Dollars and Sense: Paying For Your Children's College Education by Kenneth J. Ray, CPA In the last issue I discussed some tax-favored ways to build up a college fund for your children. In this issue I will focus on tax-advantaged methods of actually paying for your children's college education. These include taking a credit for some of their tuition expenses, writing off some of the interest on education loans, and getting college expenses paid by others. Tuition Tax Credits There are different types of tax credits to explore. You can take a Hope tax credit of up to $1,500 a year per student for the first two years of college (a 100% credit for the first $1,000 in tuition and a 50% credit for the second $1,000). You can also take a lifetime learning credit of up to $1,000 per family for every additional year of college or graduate school (a 20% credit for up to $5,000 in tuition). Unfortunately, both of these credits begin to phase out for couples with an adjusted gross income (AGI) of $80,000, or a single person with an income of $40,000; the entire credit is gone for couples making $100,000 and singles grossing $50,000. Only one credit may be claimed for the same student in any given year. Scholarships Scholarships are generally exempt from income taxes, but certain conditions must be met. To qualify, the scholarship must not be compensation for services and it must be used for tuition, books, fees, supplies and the like. It cannot be used for room and board. A scholarship will reduce the amount of tuition and expenses that are taken into account in the calculation of the credits discussed above. College Expense Payments by Grandparents and Others If someone other than yourself pays your child's college expenses, that person may be subject to gift taxes to the extent the payments exceed $10,000 to any one child ($20,000 in the case of married donors who consent to splitting gifts) per calendar year. However, if this other person pays the tuition directly to an educational institution, there's an unlimited exclusion from gift taxes for the payment. This gift-tax exclusion applies only to direct tuition costs; room and board, books and supplies do not qualify. Student Loans Generally, interest paid on student loans is considered personal interest and is therefore not deductible. But there is an exception. You may qualify to deduct interest on a student loan up to $1,500 for 1999, $2,000 for 2000, and $2,500 for 2001 and beyond. This deduction is actually an "above-the-line" deduction, so that, if you qualify, you may receive it even if you don't itemize. The deduction phases out for couples whose AGI is between $60,000 and $75,000 ($40,000 and $55,000 for singles.) Bank Loans As discussed above, interest on loans used to pay educational expenses is generally considered personal interest, which is not deductible. However, if the loan is "home equity indebtedness" and the interest paid on that loan is "qualified residence interest," the interest is deductible for regular tax purposes, although not for alternative minimum tax purposes. The bottom line? Consider your home an excellent source of funds to help pay college expenses. Borrowing Against Retirement Accounts Many company retirement plans, including 401(k)s, permit participants to borrow from their accounts. This option may be an attractive alternative to a bank loan, especially if your other debt burden is high. However, unless you qualify for the deduction for education loan interest (described above), there's no deduction for the personal interest paid. In addition, unless strict requirements are satisfied, a loan against a retirement account may be treated as a premature distribution (withdrawal) that is subject to regular income tax and possible penalties. Withdrawals from Retirement Accounts You can withdraw money out of your Individual Retirement Account (IRA) at any time to pay college costs without incurring the 10% early withdrawal penalty that usually applies to withdrawals from an IRA before age 59Þ. The distributions will of course be subject to income tax under the usual rules for IRA distributions. Some qualified plans (employer- sponsored) may restrict or not permit withdrawals though. For example, a 401(k) plan may allow distributions if the participant has an immediate and heavy financial need and lacks other resources to meet that need. College education is among one of those needs, as defined in IRS regulations. To the extent the funds withdrawn represent previously untaxed dollars and earnings, amounts withdrawn from a retirement plan are fully subject to income taxes and are also subject to a 10% penalty if they are made before the participant reaches the age of 59Þ. A younger plan participant may avoid triggering the penalty tax by taking annual payouts from an IRA or SEP. Not all of these tax breaks may be used in the same year, and use of some of them may reduce the amounts that qualify for the other breaks. Therefore, it takes planning to determine which should be used in any given situation. Your best bet is to consult your tax advisor. Ken Ray is a partner at Kirsch, Kohn & Bridge, CPAs in Encino, California. He can be reached via e-mail   Reprinted from The Motion Picture Editors Guild Newsletter Vol. 20, No. 4 - July/August1999   Guild Home | Newsletter Home | Top of Page   Copyright © 1999, All Rights Reserved by The Motion Picture Editors Guild, IATSE Local 700