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Education Credits and Other Tax Provisions

These credits can give you an extra boost at tax time.

Susan T. Bart, 01/29/2010

College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to advisorquest@morningstar.com.

There are currently two education tax credits: the American Opportunity Credit (the revamped Hope Scholarship Credit) and the Lifetime Learning Credit.

American Opportunity Credit
The American Opportunity Credit is 100 percent of qualified tuition and related expenses ("QTREs) not in excess of $2,000 plus 25 percent of those expenses that exceed $2,000 but do not exceed $4,000. Thus for 2010 the maximum American Opportunity Credit is $2,500.

In 2010, the American Opportunity Credit will begin to be phased out when a taxpayer's modified adjusted gross income is in excess of $80,000 ($160,000 for a joint return).

The American Opportunity Credit is available for the first four years of a student's post-secondary education. Up to 40 percent of the credit amount is refundable if the taxpayer does not have sufficient income to offset with the credit.

The taxpayer must pay the QTREs, and the person for whom the credit is claimed must be an "eligible student." QTREs for purposes of the American Opportunity Credit include qualified tuition, fees and course materials. An eligible student is one enrolled at least half-time in a program that leads to a degree, certificate or other recognized educational credential.

Lifetime Learning Credit
A taxpayer may claim a tax credit for 20 percent of up to $10,000 of QTREs for himself or herself, the taxpayer's spouse, and the taxpayer's dependent children. (Unlike the American Opportunity Credit, this amount is not indexed for inflation.) The maximum credit is $2,000 per taxpayer, without regard to the number of eligible students in the taxpayer's family. For the Lifetime Learning Credit, there is no requirement that the student be studying towards a degree or be enrolled at least half-time, and there is no limit on the number of years the credit may be taken. QTREs for purposes of the Lifetime Learning Credit do not include room and board, transportation or course materials. There is no limit on the number of years in which the credit can be claimed.

For 2010, the Lifetime Learning Credit begins to phase out when the taxpayer's modified adjusted gross income exceeds $50,000 ($100,000 for a joint return).

Limitations on Credits
A taxpayer may claim either credit for himself or herself, the taxpayer's spouse, or a dependent for whom the taxpayer claims an exemption. The taxpayer may not claim the credit if any of the following apply:

1. the taxpayer's tax filing status is married filing separately;
2. someone else claims the taxpayer as a dependent on his or her tax return; or
3. the taxpayer or the taxpayer's spouse was a nonresident alien for any part of the tax year and did not elect to be treated as a resident alien for tax purposes.

A parent who is eligible to claim a child as a dependent may elect to forego the dependency exemption in order that the student (but no one else) may claim the credit. However, a student for whom a dependency exemption may be claimed by another person (e.g., his or her parent) is not entitled to the personal exemption deduction on his or her own return. This is so whether or not the parent actually claims or benefits from the dependency exemption. Therefore, if a parent entitled to the dependency exemption for a child/student declines to claim it, the student will get the education credit but no one will get a dependency exemption with respect to the student.

Coordination of Credits, Deductions and Coverdell and 529 Distributions
The American Opportunity Credit may not be claimed in the same year the Lifetime Learning Credit is claimed for the same eligible student. The credits also may not be claimed for QTREs if the taxpayer took a deduction for the same QTREs on the taxpayer's tax return.

Expenses that are used to claim one of the education tax credits may not be used for purposes of determining the exclusion from income of distributions from a Coverdell education savings account or a qualified tuition program. Because non-qualified Coverdell or 529 account distributions are subject to income tax and a 10 percent additional tax on the earnings, forgoing the tax credit may result in lower taxes. Note, however, that the 10 percent additional tax on a Coverdell or 529 account withdrawal is waived if it results from claiming the expenses for one of the tax credits.

U.S. Savings Bonds
EE bonds purchased after 1989 and I bonds owned by someone who was at least 24 years old on the bond's issue date may be redeemed tax-free to pay for qualified higher education expenses ("QHEEs") of the taxpayer, the taxpayer's spouse, or a dependent for whom the taxpayer claims an exemption. In 2009, the tax exclusions is phased out for modified adjusted gross income between $69,950 and $84,950 (between $104,900 and $134,900 for joint filers). For 2010 the phaseout will be between $70,100 and $85,100 (between $105,100 and $135,100 for joint filers).

Kiddie Tax
Investment income of a child under age 19 is generally taxed at the parents' tax marginal rate to the extent it exceeds the sum of the standard deduction ($950 for 2009) and the greater of the standard deduction and the itemized deductions allocated to such income. In the usual case this means investment income of the child in excess of $1,900 is subject to the Kiddie Tax. Further, if a child is over age 18 but under age 24 and is a full-time student whose unearned income does not exceed one-half of the amount of his or her support, the Kiddie Tax will continue to apply.

There is no change in the unearned income threshold for 2010.

Gift Tax Annual Exclusion
The gift tax annual exclusion remains at $13,000 ($26,000 for a married couple who make a split-gift election).

Senator Charles Grassly (R-Iowa) announced on Dec. 8 that he will be introducing education-related tax legislation that would:
* Make permanent a number of tax incentives.
* Increase the American Opportunity Tax Credit from $2,500 to $3,000.
* Permanently eliminate the 60-month limit on deduction of interest on student loans, which was in effect prior to 2002.
* Raise the income limits for deduction of student loan interest.
* Permanently allow the above-the-line deduction for higher education expenses.
* Eliminate the $2,000 contribution limit and income phase-out limits for Coverdell education savings accounts.
Go, Grassly, go!

10% Additional Tax
The Tax Court case of Venet v. Commissioner sounds like a very contemporary tale of economic woe, although the taxpayer's troubles began in 2005 when he was laid off and became unemployed for four years. Taxpayer and his wife ran up credit card debt and took out a home equity loan until they were $120,000 in debt and on the verge of bankruptcy. Taxpayer, age 48, then withdrew $110,000 from his IRA. Taxpayer sought to avoid the 10 percent penalty on withdrawals prior to age 59½ by arguing the IRA withdrawal was made because of financial hardship. Unfortunately, the IRA rules do not create an exception to the penalty for hardship.

The tax court, however, did exclude some of the IRA withdrawal from the penalty tax because the taxpayer's daughter was attending college and paying for rent, utilities and food. The opinion is puzzling in that the opinion states that taxpayer did not keep records of the amounts given to the daughter, but that the court was satisfied that the petitioners provided her with $775 per month for rent, utilities and food.

Code section 72(t)(2)(E) creates an exception to the 10 percent penalty for:
Distributions to an individual from an individual retirement plan to the extent such distributions do not exceed the qualified higher education expenses (as defined in paragraph (7)) of the taxpayer for the taxable year.
Paragraph (7) defines qualified higher education expenses to include expenses of the taxpayer, the taxpayer's spouse and any child or grandchild of the taxpayer or the taxpayer's spouse.

Note, however, that the daughter's rent, utilities and food would count as qualified higher education expenses eligible for the exception to the 10 percent penalty only if the daughter was an "eligible student," and, because she was living off campus, only to the extent they did not exceed the student's allowance for room and board included in the cost of attendance as determined by her university. An eligible student is a student enrolled at least half-time in a degree or certificate program at an eligible institution of higher education.

To comply with certain Treasury regulations, we state that (i) this article is written to support the promotion and marketing of the transactions or matters addressed herein, (ii) this article is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (iii) each taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

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