by George G. Jones and Mark A. Luscombe

How best to maximize education tax incentives is a question that is being frequently asked this tax season. Complicating matters at the start of 2003 are three new variables:

1. Whether to take the $3,000 higher education deduction, which is new for 2002 but only available if a Hope Education or Lifetime Learning Credit is not claimed for the student;

2. Whether to take the Lifetime Learning Credit now that it has doubled its size starting in 2003; and,

3. Whether tax returns should be arranged so that a student is able to take an education credit in circumstances under which the parent’s income is too high to qualify.

Two credits, one deduction

Each college student has up to three tax incentives from which to choose: a Hope Education Credit of up to $1,500; a Lifetime Learning Credit of up to $1,000 ($2,000 starting in 2003); and an above-the-line higher education deduction of up to $3,000. Claim one, however, and the student (or any taxpayer, including the parents) cannot claim any of the others with respect to that student.

The maximum Hope Education Credit of $1,500 is based on incurring $2,000 of eligible expenses ($1,000 of eligible expenses plus 50 percent of the next $1,000). The maximum Lifetime Learning Credit is based on having $5,000 of eligible expenses ($10,000 in 2003), of which 20 percent may be claimed for the credit.

The higher education deduction is taken dollar-for-dollar on eligible expenses up to $3,000. Each credit is also reduced for taxpayers whose modified adjusted gross income falls within various phase-out ranges.

The Hope Education Credit may only be taken during freshman and sophomore years in college. The Lifetime Learning Credit, on the other hand, is available for post-secondary education that includes undergraduate and graduate classes, and even coursework that does not necessarily result in a degree or other educational credential. For either education credit, the student must be enrolled at least half-time and for at least one semester that begins during the tax year in which the credit is claimed.

AGI thresholds

To evaluate which of the three education tax incentives is best to claim, a taxpayer should first look at his adjusted gross income before addressing other eligibility requirements.

• For 2002, the higher education deduction is not permitted for taxpayers with more than $130,000 AGI filing joint returns ($65,000 for others). Unlike the education credits, there is no phase-out range for this deduction; it’s an all-or-nothing situation that suggests careful planning to stay below the cutoff amount in close situations. (Given the odds, some unlucky taxpayer would end up with AGI of $130,001 and have the unenviable distinction of being subject to an effective marginal tax rate of 3,000 percent!)

However, since the AGI cutoff for the higher education deduction is, by far, higher than that of the education credits, the deduction is available to many more taxpayers. Eligible taxpayers near the cutoff range are, at best, in a 30 percent tax bracket, which translates into an after-tax savings of $900 on the $3,000 deduction.

• Both the Hope Education and the Lifetime Learning Credits are phased out for taxpayers with AGI of between $82,000 and $102,000 when filing jointly (or between $41,000 and $51,000 for others). In 2003, the phase out occurs within the $84,000 to $104,000 and the $42,000 to $52,000 ranges.

Assuming an approximate 25 percent tax bracket at the top of this AGI range, choosing the higher education deduction (with an after-tax maximum tax benefit of $750) over the Lifetime Learning Credit would only make sense if eligible expenses were less than $3,750 (20 percent of which would equal a credit amount of $750).

Lifetime learning credit

Starting in 2003, the maximum annual Lifetime Learning Credit per student doubles from $1,000 to $2,000 based on 20 percent of $10,000 in qualifying expenses. This changes the standard advice in pre-2003 for taxpayers who were eligible for the $1,500 Hope Education Credit to take it rather than the Lifetime Learning Credit. However, the $2,000 maximum on the Lifetime Learning Credit now turns that advice around.

Full-time tuition usually satisfies the $10,000 threshold needed to maximize the Lifetime Learning Credit. At this stage, the Lifetime Learning Credit becomes the better choice. However, there are three important caveats:

1. First-year students may only have the fall semester tuition as expenses (although payment in December for the spring semester should be considered);

2. Part-time first- and second-year students may not reach the $7,500 expense level beyond which the Lifetime Learning Credit is higher than the Hope Credit; and,

3. Scholarships can reduce eligible tuition fees below the $7,500 level that triggers opting for the Hope Education Credit.

Eligible expenses

Eligible expenses for both the Hope and Lifetime Learning Credits and the higher education expense deduction cover only tuition and related expenses. Room and board, student health fees, insurance or other personal living expenses are not included. The new regs make it clear that eligible related activity costs include student activity fees and fees for course-related books, supplies and equipment if paid to the educational institution as a condition of enrollment.

The credits and the deduction are all allowed for tuition and related expenses paid in a calendar year for an academic period that begins either in that year or during the first three months of the following year. If the credit or deduction being taken is not yet maximized for the year, accelerating payment of spring tuition into December may make sense. However, if payment is made in December, it cannot be claimed as an expense related to the following year even if the education takes place only in that year.

There is one important inconsistency between the rules governing the credits and the deduction that may be a trap. A student loan taken out by the student and paid to the educational institution may be claimed as an expense by the parent for purposes of either education credit but not for the higher education expense deduction. The same goes for tuition paid by a third party such as a grandparent; it is considered a gift to the student who then pays the tuition.

The dependency exemption

If a parent has AGI that exceeds the threshold for taking one of the credits, consideration should be given to opting out of claiming the student as a dependent so that the student would be eligible to claim the credit on his return. Although some taxpayers had been cautious in trying to take advantage of what appeared to be an unintentional loophole, final regulations issued this December have been given the Treasury Department’s approval.

A parent who is eligible to claim a student as a dependent for purposes of taking the dependency exemption may chose not to take the exemption. That decision allows the student to claim either education credit, and base eligible expenses on those paid by both the student and the parent. The regulations make it clear, however, that the student loses the ability to take a personal exemption deduction on his return.

Assuming that the student is in the 15 percent bracket and the parent is in the 35 percent tax bracket, the loss of the personal exemption in 2003 translates into the student not being given a $457 after-tax benefit, while the parent loses $1,067, which must be offset in computing the real amount gained by taking the credit.

Remember, too, that the credits are not refundable. That means that the student must have enough income and, therefore, tax liability to otherwise cover the credit to make this technique worthwhile.

Similar planning cannot be done with the $3,000 higher education deduction. The Internal Revenue Code limits exclusive use of the deduction to the parents of any student where the parents are able to claim the student as a dependent, whether or not they choose to do so.

Crunching the numbers, however, reveals that this restriction seems unnecessary since, in most cases, the after-tax benefit of the deduction would not cover the cost to the parent of losing a dependency exemption in any event.

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