Academic journal article Journal of Accountancy

Smart Education Tax Moves: The 2001 Act Expanded Breaks for Students and Their Parents

Academic journal article Journal of Accountancy

Smart Education Tax Moves: The 2001 Act Expanded Breaks for Students and Their Parents

Article excerpt

As the cost of a college education remains high, Congress continued to expand and improve education tax incentives in the Economic Growth and Tax Relief Reconciliation Act of 2001. The importance of education in the act is demonstrated by the large number of provisions, some of which provide tax breaks for savings toward future education while others help parents pay current costs. The changes automatically expire after December 31, 2010, unless Congress acts before then to renew and extend them or to amend existing provisions.

This article focuses on explaining the education-related changes as well as planning strategies CPAs can discuss with their clients. As in the past, the differing limitations, definitions and interactions of these provisions, along with the education benefits already in the Internal Revenue Code, make tax planning complicated. It is more important than ever for CPAs to carefully analyze and evaluate which of the education tax benefits discussed below their clients should use in a particular situation.


Congress redesignated these programs under IRC section 529 as qualified tuition programs (QTP) in order to include educational institutions (including private schools) as eligible sponsors of private prepaid tuition type plans but not savings type plans. (See Prepaid Tuition vs. Savings Plans) Previously only states and state agencies were eligible sponsors. The school must obtain an IRS ruling and satisfy certain other requirements. The most important change to QTPs provides a complete exemption from gross income for distributions made after December 31, 2001 used to pay for qualified higher education expenses (QHEE). The exemption is broad and applies to accumulated earnings in existing QTPs. Under prior law, the earnings portion of distributions used for QHEE was taxed to the beneficiary. The new exclusion makes QTPs even more attractive when compared with other saving alternatives.

Prepaid Tuition vs. Savings Plans 
IRC section 529 permits states to establish tax-exempt qualified 
tuition programs, either as prepaid tuition or as savings plans. In a 
prepaid tuition plan, participants attempt to hedge against tuition 
inflation by purchasing tuition credits or certificates on behalf of 
a designated beneficiary. The credits will entitle the beneficiary to 
waive payment of qualified higher education expenses (QHEE) when the 
time arrives for the beneficiary to attend college. With a savings 
plan, participants contribute to an account that is specifically 
established to pay the QHEE of a designated beneficiary. The account 
is generally maintained with a private financial institution such as 
a bank, brokerage firm or mutual fund company that manages it on 
behalf of a particular state. 

When cash distributions from a QTP exceed QHEE, part of the earnings must be included in gross income. A number of states already exempt from state income taxes the earnings on qualified QTP distributions. Many more states will exempt earnings because they use the federal definition of gross income as their starting point, making QTPs even more valuable.

Example. Tom makes a one-time deposit of $50,000 to a QTP account for his 4-year-old son Jonah who will begin attending college at age 18. At a tax-free 8% growth rate, the QTP balance grows to $146,860 in 14 years, of which $96,860 is accumulated earnings. Under the new law, none of the earnings is subject to federal income tax (or, possibly, state income tax) if Jonah uses the money for QHEE. Under prior law (assuming a 15% tax rate for Jonah), the federal income tax would have been $14,529.

The act eliminates a requirement that states impose a more than de minimis penalty. Instead, a 10% federal tax applies to the earnings portion of nonqualified QTP distributions included in gross income in the same manner as the penalty imposed on nonqualified education IRA distributions. …

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