The TRA '97 offers a multitude of education incentives.

• Author: Adkins, Nell
• Position: Taxpayer Relief Act of 1997

In an effort to encourage taxpayers to pursue higher education, Congress enacted a host of incentives in the Taxpayer Relief Act of 1997. Available for the first time are Hope Scholarship and Lifetime Learning Credits, education individual retirement accounts and an above-the-line deduction for student loan interest; extended/expanded provisions include qualified state tuition programs and employer-provided education assistance.

The Taxpayer Relief Act of 1997 (TRA '97) significantly expanded the tax benefits associated with higher education expenses. The law now includes a plethora of provisions granting a variety of benefits to taxpayers, including tax credits, deductions, exclusions, and tax-favored methods of financing and saving for higher education costs. Not only did the TRA '97 expand the types of education-related tax benefits afforded to taxpayers, it also provided tax benefits to groups of taxpayers largely ignored under prior law, including both the traditional student and certain nontraditional students whose higher education expenses are not deductible under Sec. 162. The education tax incentives are summarized in Table 1 on page 246.

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The 10-year revenue cost for the TRA '97 education benefits is estimated at almost $99 billion, $76 billion of which is attributable to two tax credits available in 1998 and beyond, the Hope Scholarship Credit (Hope Credit) and the Lifetime Learning Credit (Learning Credit).(1) The Education individual retirement account (IRA), a new savings-oriented provision, can be established in 1998, but the actual tax benefits may take some time to realize. Changes to the tax treatment of qualified state tuition programs (QSTPs), including a provision to include room and board expenses as qualified higher education expenses (QHEEs), are also effective in 1998. Interest expense on qualifying student loans is deductible beginning in 1998. Finally, the employer-provided education assistance exclusion under Sec. 127 has been extended to courses beginning before June 1, 2000, making qualified assistance benefits paid to employees during 1997 excludable. Consistent with many other Code provisions, most of the new tax benefits are subject to phaseouts based on the taxpayer's adjusted gross income (AGI).

The phaseouts vary substantially among die different education provisions. The coordination of the phaseouts is but one of several considerations that must be made in attempting to maximize tax benefits for a given taxpayer. The definition of higher education expenses that qualify also differs. Some of the education provisions are intended to be long-term in nature, while others provide only a short-term benefit. In many cases, multiple provisions cannot be used in a single tax year; planning is needed to maximize tax savings over eligible periods. This article examines the education benefits created by the TRA '97, the changes made to existing education provisions and the coordination of the new and amended provisions with existing law.

Education Credits

The traditional student (typically aged between 18 and 24 and pursuing a first academic degree), as well as certain nontraditional students, have historically found no tax benefit associated with education costs due to Regs. Sec. 1.162-5(b)(2) and (3), which denies deductions when the education prepares a taxpayer to enter a new trade or business, to gain entry into a business or to meet the minimum standards required therein. These students may benefit from the Hope and Learning Credits.

General Provisions

The Hope and Learning Credits are provided under new Sec. 25A, added by TRA '97 Section 201, for certain qualified tuition and related expenses (QTREs). The key provisions, definitions, phaseouts and effective dates of the two credits are summarized in Table 2 on page 248. QTREs are defined as tuition and fees, excluding books, room and board, equipment, meals, lodging, transportation and excludable assistance/scholarships. Taxpayers can claim a nonrefundable Hope Credit up to $1,500 per eligible student for QTREs paid during the year on the student's behalf. Under Sec. 25A(b)(1), the credit is 100% of the first $1,000 of QTREs and 50% of the next $1,000 of QTREs. Sec. 25A(b)(2) specifies that the Hope Credit is allowed for only the first two years of a student's postsecondary education.

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Taxpayers can claim a nonrefundable Learning Credit of 20% of QTREs, up to a maximum of $5,000 ($10,000 in 2003 and thereafter) paid during the tax year on behalf of one or more eligible students. In contrast to the Hope Credit, the Learning Credit may be claimed for an unlimited number of years; the amount that may be claimed is not affected by the number of eligible students. The maximum annual Learning Credit of $1,000 ($2,000 for 2003 and beyond) will not be adjusted for inflation.

Clearly, the Hope Credit is designed to benefit taxpayers funding the education costs of the traditional student, while the Learning Credit will benefit a broader range of taxpayers, including both traditional and nontraditional students. According to Sec. 25A(c)(2)(A), these elective credits are mutually exclusive with respect to an eligible student; thus, they present a choice if the QTREs qualify the taxpayer for either credit. In addition, Sec. 25A(e)(2) specifies that the Education IRA tax-free withdrawal provisions (discussed below) cannot be used for a tax year in which either credit is elected. For the traditional student, the Hope Credit is generally more beneficial through 2002 for education expenses incurred in the first two years of postsecondary education. The Learning Credit may be more beneficial beginning in 2003, depending on the amount of QTREs incurred during the tax year and the inflation adjustments made.

Example 1: J incurs and pays $11,000 in QTREs on behalf of his son, A, an eligible student, in 1999. J can take a Hope Credit of $1,500 (100% of $1,000 + 50% of $1,000); alternatively, J can take a Learning Credit of $1,000 (20% of $5,000). For 1999, J should elect the higher, the $1,500 Hope Credit.

Example 2: The facts are the same as in Example 1, except that it is 2003 and the Hope Credit has been indexed for inflation to $1,650. J can take a $1,650 Hope Credit or a $2,000 Learning Credit (20% of $10,000). J should claim the Learning Credit.

Because the Hope Credit is a per-eligible-student computation and the Learning Credit is a per-return computation, the presence of more than one eligible student also favors taking the Hope Credit over the Learning Credit.

Example 3: J incurs and pays $7,000 in QTREs on behalf of each of his triplets, all freshmen and eligible students, during 1999. J is entitled to a Hope Credit of $4,500 (3 X $1,500) or a Learning Credit of $1,000 (20% of $5,000). J should elect the Hope Credit.

Planning opportunities: The Hope Credit's two-year rule produces important planning opportunities, because academic and tax years often do not coincide. Taxpayers may not be able to claim the Hope Credit for the entire first two years of postsecondary education because they are typically spread over three tax years. This situation has little or no effect at higher levels of QTREs (i.e., above $2,000 per year through 2001), but at lower levels, some of the tax benefit may be lost without proper planning.

Example 4: M graduates from high school in Spring 1998 and attends State U. full-time beginning in Fall 1998. Her QTREs for her freshman and sophomore years, paid at the beginning of each term, are as follows:

Fall 1998 $4,000 Spring 1999 4,000 Fall 1999 4,000 Spring 2000 4,000 M's parents can take a $1,500 Hope Credit for each of 1998 and 1999; if they do so, they cannot also take a Hope Credit for the education expenses associated with the Spring 2000 term. They can take a Learning Credit in 2000.

Example 5: The facts are the same as in Example 4, except that M's eligible education expenses are as follows:

Fall 1998 $1,200 Spring 1999 1,200 Fall 1999 1,200 Spring 2000 1,200 M's parents' Hope Credit is $1,100 (100% of $1,000 + 50% of $200) for 1998 and $1,500 for 1999. Because 1998 tuition is less than $2,000, $400 of the maximum allowable credit is left unused.

This underuse may be avoided by prepaying spring term tuition at the end of the fall term. Many educational institutions impose December deadlines for spring term tuition and fees. Under Sec. 25A(g)(4), if QTREs...