Tax benefits for education.

• Author: Zook, John D.

Before taxpayers and/or their dependents enter the classroom, it would benefit them to educate themselves about the many tax provisions related to education that may save them tax dollars. This is especially true because postsecondary education and its costs have been on the rise. Undergraduate enrollment rose 25% between 1997 and 2007, while graduate enrollment rose 67% between 1985 and 2007. (1) If those enrollment numbers seem surprising, consider the cost of the education for those enrolled. While the average tuition, room, and board for students at the nation's four-year public colleges and universities for the academic year 2007-2008 was $13,424, the cost for four-year private colleges and universities during that period was $30,393. (2)

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Given the size and frequency of these educational costs, taxpayers must take advantage of any opportunities to mitigate them, and practitioners need to be alert to the tax benefits that can best serve their clients. This is important not only for tax compliance reasons but also--and perhaps more beneficially--for financial planning reasons. In fact, these potentially significant tax-saving measures could affect not only the taxpayer but also multiple generations within the taxpayer's family. This article provides an indepth discussion of available educational benefits as well as recent federal legislation that increases those benefits.

Categories of Exclusions

Perhaps the most advantageous available tax benefits are six exclusions for educational benefits that would otherwise be taxable. The IRS has established a hierarchy within which these six exclusions function that allows taxpayers and their family members to take advantage of multiple exclusions for qualified tuition and related expenses.

Employer-Provided Educational Assistance

The employer-provided educational assistance exclusion is twofold: While taxpayers may avail themselves of an employer-provided plan by which to derive a tax-free benefit, the taxpayers' employers can provide employees with a limited form of tax-free compensation without all the related payroll tax and benefit payments that would normally be attached (for example, FICA tax, workers' compensation, and benefit plan contributions). Ultimately, this also improves the company long term by developing a more educated work force. What is needed to make it work?

An employee's gross income does not include amounts paid or expenses incurred by the employer for educational assistance to the employee if the employer furnishes the assistance under a qualified program. (3) In order for employees to take advantage of this exclusion, the educational assistance program offered by the employer must consist of a separate written plan for the exclusive benefit of the employees to provide them with educational assistance. There are also other requirements, such as meeting eligibility standards and notifying employees of the existence of such a program. This exclusion is limited to the first $5,250 furnished to an individual during a calendar year. Since 2001 this exclusion has applied to both undergraduate and graduate educational expenses. (4)

If an employer's program qualifies, the educational assistance that is excludible by the employee consists of any payments by an employer for expenses incurred by or on behalf of an employee for the education of the employee. (5) Such payments include, but are not limited to, expenses for tuition, fees, books, supplies, and equipment, as well as any courses of instruction offered to the employee. However, employer-provided tools or supplies that the employee may retain after completing a course of instruction, along with the costs of meals, lodging, or transportation incurred during the education, are not excludible. (6)

Qualified Scholarships and Tuition Reductions

Qualified scholarships: Another available exclusion is for qualified scholarships. Any amount received as a qualified scholarship by an individual taxpayer who is a candidate for a degree at a qualifying educational organization is excluded from income. (7) Under Treasury regulations, a qualifying educational organization includes primary, secondary, preparatory, and high schools in addition to colleges and universities. (8) This creates a very long window of time to use this exclusion if taxpayers or their dependents are fortunate enough to receive them. Qualified scholarships include any funds that the individual received as a scholarship or fellowship grant that were used for qualified tuition and related expenses. (9) However, taxpayers must be aware that they cannot exclude the component of scholarships designated for room, board, and travel expenses. (10) In addition, this exclusion does not apply to any portion of an amount received that represents payment for such services as teaching, research, or other services required as a condition for receiving the qualified scholarship. (11)

Qualified tuition reductions: The sister exclusion to the qualified scholarship exclusion is the qualified tuition reduction exclusion. Under this, gross income does not include any tuition reduction provided to an employee--or a person treated as an employee--of an educational organization for education below the graduate level. (12) "A person treated as an employee" is defined by reference to Sec. 132(h). This includes the spouse and the dependent children of the employee. (13) A special rule applies to individuals who are graduate students at an educational organization and are engaged in teaching or research activities for that organization. These individuals may exclude a qualified tuition reduction from income regardless of the fact that the individual is being educated at the graduate level. (14)

Education Savings Bond Program

A third form of income exclusion applies to U.S. Series EE Bonds, provided for under Sec. 135, which was enacted as part of the 1988 Technical and Miscellaneous Revenue Act. (15) This section excludes from the gross income of any individual who pays qualified higher education expenses during the year any income received from the redemption of any qualified U.S. savings bond, subject to certain limitations. (16)

The exclusion applies to qualified higher education expenses such as tuition and fees, net of benefits such as amounts from a qualified tuition program (QTP), (17) employer-provided educational assistance, and scholarships. (18) It also includes any contributions to a QTP on behalf of a designated beneficiary and contributions to a Coverdell education savings account. (19) However, the interest exclusion applies only to bonds issued after December 31, 1989, to an individual who reached age 24 before the date of issuance. (20) The deduction is further limited based upon modified adjusted gross income (MAGI) and is currently adjusted to phase out between $70,100 and $85,100 in 2010 ($105,100 and $135,100 in the case of joint returns). (21)

Coverdell Education Savings Account

The Coverdell education savings account (CESA), formerly known as the education IRA, (22) is found under Sec. 530. Distributions from a CESA are not taxable to the extent they do not exceed the qualified education expenses for the year. (23) The CESA is a trust created for a designated beneficiary exclusively to pay for his or her qualified education...