IRSRRA '98 revamps higher education incentives.

• Author: Foran, Nancy J.
• Position: IRS Restructuring and Reform Act of 1998

EXECUTIVE SUMMARY

* The IRSRRA '98 clarified the definition of "excess contributions" for Education IRA purposes.

* Regulations will explain the 60-month period of eligibility for deducting interest on multiple student loans.

* Parents, but not grandparents, can borrow funds to pay for their child's education and deduct the interest.

While the Taxpayer Relief Act of 1997 created or extended many higher education incentives, such as Education individual retirement accounts, qualified state tuition programs, U.S. savings bond interest exclusion and deduction of student loan interest, it left many related issues ambiguous. The Internal Revenue Service Restructuring and Reform Act of 1998 has clarified many of these issues, as described in this article and illustrated by numerous examples.

The Taxpayer Relief Act of 1997 (TRA '97) significantly expanded the higher education tax incentives available to taxpayers.(1) Many of the new provisions were hastily written, unclear and did not reflect congressional intent. The Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98) corrected numerous errors, omissions, conflicts and ambiguities in the TRA '97 higher education incentive provisions. Most of these corrections significantly affect the original provisions and are effective as if included in the TRA '97. This article describes the effects of the IRSRRA '98 on those incentives.

As this article examines only the IRSRRA '98 higher education amendments, the TRA '97 provisions should be scrutinized by practitioners to determine client eligibility (e.g., adjusted gross income (AGI) limits). The table in the box on p. 170 summarizes the IRSRRA '98 higher education incentive revisions.

Education IRAs

The IRSRRA '98 changed the Education individual retirement account (Education IRA) rules extensively.

Treatment of Contributions

Sec. 530, added by TRA '97 Section 213(a), provides that contributions to an Education IRA cannot exceed $500 per year (Sec. 530(b) (1) (A) (iii)) and are subject to an AGI phaseout (Sec. 530(c)(1)). A 6% excise tax is imposed by Sec. 4973(a)(4), as amended by TRA '97 Section 213(d), on "excess contributions." IRSRRA '98 Section 6004(d)(10)(A) clarified the definition of "excess contributions" in Sec. 4973(e)(1)(A). If an Education IRA contribution is reduced due to the AGI phaseout, the reduced amount is the starting point for calculating any excess contribution. In addition, Sec. 4973 (e) (1) (C), as amended by IRSRRA '98 Section 6004(d)(10), provides that the 6% excise tax applies each year the excess contribution remains in the account, not just the year it is first made.

According to Sec. 4973(e), as amended by IRSRRA '98 Section 6004(d) (10), an "excess contribution" is calculated as follows:

1. The amount by which the Education IRA contributions for the year exceeds $500 (or less, if the contributor's AGI exceeds the applicable limit); plus

2. Any contribution made to the Education IRA for the year, if a contribution was also made during the year to a qualified state tuition program (QSTP) for the beneficiary (other than a contribution from an Education IRA to the QSTP); plus

3. The excess contribution for the preceding year, less the sum of.

4. Distributions from the Education IRA (other than rollover distributions) and

5. The excess of the maximum amount that may be contributed to a beneficiary's Education IRA for a year over the actual contributions for the year.

Contributions should be reviewed annually to ensure excess contributions have not been made. Excess contributions returned timely under Sec. 530(d)(4)(C) are not subject to either the Sec. 4973(e)(1) 6% excise tax or the Sec. 530(d)(4) 10% additional tax on excess distributions.

Example 1: T's parents establish an Education IRA for him to which they contribute $500 in 1999. Without consulting T's parents, T's grandparents also establish an Education IRA for T in 1999 with a $500 contribution. If the excess contribution (i.e., the grandparents' $500 contribution) and its earnings are distributed to T before the extended due date of his return (or by April 15, 2000, if T does not file a return), neither the 10% Sec. 530(d)(4) tax nor the Sec. 4973(e)(1) 6% excise tax will apply to the distribution. However, the returned earnings are includible in T's income.

Treatment of Distributions

Distributions from an Education IRA are not taxable to the beneficiary if used to pay his qualified higher education expenses (QHEEs), as defined in Sec. 530(b)(2). Sec. 530(b)(1), as amended by IRSRRA '98 Section 6004(d) (1), clarifies that an Education IRA beneficiary must be an "individual." The Senate Report(2) defines an "individual" as a life-in-being; thus, a beneficiary cannot be a group of individuals or an unborn child.

IRSRRA '98 Section 6004(d) (3) (13) amended Sec. 530(d)(1) to require that the annuity rules of Sec. 72(e)(9) apply to distributions. (The TRA '97 had referred to the Sec. 72(b) rules.) Under Sec. 72(e)(9), each Education IRA distribution is deemed made ratably from contributions (excludible from...