, any distributions (other than rollovers) from retirement accounts are required to be reported as income on the FAFSA and PROFILE whether taxable or not.
✵ The 2001 tax law also expanded the availability of the deduction of student loan interest paid on qualified educational loans. Taxpayers will still not need to itemize deductions to claim this benefit, which increased to $2,500 in 2002 and beyond. The income limits for the full deduction are currently $65,000 for single filers and $130,000 for joint returns. The maximum amount of the deduction will then gradually phase out until the income reaches the upper limits of $80,000 and $160,000, respectively. (Prior to 2002, the phase-out limits were $40,000 to $55,000 for single filers, and $60,000 to $75,000 for married filing jointly.) Since 2002, this deduction is now no longer limited to the first 60 months in which interest payments were required as it was under the prior law. These changes will mean that more taxpayers are able to claim this deduction for a longer period of time. Qualifying educational loans can be those incurred to cover your own post-secondary expenses, as well as those of your spouse or any other dependent at the time the loan was taken out. If you are claimed as a dependent on someone else’s tax return for a particular year, however, you cannot claim this deduction.
The Bad News
When the Economic Growth and Tax Relief Reconciliation Act of 2001 was first enacted, politicians from both sides of the aisle were patting themselves on the back. But now that the dust has settled, the truth of the matter is that the changes have been so complicated that many experts have stated that the major beneficiaries of all these changes are the tax preparers and accountants across the country.
We used to tell our clients to look before they leapt. Since 2002, we now tell them to look both ways, since the 2001 tax law and subsequent legislation are anything but tax simplification. Some of the provisions may still expire in a few years. And given the constant budget battles in Congress, there is nothing to prevent new legislation form being introduced that would impact some of these educational tax benefits.
Note: Unlike many of the other provisions which are scheduled to sunset sometime in future, legislation was enacted in 2006 to permanently extend the provisions regarding tax-free distributions from 529 plans, provided the funds are used for qualified higher education expenses. Recent legislation has also made many provisions permanent involving Coverdell Education Savings Accounts.
Though the income restrictions on many of these benefits have been liberalized, many families are going to discover that they still don’t qualify for them. Indeed, whenever news breaks about new or enhanced education tax breaks, a number of our clients will call to ask what we think already assuming the increased benefits will apply to them. We often have to burst their bubbles and tell them they won’t be able to qualify because their income is too high or they do not meet all the criteria.
Many families who could qualify may also fail to get the maximum benefits simply because they don’t understand all the fine print. The regulations are rather extensive and the timing of certain transactions is very important. For example, let’s say your child will be graduating at the end of the 2016-2017 academic year. If you’re overly eager and pay the spring 2017 tuition bill as soon as you get it in mid-December 2016 (instead of waiting until January 10, 2017 when it’s due), you won’t be able to claim the American Opportunity Credit or Lifetime Learning Credit in 2017 for that child simply because you paid the money too soon. That mistake might have cost you as much as $2,500 as you can only claim the credit for the tax year in which you make the payment. If the college insists on payment before you sing “Auld Lang Syne”, consider going on a payment plan for the final semester. Installment payments made after the new tax year begins may allow you to claim the credits for another tax year, provided you meet all the other criteria.
There’s also the linkage among the different provisions. To prevent some tax-payers from hitting the jackpot, the benefit you receive from one of the tax benefits can often eliminate your eligibility for other goodies. For example, you can’t claim both the American Opportunity Credit and the Lifetime Learning Credit during the same tax year for educational expenses paid for the same child. You can, however, claim the American Opportunity Credit for one undergraduate student and the Lifetime Learning Credit for an older sibling in graduate school on the same year’s tax return (provided you meet all the other criteria). In addition for the tax year 2002 and beyond: if you claim the American Opportunity Credit or the Lifetime Learning Credit for expenses paid with funds withdrawn from a section 529 plan or Coverdell ESA, part or all of the funds withdrawn may no longer qualify for tax-free treatment unless you forego claiming the credit. You can still withdraw funds from these plans and claim an education tax credit for the same student in the same tax year, but you’ll have to pay some of the qualified expenses (as defined by the IRS for the credit you are claiming) with funds from other accounts and/or loans. Finally, many of the provisions are not available to married couples who file separate returns.
Then there is the impact of these provisions on financial aid. For example, the Lifetime Learning Credit and any non-refundable portion of the American Opportunity Credit will reduce your aid eligibility under the institutional methodology. Since these credits reduce your U.S. income taxes paid (an expense item in the IM formula), your available income will be higher and so your IM EFC will go up as well. While the amount of the credit will still be greater than the amount of aid that is lost, the value to you of those credits is reduced under the institutional formula for any base income year. The tuition and fees deduction (see this page) also will not help you in the institutional formula, since the amount of the deduction will be added back as part of your untaxed income. In fact, it will even hurt you somewhat since your total income (i.e., the sum of your AGI plus untaxed income) will remain the same but your tax liability will decline.
Other provisions are potential financial aid traps. As mentioned earlier in this book, distributions from IRAs and other retirement accounts (other than rollovers) boost your income, thereby reducing your aid eligibility. It also remains to be seen how some IRA withdrawals will impact eligibility. Will a grandmother’s penalty-free withdrawal from a regular IRA to pay for her grandson’s education be considered? Will the conversion of a regular IRA to a Roth IRA be considered a special circumstance taken into account by an FAO when awarding aid? Because these provisions often change from year to year, the Department of Education, the College Scholarship Service, and most college financial aid offices still have not finalized their policies as to how to handle most of these items. We will of course provide updates on our website (www.princetonreview.com/financialaidupdate) if more details become available. In the meantime, we suggest that those families who are interested in maximizing aid eligibility avoid discretionary withdrawals from retirement accounts until the rules are clarified or until they are out of the base income years.
Reminder: Most traditional financial advisors (e.g., accountants, financial planners, attorneys, stockbrokers, etc.) rarely take financial aid implications into account when making recommendations. Now more than ever before, you should investigate how such advice will affect your aid eligibility before you proceed.
Even if you qualify for these benefits and are still ahead of the game after factoring in the reduced aid, the various tax provisions may still not save you any money by the ninth inning. For the big question still remains: “Will these tax benefits save you any money in the long run?” For while many families are saving money on their taxes, many colleges have realized that fact and have just raised their tuition even higher to follow suit. So the jury is still out on how much these provisions will actually help any family or student pay for college.