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CHAPTER 6: TAKING CARE OF THE MIDDLE CLASSBy Laura Greene Knapp
The traditional forms of student financial aid provide assistance directly to students through grants, loans, and work-study. Most of this financial aid is need-based; that is, it goes to students from low-income families who do not have sufficient income and assets to pay for college. Since the enactment of the Taxpayer Relief Act of 1997, however, the government has also offered a fundamentally different method of financial assistance that is not need-based. Students and their families with incomes too high to qualify for the traditional forms of need-based financial aid are the primary beneficiaries of these new forms of aid.
This article outlines three kinds of government-sponsored assistance available to students who do not qualify for need-based financial aid: education savings plans, federal income tax credits, and federal income tax deductions. Education savings plans are designed to help families whose children are not yet in college; federal tax credits and deductions reduce the income tax bills of college students or their families. While several forms of education savings plans were available prior to 1997, the Taxpayer Relief Act enhanced their financial incentives. In 2001, the Economic Growth and Tax Relief Reconciliation Act made them even more attractive.
1. Education Savings Plans
Students and their families use a variety of methods to save for college. Three of the most common are prepaid tuition plans, education IRAs (now known as Coverdell Education Savings Accounts), and 529 plans.
Prepaid Tuition Plans
Prepaid tuition plans, first offered in 1988 through the Michigan Education Trust, allow investors to pay for one or more years of future college tuition at current prices. These plans vary by state and not all states have prepaid tuition plans. Most plans cover tuition and mandatory fees at in-state public colleges, universities, or community colleges. Some plans also cover at least a portion of tuition and fees at private schools or out-of-state institutions. Portions of tuition (years or units, depending on the plan) may be purchased through a one-time payment or in monthly installments.
Prepaid tuition plans are attractive to families who do not want to risk their education savings by investing independently in the volatile stock and bond markets. Many plans have penalties for early withdrawals.
Education IRAs (Coverdell Education Savings Accounts)
Beginning this year, parents whose adjusted gross income is less than $220,000 can contribute up to $2,000 a year per child to a Coverdell Education Savings Account. Contributions are not federally tax deductible, but some states allow a state tax deduction. The parents decide how to invest the funds (in bonds, stocks, or mutual funds) and thus assume the investment risk.
When the student beneficiary turns 18, the account's assets belong to the student. Withdrawals from the account, both principal and investment earnings, are also the property of the student and are not subject to income tax if they are used for qualified education expenses (which include elementary and secondary school expenses, as well as college expenses).
Once the student owns the account, the assets must be included on the student's application for need-based financial aid, thereby reducing any such award (though not on a one-to-one basis).
Parents who fund a Coverdell account also may contribute to a 529 plan.
State-sponsored 529 plans (named for the tax code section that created them in 1996) are available to college savers regardless of annual income. The accountholder can designate one or more student beneficiaries and can change beneficiaries at any time. If a beneficiary decides not to attend college or earns a scholarship and doesn't spend all the 529 plan funds, the accountholder simply names a new beneficiary.
There are no annual limits on contributions to a 529 plan, and some plans allow accounts to exceed $250,000. Investment options are limited to those provided by the individual plan.
The assets of a 529 plan belong to the parent (or other accountholder), and the withdrawals belong to the student. Although contributions are not tax deductible, withdrawals used for college expenses, as of 2002, are not subject to federal income taxes. (Through 2001, withdrawals were taxed at the student's tax rate.) If Congress does not extend the current rules, however, withdrawals from 529 plans will once again be taxable at the student's rate after 2011.
Many states offer additional tax incentives for state residents who participate in their 529 plans, such as state tax deductions for plan contributions. Most states offer their plans to nonresidents, minus the state tax benefits.
Because withdrawals from 529 plans belong to the student, they reduce the student's need-based financial aid award. For instance, if a student withdrew $10,000 from a 529 plan, his or her prospective financial aid award would be reduced by $5,000.
2. Federal Income Tax Credits
Two federal income tax credits were created by the Taxpayer Relief Act of 1997: the HOPE Scholarship tax credit and the Lifetime Learning tax credit. The HOPE Scholarship tax credit is limited to students who are enrolled at least half-time and are in their first or second year of college. The Lifetime Learning tax credit is for students who have completed two years of college (including graduate students) or who are in their first or second year and are enrolled less than half-time.
These tax credits may be claimed by students who file their own taxes and by parents who claim an eligible student as a dependent on their tax forms. However, the credits cannot be taken by single tax filers whose adjusted gross income exceeds $50,000 or joint filers whose adjusted gross income exceeds $100,000. These programs also exclude the lowest-income students and families, because the tax credit can be taken only by those who earn enough to owe federal income taxes.
A qualifying student's HOPE Scholarship consists of a tax credit of up to 100% of the first $1,000 of tuition and required fees paid by the student plus up to 50% of the second $1,000 of tuition and required fees paid by the student. Thus, the maximum HOPE Scholarship is a $1,500 tax credit, which can be taken only if the student (or family) paid at least $2,000 in tuition and required fees and owes at least $1,500 in federal income taxes. Many students attending community college do not receive the full benefit of the HOPE Scholarship because their tuition bill is less than $2,000.
For tax years 2001 and 2002, students who qualify for the Lifetime Learning tax credit can take a federal income tax credit for up to 20% of the first $5,000 of tuition expenses and required fees. The maximum Lifetime Learning tax credit ($1,000) can be taken only if the student owes at least $1,000 in federal income taxes and paid at least $5,000 in tuition and required fees.
In tax year 2003, the maximum Lifetime Learning credit is scheduled to increase.
3. Federal Income Tax Deduction
As a result of the Tax Relief Act of 2001, taxpayers can claim a federal income tax deduction for tuition and fees they pay for their own education or for the education of their spouse or dependent children. In 2002 and 2003, the maximum deduction of $3,000 is available to single tax filers whose adjusted gross income does not exceed $65,000, and to joint tax filers whose adjusted gross income does not exceed $130,000. In 2004, the maximum deduction and the income limits will increase. Taxpayers are not allowed to claim the new deduction and a HOPE or Lifetime Learning tax credit in the same year for the same student. The deduction is scheduled to lapse in 2006.
What educational savings plans are available in the states?
Laura Greene Knapp is an educational consultant in North Carolina.
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