New tax breaks for educational expenses, thanks to tax legislation over the past several years, can provide hundreds and sometimes thousands of dollars of tax reduction off the total tax bill of families, not only for children in college or graduate school, but also for parents to pursue further education and training to help them at work. These new tax breaks - started in 1997 and expanded by 2001 and 2002 tax legislation - often require coordination.

Many of the new education tax breaks are complicated. Maximizing the benefits from these new deductions, credits, exclusions and opportunities for tax-free savings often requires careful planning, particularly because of the interrelationship between many of the rules. Although the Internal Revenue Service has provided additional guidance during the past several years to help taxpayers comply with many of the rules, some of these new IRS procedures have actually complicated matters in some circumstances.  

The primary tax breaks carved out for education include the following:

Education tax credits. These consist of two separate credits: the "HOPE" scholarship credit of up to $1,500 per year per student for tuition and fees for each of the first two years of college, and the Lifetime Learning credit that is worth up to $2,000 per year beginning in 2003 (up from $1,000 for 1998-2002) per year for an unlimited number of years for college juniors, seniors, graduate students or working Americans pursuing job skill training. Employees will benefit from the new Lifetime Learning credit since it includes tuition and related expenses in connection with any course of instruction at an eligible educational institution to acquire or improve job skills. The benefits of the credits begin to get "phased out" for couples with more than $83,000 in adjusted gross income ($41,000 for singles) for 2003 (as adjusted for inflation each year). The credits apply to qualified tuition and related expenses of the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer for whom a personal exemption can be claimed. Some tricky rules on course-load levels and covered expenses apply.

Deduction for higher education expenses. Starting in 2002, Congress introduced an above-the-line deduction for qualified tuition and related expenses. As the law is now written, this deduction is temporary, ending after 2005. Eligible expenses may be for the taxpayer, his or her spouse or dependents. No business connection needs to be proved to be entitled to this deduction. The amount of the deduction depends upon the taxpayer's adjusted gross income (AGI) and the tax year in which the deduction is taken:

• In 2002 and 2003, the deduction is limited to $3,000, for taxpayers with AGI not exceeding $65,000 for singles, $130,000 for joint returns;
• In 2004 and 2005, the deduction is limited to $4,000, for taxpayers with AGI not exceeding $65,000 for singles, $130,000 for joint returns; and
• In 2004 and 2005, the deduction is limited to $2,000, for taxpayers whose AGI exceeds the $65,000/$130,000 limit but does not exceed $80,000 if filing as a single, $160,000 if filing jointly.

If the HOPE education credit or the lifetime learning credit is taken by the taxpayer or any other person with respect to the student, the higher education expense deduction cannot be taken. However, the education credits phase-out between $41,000 - $51,000 for single taxpayers and between $83,000 and $103,000 for joint filers (as inflation adjusted for 2003), are far lower than the $130,000/ $160,000 upper limits for the new higher education deduction.

Section 529 plans. Changes in the law now extends "section 529" qualified tuition programs to private institutions of higher learning in addition to continuing to cover state programs. An eligible educational institution generally includes colleges, universities, vocational schools or other post-secondary educational institutions. In addition, distributions from state programs, even to the extent of earnings, are now entirely tax-free to the extent used for qualified higher education expenses. Beginning in 2004, this tax-free treatment will be available for distributions from private college and university programs. Investment gains before those dates are taxed to the student.

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Education savings accounts. The maximum annual contribution to an education savings accounts (formerly education IRAs) has been increased from $500 to $2,000, starting in 2002. This limit continues to be applied per beneficiary, rather than per contributor. Parents can still maximize benefits, however, by transferring older siblings' accounts for use by a younger brother, sister or first cousin, thereby maximizing the tax-free growth period.

The phase-out amounts of adjusted gross income allowed for a contributor to an education account has been raised, effective beginning for 2002 tax year contributions, to eliminate the "marriage penalty" for joint filers, from $150,000-$160,000 to $190,000-$220,000.

Amounts in education savings accounts may now also be used for K-12 tuition and related expenses, as well as for higher education expenses. However, if a student is college bound, it nevertheless usually will make more sense to retain amounts in the account until college so earnings can continue to be compounded tax-free for the longest period of time permitted.

Employer-provided educational assistance exclusion. The '01 Tax Act made permanent the employee exclusion of up to $5,250 of employer-provided education assistance paid under an employer's qualified educational assistance program. Excludable education allowances from an employer need not be related to the employee's current job. Graduate-level courses have been covered, thanks to a recent change in the law, since 2002.

Deduction for interest on education loans. Student loan interest of up to $2,500 a year is deductible each year whether or not a taxpayer itemizes deductions. The deduction begins to "phase out" based on AGI above $100,000 ($50,000 for singles). However, the rules can be tricky. Only those legally obligated to make the loan payments may deduct them. Students who are claimed as dependents on their parents' return are also foreclosed from taking this deduction.

Other beneficial education incentives include penalty-free withdrawals from retirement IRAs for higher education expenses and expanded tax-free treatment for state prepaid tuition plans. Undoubtedly, some of these provisions will be more important to you than others, depending upon personal circumstances.