In my last article, I discussed the above-the-line "education deduction" available for many individual taxpayers for qualified tuition and related expenses. Taxpayers eligible to take the education deduction often will also be eligible to take either the Hope Scholarship or Lifetime Learning Credits for the same expenses.
However, the education deduction cannot be taken in the same tax year for qualified tuition and related expenses for the same student, even if total expenses are high enough so that different expenses can be used to calculate the deduction and the credit. In some situations, a taxpayer may only be eligible to take the education deduction because of the higher modified adjusted gross income limits that apply in determining eligibility for the deduction, compared to the eligibility limits that apply for the credits.
A summary of the rules
The Hope Scholarship Credit is available in 2004 and 2005 for:
* 100 percent of qualified tuition and related expenses paid by the taxpayer during the tax year, up to $1,000, for education furnished to an eligible student who is the taxpayer, the taxpayer's spouse or any claimed dependent during any academic period beginning in the tax year (or those paid in the tax year for expenses for an academic period beginning in the first three months of the following tax year).
* 50 percent of the expenses so paid over $1,000, but not over $2,000. Thus, for 2004 and 2005, the maximum allowable Hope Scholarship Credit is $1,500. The Hope Scholarship Credit is only allowed for the qualified tuition and related expenses paid for the first two years of a student's college education in a degree or certificate program.
The Lifetime Learning Credit for any taxpayer for any tax year equals 20 percent of qualified tuition and related expenses paid by the taxpayer during the tax year for education furnished during any academic period that begins in that tax year (or that is paid in the tax year for expenses for an academic period beginning in the first three months of the following tax year), up to $10,000.
Thus, the maximum credit for any taxpayer for a tax year is $2,000 (20 percent of $10,000), regardless of the number of students for whom qualified tuition and related expenses are paid. The education must be furnished to the taxpayer, the taxpayer's spouse or any claimed dependent.
The following requirements and limitations that apply to the Hope Scholarship Credit do not apply to the Lifetime Learning Credit:
* The Hope Scholarship Credit requirement that the student be enrolled in a degree program doesn't apply to the Lifetime Learning Credit.
* To be eligible for the Hope Scholarship Credit, a student must be enrolled at least half-time during the academic period. There is no similar requirement for the Lifetime Learning Credit.
* The Lifetime Learning Credit is not limited to expenses paid for the first two years of college education.
* The Hope Scholarship Credit is not available for a student who has a felony drug conviction. This restriction on eligibility does not apply to the Lifetime Learning Credit.
* A taxpayer may not make an election to claim the Hope Scholarship Credit with respect to a student for a tax year if such an election (by the taxpayer or any other individual) was in effect with respect to that student for any two earlier tax years. There is no limit on the number of tax years for which the Lifetime Learning Credit may be claimed for a student.
For 2005, the Hope/Lifetime Learning Credit is phased out ratably for taxpayers with modified AGI between $43,000 and $53,000 ($87,000 and $107,000 in the case of a joint return). For 2004, the Hope/Lifetime Learning Credit was phased out ratably for taxpayers with modified AGI between $42,000 and $52,000 ($85,000 and $105,000 in the case of a joint return).
The deduction for qualified tuition and related expenses may be available for some taxpayers who are not eligible for either the Hope Scholarship Credit or the Lifetime Learning Credit.
The otherwise allowable $4,000 education deduction for qualified tuition and related expenses is not phased out in 2004 or 2005, but is reduced to $2,000 if MAGI is more than the $65,000 ($130,000 for couples filing a joint return), and is lost entirely if MAGI is more than $80,000 ($160,000 for couples filing a joint return).
Thus, the full $4,000 deduction was available in 2004 for a taxpayer with MAGI between $52,000 and $65,000 (between $105,000 and $130,000 for couples filing a joint return) even though neither the Hope Scholarship Credit nor the Lifetime Learning Credit would be available for those taxpayers. For taxpayers with MAGI between $65,000 and $80,000 (between $130,000 and $160,000), a $2,000 education deduction is available, though neither of the education credits is available.
Example 1: Your client is a divorced taxpayer who spent $10,000 for qualified tuition and related expenses for her son during his first year at college in 2004. Her MAGI is $60,000. She is not eligible to claim either the Hope Scholarship Credit or the Lifetime Learning Credit with respect to the expenses that she paid. However, she is eligible to claim the full $4,000 above-the-line deduction for the expenses she paid.
Example 2: The same facts apply as in Example 1, except that your client's MAGI for 2004 was $75,000. She can claim a $2,000 above-the-line deduction for the expenses she paid, but no education credit.
Take the full credit
If a taxpayer is eligible to claim the full Hope Scholarship Credit or the full Lifetime Learning Credit with respect to qualified tuition and related expenses incurred for a student, it will almost always be better to claim the credit rather than the education deduction. This is because the tax bracket of a taxpayer who is eligible to claim the credit cannot be over 25 percent if the MAGI requirements are met, and may very well be even lower. This is true for both single individuals, head of households, and married couples filing jointly.
Thus, for a taxpayer in the 25 percent bracket, if the $4,000 education deduction is claimed, it will save only $1,000 in federal income taxes (25 percent of $4,000). If the Hope Scholarship Credit is claimed, it will save $1,500 in federal income taxes. If the qualified tuition and related expenses for a student are at least $10,000 and the Lifetime Learning Credit is claimed, it will save $2,000 in federal income taxes.
Example 3: Your clients, a married couple filing a joint return, spent $10,000 in 2004 to pay the qualified tuition and related expenses for their daughter's first year at college. Their MAGI was low enough to make them eligible to claim the full Hope Scholarship Credit, the full Lifetime Learning Credit, and the full above-the-line deduction. They did not pay any other qualified tuition and related expenses for themselves or for any other dependent, and they live in a state without a state income tax. They are in a 25 percent federal income tax bracket.
They should claim the Lifetime Learning Credit, since this will save them $2,000 in federal income taxes (20 percent of $10,000). They will only save $1,500 in federal income taxes if they claim the Hope Scholarship Credit, and $1,000 if they claim the education deduction (25 percent of $4,000, the maximum amount of the education deduction).
Observation: If a state with an income tax also allows an above-the-line deduction for qualified tuition and related expenses, there will be a higher savings if that deduction is claimed, but I know of no state where the tax rate, when added to the federal income tax rate, will cause the combined federal and state income tax savings from taking the deduction to exceed the federal savings from claiming either of the education credits.
Observation: Since the education deduction is an above-the-line deduction, taking the deduction reduces AGI. Thus, in theory, taking the education deduction instead of one of the education credits should benefit taxpayers who might be subject to a phase-out of other tax benefits when AGI exceeds specific limits.
However, the MAGI limits for claiming the education credits are generally much lower than the AGI limits that would affect the amount of other deductions or exclusion a taxpayer is allowed, e.g., the personal exemption, itemized deductions and the adoption credit. However, see below for where a taxpayer who is eligible to take a partial education credit for two or more students may increase the total credit for one or more of the students by taking the education deduction for another student.
The deduction may be more beneficial than a credit where only a partial credit is available because of MAGI limits. If a taxpayer is entitled to only a partial education credit because her income is in the phase-out range, then it often will be better to claim the education deduction than the credit, since the full education deduction will be available for any taxpayer who is in the phase-out range for either of the credits.
Example 4: The same facts apply as in Example 3, except that your clients' MAGI is at a level that causes them to lose 60 percent of the education credits that they would otherwise be entitled to claim. Thus, they would only be entitled to a Lifetime Learning Credit of $800 (40 percent of $2,000) and a Hope Scholarship Credit of $600 (40 percent of $1,500) for the education expenses that they paid for their daughter.
However, they are still entitled to the full education deduction. Since they are in a 25 percent tax bracket, claiming the education deduction will save them $1,000 in federal income taxes (25 percent of $4,000).
Claiming the education deduction for one student may increase credit for one or more other students and lower total taxes more than claiming a credit for each student. The education deduction is allowed in determining MAGI for purposes of determining the amount of the Hope Scholarship Credit and the Lifetime Learning Credit that a taxpayer is eligible to claim. Thus, in some circumstances, it may be possible to increase the total credit amount available for one or more students by claiming the education deduction for another student, even though that other student is also eligible for a credit.
Example 5: Your clients, a married couple who file joint returns, took out a home equity loan to help finance the education costs of their three children. In 2004, their twin daughters were freshmen in a state college, while their son was in his junior year at the same college. Your clients paid over $4,000 in qualified tuition and related expenses for each of their children.
In 2004, their MAGI was $91,000 before taking into account any education deduction that they are eligible to claim. Their taxable income was $62,500 ($4,400 above the amount at which their taxable income is taxed at a rate of 25 percent), and the amount of federal income tax they would have to pay before taking any education credits into account would be $8,850.
They are eligible to claim a $1,050 Hope Scholarship Credit for each of their daughters (70 percent of the otherwise available credit of $1,500, because 30 percent of the credit was phased out because their MAGI was 30 percent into the phase-out range of from $85,000 to $105,000 for 2004) and a $1,400 Lifetime Learning Credit for their son (70 percent of the otherwise available credit of $1,400).
Thus, if they claim only the credits, they will reduce their taxes by $3,550 ($1,050, plus $1,050, plus $1,400).
On the other hand, if your clients claim the education deduction of $4,000 for one of their daughters instead of the Hope Scholarship Credit, they will save $1,000 in taxes as a result of claiming the deduction, instead of the $1,050 Hope Scholarship Credit they could otherwise claim. However, claiming the deduction would reduce their MAGI by $4,000 to $87,000, and thus put them only 10 percent into the phase-out range. By doing this, they will be able to claim a $1,350 Hope Scholarship Credit for their other daughter (90 percent of $1,500) and an $1,800 Lifetime Learning Credit for their son (90 percent of $2,000).
Their total tax savings by claiming the education deduction instead of the Hope Scholarship Credit for one of their daughters will be $4,150 ($1,000 from the education deduction for one daughter, $1,350 for the Hope Scholarship Credit for the other daughter, and $1,800 from the Lifetime Learning Credit for their son). This will be $600 more than the amount they would have saved by claiming credits for each of their children.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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