Diverse planning opportunities available under the TRA '97.

• Author: Bukofsky, Ward M.
• Position: Part 2 - Taxpayer Relief Act of 1997

Need to advise clients on how to save for retirement or put their children through college? The Taxpayer Relief Act of 1997's (TRA '97) myriad education and retirement incentives provide numerous planning opportunities. The second part of this two-part article examines the array of strategic possibilities stemming from the changes made by the TRA '97 in these areas.

The Taxpayer Relief Act of 1997 (TRA '97), enacted Aug. 5, 1997, contains many provisions affecting individuals. Part I of this two-part article, published in the January 1998 issue, covered the TRA '97's investment, personal residence, family and miscellaneous provisions. This part explains the legislation's education and retirement tax incentives and highlights planning opportunities.

Education Incentives

Seven provisions provide education incentives. The TRA '97 created a labyrinth of new rules, phaseouts and, in some cases, choices for taxpayers between competing provisions. Overall, these provisions offer many interesting and useful ways to fund a child's education.

Planning opportunities: The provisions are not limited to use by parents of college-age children. Grandparents, workers, students and even persons unrelated to a child may all benefit from these new rules. Further, in many cases (e.g., Education individual retirement accounts (IRAs) or qualified state tuition programs), the tax benefit can be enhanced substantially by planning years in advance of the expenditures.

Included among the education incentives are the "Hope Scholarship" Credit, the "Lifetime Learning" Credit, the Education IRA and the deduction for education loan interest. These incentives are described in the table on pages 110-111.

A taxpayer may claim either the Hope Scholarship Credit, the Lifetime Learning Credit or the Education IRA distribution exclusion for any one student in a given year. However, a student may waive the tax-free treatment of an Education IRA distribution in any tax year so that he or his parents may claim a Hope Scholarship Credit or Lifetime Learning Credit for expenses paid in the same year in which Education IRA distributions are received.

Planning opportunities: Before making any Education IRA withdrawal to cover education costs, the practitioner, the parents and/or grandparents should analyze whether the tax-free treatment waiver exceeds the loss of a portion of the credit. Also, the term "Education IRA" is a misnomer, because the account has nothing to do with retirement and does not affect an otherwise eligible taxpayer's ability to contribute to a regular or Roth IRA (discussed below).

Hope Scholarship and Lifetime Learning Credits; Penalty-Free IRA Withdrawals

In determining expenses eligible for the Hope Scholarship and Lifetime Learning Credits and penalty-free IRA withdrawals, Secs. 25A(g)(2) and 530(b)(2) provide that "qualified" tuition is reduced by amounts (1) excludible from gross income (e.g., Sec. 117 tax-free and Pell Grant scholarships, Sec. 127 employer assistance or tax-free distributions from Education IRAs) or (2) deductible as expenses (e.g., Sec. 162 business expenses); no reduction is required for a gift, bequest, devise or inheritance under Sec. 102(a). Expenses paid from a student's earnings, a loan, a gift, an inheritance or personal savings (including savings from a qualified state tuition program) qualify in calculating the credit and eligible withdrawal amount. According to Sec. 25A(g)(6), the Hope Scholarship and Lifetime Learning Credits are not available to taxpayers married filing separately.

Planning opportunity: For both the Hope Scholarship and Lifetime Learning Credits, Sec. 25A(g)(4) provides that expenses must be paid for classes beginning during the tax year or during the first three months of the following tax year (i.e., prepayments are generally not permitted). However, taxpayers can prepay in 1998 for academic periods beginning in January through March 1999 and claim the credit on their 1998 returns. The Lifetime Learning Credit may also be available for clients considering career changes.

Education IRAs

The Education IRA is a trust or custodial account created exclusively for the purpose of paying qualified higher education expenses (defined in Sec. 530(b)(2)).

Planning opportunities: There is no requirement that the contributor be related to the beneficiary and no limit on the number of beneficiaries on behalf of whom contributions can be made; thus, this provision might be of interest to taxpayers with income below the phaseout limit (see the table on page 110). Because the contributor is not required to have a minimum adjusted gross income (AGI) (unlike with a regular IRA), students can contribute on their own behalf even if they have little or no income.

Multiple Education IRAs could be created for one beneficiary, but the Sec. 530(b)(i)(A)(iii) limit on contributions for a single beneficiary is $500 in any one tax year. Under Sec. 530(d)(4), aggregate contributions for the benefit of a particular child in excess of $500 for a year constitute excess contributions. If the excess contributions (and any earnings thereon) are not withdrawn from the child's account(s) before the due date of the return for that year, they are subject to a 6% excise tax each year such excess remains in the account.

Assuming a maximum annual contribution of $500 is made each year from birth on the beneficiary's birthday and the account earns 8% annually, the account would be worth approximately $22,300 by the beneficiary's 18th birthday.

Planning opportunities: Transfers and rollovers of account balances from an Education IRA benefiting one beneficiary to an Education IRA benefiting another beneficiary (and redesignations of the named beneficiary) are permitted under Sec. 530(d)(5) (with no transfer tax consequences, if the beneficiaries are in the same generation) if certain conditions are met. The new beneficiary must be a member of the original designated beneficiary's family (i.e., the designated beneficiary's ancestor, spouse, lineal descendant, lineal descendant of the spouse or of a parent of either or the spouse of any such lineal descendant). In addition, the transfer or rollover must occur before the original beneficiary reaches age 30. The $500 annual contribution limit to Education IRAs does not apply to rollover contributions.

Example 1: X is 22 and graduating from college in 1998 with a $3,000 balance in an Education IRA. In 1998, X can rollover that balance to Y, his 15-year-old sister, tax-free; Y's parents may additionally contribute $500 in 1998 to Y's education IRA.

Rather than rolling over funds from one Education IRA to another, the account name can simply be changed from one designated beneficiary to another tax-free, provided the account's terms permit a change in the designated beneficiary and the...