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Education Credits and Deductions: Interaction

By Roy Lewis

Like prescribed medication, there can be some ugly results due to the uninformed interaction between education deductions and credits. So, we'll look at some of those interactions, and provide strategies to avoid potentially deadly (at least financially) combinations.

Education IRAs and HOPE/Lifetime Credits

If a beneficiary excludes from income any amount of an education IRA distribution for a tax year, s/he cannot claim either a HOPE or a Lifetime Learning credit for that tax year.

Example: Peter qualifies for the Lifetime Learning credit. He also has an education IRA account. He needs to pay $2,500 in qualified education expenses. He wants to pay for these education expenses using $300 from his education IRA account (tax-free), and the balance out of his own pocket.

In this example, Peter would not be able to claim the Lifetime Learning credit. Why? Because he excluded $300 from his income via the tax-free education IRA distribution. So, Peter loses the benefit of the Lifetime Learning credit just to save the taxes on the income from the education IRA. If Peter is in the 28% bracket, his tax savings would amount to only $84 on his tax-free education IRA distribution. Not a very good trade-off.

What should Peter do? He might want to waive the income exclusion for the education IRA. Peter would then report the $300 education IRA distribution as income (which would cost him an extra $84 in taxes). But, by waiving the tax-free nature of the education IRA, Peter can claim the Lifetime Learning credit and save $500 in taxes using that credit -- a much better deal.

As a general strategy, whenever possible, students with education IRAs should bunch distributions from their IRAs into years when no higher-education credit is available. Or, at the very least, they should bunch distributions from education IRAs into years when the value of the education IRA exclusion would exceed the maximum available HOPE/Lifetime credits.

Education IRAs and Qualified State Tuition Programs

Making a contribution to a qualified state tuition program (established by a state to allow a person to purchase tuition credits or otherwise pay for higher education) for a beneficiary could cause any amount contributed to an education IRA for that same beneficiary to be subject to a 6% penalty excise tax.

What to do? Make sure, if you participate in a qualified state tuition program, that you don't make any contributions to an education IRA in that same year for that same student.

There are no restrictions on making a contribution to a qualified state tuition program for one student and to an education IRA for a different student. Additionally, there are no restrictions on making a state tuition program contribution (in one year), and an education IRA contribution (the next year) for the same student.

HOPE/Lifetime Credits and Education Deductions

Remember that the HOPE or Lifetime credit cannot be claimed for any education expenses that are otherwise claimed as a business expense.

Example: Paul is qualified to claim the HOPE/Lifetime credit. Paul pays $1,750 in qualified education expenses that maintain/improve his current job skills. Paul can either claim a deduction for these expenses (as an itemized deduction), or he can take the HOPE/Lifetime credit. But he can't claim both the deduction and the credit.

What should Paul do? He must closely review his tax situation and take the largest tax benefit available to him. Generally, a credit is much more valuable than a deduction. In addition, the education deduction would be subject to the 2% AGI limitation for miscellaneous itemized deductions. So, it is very likely that Paul would benefit most from "passing" on the education deduction and claiming the HOPE/Lifetime credit instead. But, only Paul, after a close review of his personal tax situation, will be able to make that determination.

HOPE Credit and Lifetime Credit for the Same Student

Remember that the HOPE and Lifetime credits can't be claimed in the same tax year for the same student. But, claiming the HOPE credit in one year doesn't prevent a taxpayer from claiming the Lifetime credit in other years for qualifying expenses paid in that same tax year. In addition, if there are two students involved, there is no restriction from claiming the HOPE credit for the first student and claiming the Lifetime credit for the second student.

Example: Peter and Mary have two children in college. The first student is a freshman and the second student is a junior. Assuming that all of the other requirements have been met for each credit, Peter and Mary can claim the HOPE credit for the first student's expenses and the Lifetime credit for the second student's expenses.

Please remember that, until tax-year 2003 (when the maximum Lifetime credit increases to $2,000), the HOPE credit will always produce the larger credit. After year 2002, the Lifetime credit will produce a larger credit than the HOPE if qualified tuition and expenses for the tax year exceed $7,500. So, plan the use of your credits wisely.

HOPE/Lifetime Credits and Drug Problems

Remember that, while the HOPE credit is not allowed for a student who has been convicted of a federal or state drug felony, there is no such restriction for the Lifetime credit. So, even if the HOPE credit is not available (because of drug problems), the student can still qualify for the Lifetime credit.

While there are other twists and turns regarding the interaction between the various education credits and deductions, these are the major issues that will impact most people. The key to claiming any education credits or deductions is understanding the law and making the best choices allowable.