Saving With Education

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KLEINROCK
Saving with Education

Tax Incentives
Contributions by:
L. Edward O’Hara, Jr., CFP, EA
Capital Asset Management Services
12510 Prosperity Drive, Suite 150
Silver Spring, MD 20904-1663
(301) 680-0840
Copyright © 2005 by Kleinrock Publishing. All rights reserved.
ISBN 1-933221-05-4
Kleinrock Publishing
11300 Rockville Pike
Suite 1100
Rockville MD 20852
1-800-678-2315
www.kleinrock.com
Contents
Introduction ........................................................................................................................1
Mixing and Matching the Education Tax Incentives........................................................1
About This Handbook ......................................................................................................2
Quick Answers ....................................................................................................................3
Coverdell Education Savings Accounts ............................................................................5

Generally ..........................................................................................................................5
Contributions ...................................................................................................................8
Limitations and Reductions .........................................................................................8
Excess Contributions .................................................................................................10
Distributions...................................................................................................................12
Qualified Education Expenses .......................................................................................13
Qualified Higher Education Expenses .......................................................................14
Qualified Elementary and Secondary Education Expenses .......................................16
Additional Tax ................................................................................................................17
Rollover and Change of Beneficiary ..............................................................................17
Qualified Tuition Programs (529 Plans) .........................................................................19

Generally ........................................................................................................................19
Designated Beneficiaries ................................................................................................21
Qualified Higher Education Expenses ...........................................................................21
Income Tax Treatment of Distributions and Rollovers ..................................................23
Estate and Gift Tax Treatment of Contributions ............................................................27
Additional Tax ................................................................................................................29
529 Plan Requirements ..................................................................................................30
Plan Sponsors .............................................................................................................30
Cash Contributions ....................................................................................................31
Separate Accounting ..................................................................................................31
No Investment Direction ............................................................................................32
No Pledging of Interest as Security ...........................................................................33
Safeguards Against Excess Contributions .................................................................33
Hope Scholarship and Lifetime Learning Credits ........................................................35

Generally ........................................................................................................................35
Hope Scholarship Credit ................................................................................................38
Lifetime Learning Credit ...............................................................................................39
Rules Applicable to Both Credits ...................................................................................41
Phaseouts....................................................................................................................41
Qualified Expenses.....................................................................................................42
Eligible Institution and Academic Period ..................................................................45
ii
Claiming a Credit for a Dependent ............................................................................46

Third-Party Payments ................................................................................................48
Joint Return Required of Married Taxpayers .............................................................49
Non-Resident Aliens ..................................................................................................50
Credit Recapture ........................................................................................................50
Reporting ...................................................................................................................52
Deduction for Qualified Higher Education Expenses ...................................................53

Generally ........................................................................................................................53
Qualified Expenses.........................................................................................................54
Deduction Limits ...........................................................................................................55
Timing of Deduction ......................................................................................................57
Business Deductions for Educational Expenses ............................................................59

Generally ........................................................................................................................59
Maintaining or Improving Skills ....................................................................................60
Meeting Requirements of Employer or Law ..................................................................61
Non-Deductible Education Expenses ............................................................................62
Qualifying for a New Trade or Business ....................................................................62
Minimum Education Requirements ...........................................................................63
Transportation and Travel Expenses ..............................................................................64
Use of Tax-Exempt Income to Pay for Education ..........................................................65
Claiming the Deduction .................................................................................................66
Exclusion for Bond Interest Income ...............................................................................67

Generally ........................................................................................................................67
Limit Based on Qualified Expenses ...............................................................................70
AGI Phaseout .................................................................................................................71
Scholarships and Fellowships ..........................................................................................73

Generally ........................................................................................................................73
Compensation for Services ............................................................................................75
General Rules .............................................................................................................75
Scholarships Granted by Employer ............................................................................77
Record-Keeping Requirements ......................................................................................79
Qualified Tuition Reduction Programs ..........................................................................81

Generally ........................................................................................................................81
Non-Discrimination Requirement..................................................................................82
Compensation for Services ............................................................................................84
iii
Educational Assistance Programs ...................................................................................85

Generally ........................................................................................................................85
Maximum Exclusion ......................................................................................................86
Educational Assistance...................................................................................................87
Non-Discrimination Requirements ................................................................................88
Reporting Requirements ................................................................................................89
Student Loan Interest Deduction....................................................................................91

Generally ........................................................................................................................91
Qualified Loans ..............................................................................................................93
Reporting .......................................................................................................................96
Financial Aid.....................................................................................................................99
Financial Need ...............................................................................................................99
Cost of Attendance .....................................................................................................99
Expected Family Contribution .................................................................................101
Effect of Education Tax Incentives on EFC .............................................................105
Types of Federal Financial Aid ....................................................................................106
Pell Grants ................................................................................................................106
Supplemental Educational Opportunity Grants (SEOGs) .......................................107
Work-Study Programs ..............................................................................................107
Perkins Loans ...........................................................................................................107
Stafford Loans ..........................................................................................................107
Parent Loans for Undergraduate Students (PLUS Loans) .......................................109
Leveraging Education Assistance Partnership (LEAP) Programs ...........................109
Robert C. Byrd Honors Scholarship Program .........................................................110
Planning and Practice ....................................................................................................111

Determining Appropriate Contribution Amounts for 529-Plan Accounts ...................111
Examples ..................................................................................................................112
Example 1 – Saving for Infant’s Future College Costs ........................................112
Example 2 – Saving for Teenager’s Future College Costs ...................................113
Example 3 – Required Savings for Less Expensive Schools ...............................114
Use of Education Tax Incentives During the
College Years – A Comprehensive Example ............................................................118
Client Letter – Saving for College Expenses ...............................................................121
Major Education Tax Incentives After EGTRRA ........................................................122
2004 Annual Limits and Phaseout Ranges...................................................................123
Expenses Covered by Education Tax Incentives ..........................................................124
State 529 Plan Contact Information .............................................................................125
States Offering Income Tax Deductions for Contributions to
Their 529 Plan(s)......................................................................................................129
iv
Sample Election Statement to Treat Contributions to a 529 Plan as

Made Over a Five-Year Period .................................................................................130
Sample Election to Recognize Current Income on Non-Interest Bearing
Discount Bonds Under Code Section 454 ...............................................................131
Sample Statement for Automatic Consent of Accounting Method
Change upon Redemption of Savings Bonds ...........................................................132
Financial Aid Tables for Dependent Students ..............................................................133
Income Protection Allowance for 2004-2005 Award Year .......................................133
Business/Farm Net Worth Adjustment for 2004-2005 Award Year ..........................133
Social Security Tax Allowance for 2004-2005 Award Year ......................................133
Education Savings and Asset Protection Allowance for
2004-2005 Award Year .........................................................................................134
Parents’ Contribution from AAI for 2004-2005 Award Year ....................................135
State and Other Taxes Allowance (Parents Only) for 2004-2005
Award Year ...........................................................................................................135
State and Other Taxes Allowance (Students Only) for 2004-2005
Award Year ...........................................................................................................136
State Higher Education Agencies.................................................................................137
Byrd Scholarship Program State Education Agency Contact List ...............................143
Introduction
For the 2003-2004 academic year, the average annual cost of tuition, fees, room, and board for
an undergraduate student at a four-year public college or university was $10,636. At a private
four-year college or university, the average annual cost was $26,854.1 At an increase of 8.6
percent for public schools and 5.7 percent for private schools over the year before, the cost of a
college education once again has risen at an annual rate far exceeding the rate of inflation. Since
higher education costs are expected to continue rising at a rapid rate, the total cost for obtaining
an undergraduate degree for a child born in 2003 will easily exceed $100,000 when incidental
costs such as books, supplies, transportation costs, and personal expenses are included. To ease
the financial burden on taxpayers who are trying to put their children through college or further
their own education, the Internal Revenue Code (Code) offers a diverse mix of tax incentives
designed to help taxpayers save for and pay educational expenses.
The education tax incentives provide savings from the time a child is born until well after he com-
pletes his education and come in the form of deductions, credits, and exclusions. For instance,
parents and grandparents (and others) can begin saving for a child’s education immediately after
birth using either a 529-plan account or a Coverdell education savings account (Coverdell ESA).
Earnings in both these accounts grow tax free, and distributions from the accounts are excluded
from income to the extent they are used to pay for certain education expenses. When the child
enters college, whoever is paying the tuition bills may be able to claim the Hope credit, lifetime
learning credit, or deduction for higher education expenses (a.k.a. the tuition deduction). A busi-
ness deduction is also available if the grown child furthers his education to maintain or improve
work skills, meet certain requirements of his employer, or retain his salary or job status. Certain
exclusions are also available for income used to pay for the child’s education expenses, such as
the exclusions for interest income from U.S. Savings Bonds, scholarship and fellowship grants,
payments under a school’s qualified tuition reduction program, and benefits provided under an
employer’s qualified education assistance program. Finally, a deduction is provided for interest
payments on loans taken out to pay for the child’s higher education costs. Since this deduction
is available for as long as loan interest payments are being made, it can be taken years after the
child graduates.
Mixing and Matching the Education Tax Incentives

Many of the education tax incentives are interdependent – so claiming a benefit under one incen-
tive may reduce (or even eliminate) the availability of other incentives. This forces taxpayers to
carefully pick and choose the tax incentives they want to use. For example, the exclusions for
distributions from Coverdell ESAs and 529 plans are not available for distributions used to pay
for expenses that are taken into account in determining a Hope or lifetime learning credit and
1
College Board (Oct. 2003).
2 Saving with Education Tax Incentives
are further reduced by the amount of any tax-exempt scholarship, veterans’ or military personnel
education assistance, or other payments for the student’s education that are excluded from gross
income (e.g., employer-provided assistance).
The Hope credit, lifetime learning credit, student loan interest deduction, tuition deduction, sav-
ings bond interest exclusion, and business deduction for educational expenses are also reduced
by the amount of any tax-exempt scholarship, veteran/military assistance, and other excluded
payment. In addition, neither credit can be used if a tuition deduction or business deduction
for education expenses is claimed (and the tuition deduction cannot be used if either credit is
claimed).
In addition to the reductions stated above, the student loan interest deduction and the tuition
deduction are decreased by the amount of any excluded Coverdell ESA or 529 plan distribution,
U.S. Savings bond interest, or education assistance program payment. The business deduction
for educational expenses is also reduced by exclusions for U.S. Savings bond interest and educa-
tion assistance program payment, while the savings bond interest exclusion is cut back for the
amount of educational expenses taken into account in claiming one of the education tax credits
or excluding distributions from a Coverdell ESA or 529 plan.
About This Handbook

This Kleinrock handbook, Saving with Education Tax Incentives, is designed to provide easy-
to-find answers and guidance concerning the various Code provisions offering education-related
tax benefits. Chapters dealing with Code provisions designed to help taxpayers save for college
(Coverdell ESAs and 529 plans) are presented first. The credits (Hope and lifetime learning
credits) and deductions (tuition deduction and business expense deduction) used during the
college years are discussed next, followed by discussions on the various exclusions for amounts
used to pay for education expenses (U.S. Savings Bond interest, scholarships and fellowships,
qualified tuition reduction program payments, and educational assistance program benefits).
The student loan interest deduction, which is generally claimed beyond the college years, is then
discussed. Special sections offering planning advice (“planning pointers”) and information on
financial aid (“financial aid considerations”) appear throughout these chapters.
We have also included chapters that provide quick answers to frequently asked questions; de-
scribe the different federal financial aid programs and explain how a student’s need for financial
aid is determined; and offer additional planning and practice information (e.g., advice on de-
termining how much to contribute to a 529 plan, details about state 529 plans, a comprehensive
example showing how to use various available education tax incentives, a sample client letter,
charts comparing the various education tax incentives, sample election statements, and informa-
tion on calculating financial aid eligibility).
The information contained in this handbook reflects changes in the law through October 4,
2004.
Quick Answers
Who can make contributions to a 529 plan or Coverdell ESA––
Any “person” can contribute to a 529 plan or Coverdell ESA. This includes individuals, corpo-
rations, companies, partnerships, associations, trusts, and estates. However, the $2,000 per year
contribution limit for Coverdell ESAs is phased out for individuals with modified AGI between
$95,000 and $110,000 (between $190,000 and $220,000 for joint filers). The phase-out rules do
not apply, however, to corporations and other entities. There are no annual contribution limits
for 529 plans.
Are parents penalized if they make contributions to a Coverdell ESA and a 529 plan on
behalf of the same child in the same year?
No, contributions may be made to both a Coverdell account and a Section 529 plan in one year
on behalf of the same beneficiary. In addition, tax-free distributions from both a Coverdell ESA
and a 529 plan can be taken in the same year. However, if the total distributions exceed the
beneficiary’s qualified higher education costs for the year (after reduction by amounts used in
claiming the Hope or lifetime learning credit), the beneficiary must reasonably allocate the ex-
penses between the distributions to determine the amount includible in income.
Can a tax credit be claimed for the costs of a single college course?
Yes. The lifetime learning credit is available for qualified expenses relating to any course at an
eligible educational institution if it is taken to acquire or improve the student’s job skills (i.e.,
students in school solely for personal, non-business purposes cannot claim the credit). Unlike
the Hope scholarship credit, which is only available if the student is enrolled at an eligible edu-
cational institution on at least a half-time basis, a student may take just one course and claim the
lifetime learning credit.
How much in employer-provided educational assistance can be excluded from an employ-
ee’s gross income?
An employee can exclude up to $5,250 for amounts paid or expenses incurred by her employer
for assistance furnished under a qualified educational assistance program. In addition, tuition
reductions offered by schools to teachers and staff are excluded from gross income if provided
under a qualified tuition reduction program. Finally, although generally taxable, scholarships
awarded under employer-related programs can be excluded from the recipient’s gross income
under certain conditions.
How many states offer state income tax deductions for contributions to their own
529 plans?
Twenty-four states offer deductions (as of September 30, 2004). They are: Colorado, Georgia,
Idaho, Illinois, Iowa, Kansas, Louisiana, Maryland, Michigan, Mississippi, Missouri, Montana,
Nebraska, New Mexico, New York, Ohio, Oklahoma, Oregon, Rhode Island, South Carolina,
Utah, Virginia, West Virginia, and Wisconsin.
Is it true that the deduction for qualified higher education expenses (the “tuition deduc-
tion”) expires soon?
Yes. Unless extended by Congress, the tuition deduction is only available for payments made
from 2002 to the end of 2005.
Is a student’s ability to obtain federal financial aid affected by use of the education tax
incentives?
It can be. Most federal financial aid is awarded on the basis of financial need, which is equal to
the difference between the student’s “cost of attendance” (COA) at a particular college or uni-
versity and her “expected family contribution” (EFC). A dependent student’s EFC is equal to
the sum of her parents’ contribution (based on income and assets), her own contribution from
income, and her own contribution from assets. Since the four main components of the EFC
formula (parents’ income, parents’ assets, student’s income, and student’s assets) are weighted
differently, education tax incentives can affect a student’s eligibility for financial aid to the extent
that they increase or decrease the income or assets of the parents or the student. For example,
Coverdell ESAs are treated as an asset of the student – even if the account is opened and funded
by the parents. Therefore, 35 percent of the account balance is counted toward the student’s EFC.
If the account were considered an asset of the parents, no more than 5.64 percent of the account
balance would be counted toward the student’s EFC (the lower the EFC, the greater the chance
of receiving financial aid).
Can I claim a tax credit or deduction for tuition payments to my child’s private high
school?
No, but you can use funds from a Coverdell ESA to pay for certain elementary and secondary
education expenses (including private or religious schools). Expenses that can be paid for with
tax-free distributions from a Coverdell ESA include tuition, fees, academic tutoring, books,
supplies, special need services, and other equipment necessary for the enrollment or attendance
at the school. Coverdell ESA distributions can also be used to purchase computers and internet
access for an elementary, middle, or high school age child. No other education tax incentive may
be used to save for or pay elementary or secondary school costs.
Can unused Hope or lifetime learning credits be carried forward to subsequent years?
No carryforward of unused education tax credits or excess qualified education expenses is per-
mitted.
Coverdell Education Savings

Accounts
Generally
Coverdell education savings accounts (Coverdell ESAs)1 are special accounts that allow taxpay-
ers to save for certain education expenses on a tax-advantaged basis. Up to $2,000 per year can
be contributed to one or more Coverdell ESAs on behalf of a single designated beneficiary. See
Contributions, p. 9. Contributions to Coverdell ESAs are not deductible; however, the account
itself is not subject to tax, so earnings grow without tax, and distributions from the accounts are
not taxed as long as they are used to pay for qualified expenses.2 See Distributions, p. 13; Quali-
fied Education Expenses, p. 15. Distributions that are not used for such expenses are included
in the income of the person to whom they are distributed and are also subject to a 10 percent
additional tax.3 See Additional Tax, p. 18. Although a Coverdell ESA is not subject to federal
income taxes, it can be subject to the tax on unrelated business income.4
PRACTICE TIP: The designated beneficiary does not have to be the child of the con-
tributor or even related to the contributor. Any friend, as well as the beneficiary himself,
can establish and contribute to a Coverdell ESA.
OBSERVATION: The rules governing Coverdell ESAs are applied without regard to
any community property laws.5
The amount that may be contributed each year to a Coverdell ESA is limited, reduced, and even-
tually denied for individuals above certain modified adjusted gross income (AGI) levels. See
Limitations and Reductions, p. 10. However, corporations and other entities may make contribu-
tions to Coverdell ESAs regardless of their income level during the year of the contribution.6
A Coverdell ESA is actually a trust created or established in the United States for the exclusive
purpose of paying the qualified education expenses of an individual designated beneficiary. To
qualify as a Coverdell ESA, the trust must be created by a written instrument and be designated
as such at its creation. It may have no purpose other than to pay for qualified educational ex-
penses of a designated beneficiary.7 See Qualified Education Expenses, p. 15.
The trust must also meet specific requirements and comply with specific restrictions to qualify
as a Coverdell ESA. For instance, the written instrument creating the trust must provide that:8
1
Coverdell ESAs were originally called education individual retirement accounts (education IRAs).
2
Code Section 530(d)(2).
3
4
Code Section 530(a). See Kleinrock’s Analysis and Explanation, Ch. 477, for a discussion of the unrelated
business income tax.
5
Code Section 530(f)
6
Code Section 530(c)(1).
7
Code Section 530(b)(1).
8
(1) The designated beneficiary must be an individual;

(2) No contribution may be accepted unless it is in cash;
(3) No contributions may be accepted after the date on which the beneficiary becomes
18, except with respect to any designated beneficiary with special needs;9
(4) Contributions on behalf of any one beneficiary for the taxable year are limited in the
aggregate to $2,000;
(5) The trustee must be a bank or other person who meets certain U.S. Treasury
Department standards;10
(6) No part of the trust assets may be invested in life insurance contracts;
(7) No part of the trust assets may be commingled with other property except in a com-
mon trust fund or investment fund; and
(8) Except with respect to any designated beneficiary with special needs, any balance
in the account to the credit of the designated beneficiary on the date on which the
beneficiary attains age 30 must be distributed within 30 days after that date to the
beneficiary or, if the beneficiary dies before attaining age 30, must be distributed
within 30 days after the death of the beneficiary.
PRACTICE TIP: The negative consequences of requirement number (8) above can be
avoided by rolling the account over to a family member or naming a new beneficiary
before the beneficiary reaches age 30. See Rollover and Change of Beneficiary, p. 19.
COMPLIANCE TIP: The IRS has provided model agreements that satisfy these re-
quirements and have been automatically approved by the IRS. These model agreements
can be used to establish a Coverdell ESA as either a trust (Form 5305-E, Coverdell Edu-
cation Savings Trust Account) or a custodial account (Form 5305-EA, Coverdell Educa-
tion Savings Custodial Account).
A trustee or custodian of a Coverdell ESA must make reports to the IRS and to the beneficiary
with respect to contributions, distributions, and other matters as required by the IRS.11 Con-
tributions, including rollover contributions, are reported on Form 5498-ESA, Coverdell ESA
Contribution Information. Gross distributions, and the earnings and the basis portions of the
distributions, are reported on Form 1099-Q, Payments From Qualified Education Programs (Un-
der Sections 529 and 530). Distributions that are reportable include transfers from the Coverdell
ESA to a qualified tuition program (see Qualified Tuition Programs (529 Plans), p. 22) and
trustee-to-trustee transfers from one Coverdell ESA to another. A trustee or custodian may pro-
vide the statements electronically.12
9
Congress intends that IRS regulations will define a special needs beneficiary to include an individual who, be-
cause of a physical, mental, or emotional condition (including a learning disability) requires additional time to
complete his education. H. Conf. Rep. 107-84, 107th Cong., 1st Sess. 152 (2001).
10
A custodial account (such as a bank account established for a child) may qualify even though not a trust as long
as it meets the other requirements. Code Section 530(g).
11
Code Section 530(h).
12
Notice 2004-10, 2004-6 I.R.B. 433.
Coverdell Education Savings Accounts 7
COMPLIANCE TIP: To allow additional time for trustees and custodians to imple-
ment recordkeeping procedures to enable them to report basis and earnings information,
the IRS has made modifications to the reporting requirements to remain in effect until
further guidance is issued.13 If a trustee or custodian is unable to calculate the earnings
and basis portions of a distribution from a Coverdell ESA, the reporting requirements
nevertheless will be satisfied if the Form 1099-Q includes:
(1) Gross distributions, including the amount of any excess contributions and earnings
thereon distributed to a participant during the calendar year, in Box 1;
(2) All other required information except for earnings and basis information in Boxes 2
and 3, which should be left blank unless the gross distribution includes a distribution
of earnings on excess contributions;
(3) The amount of any earnings on excess contributions in Box 2, computed using the
method for calculating the net income attributable to IRA contributions that are
distributed as a returned contribution under Notice 2000-39, 2000-2 C.B. 132, and
Regulation Section 1.408-11;
(4) If earnings on excess contributions are reported in Box 2, an indication in the empty
box below Boxes 5 and 6 that the amount in Box 2 includes earnings on excess con-
tributions;
(5) The fair market value of the Coverdell ESA as of the end of the calendar year, in the
empty box below Boxes 5 and 6; and
(6) A cross reference in the empty box below Boxes 5 and 6 to Publication 970, Tax Ben-
efits for Education, as provided in the instructions to Form 1099-Q, so that recipients
will know how to calculate the earnings portion of the gross distribution.
If the trustee or custodian does not have records indicating whether a gross distribution from
a Coverdell ESA was a trustee-to-trustee transfer, the trustee or custodian may leave Box 4 of
Form 1099-Q blank.
✔ FINANCIAL AID CONSIDERATIONS

A Coverdell ESA is treated as an asset of the student in computing the expected family contribu-
tion (EFC). See Financial Aid, p. 107, for a general discussion of the federal financial aid sys-
tem. As a result, Coverdell ESAs are assessed at a 35 percent rate for purposes of determining
the student’s contribution from assets. In addition, when the student receives distributions from
a Coverdell ESA, the earnings portion of the distributions are chargeable to the student’s income
for purposes of determining EFC (assessed at a 50 percent rate) in the following year (which
reduces the student’s ability to receive financial aid in that year).
13
Notice 2003-53, 2003-2 C.B. 362.
However, allowing Coverdell ESA distributions to be used for elementary and secondary school
expenses enables taxpayers to obtain several years of tax-free income on investments and then
deplete the account by paying elementary and secondary educational expenses before the child
applies for college financial aid.
Contributions
A person may contribute up to $2,000 to Coverdell ESAs on behalf of each beneficiary in any
taxable year.14 Generally, contributions are taken into account for the year in which they are
made. Contributions made by individuals are deemed to have been made on the last day of the
preceding year if the contribution is made on account of that preceding year and is made by the
due date of the individual’s return for that preceding year (not including extensions). Thus, cal-
endar-year individual taxpayers (but not corporations or other entities) can make contributions
for a year as late as April 15 of the following year.15
PRACTICE TIP: Since individual taxpayers are allowed to make contributions for a
year as late as April 15 of the following year, tax practitioners can advise their clients
on whether to contribute to a Coverdell ESA in conjunction with the preparation of their
returns.
Contributions to the account are treated as completed gifts to the beneficiary for purposes of the
estate and gift tax. Consequently, a gift tax is not due on the contribution unless the contributor’s
aggregate gifts to the beneficiary exceed the gift tax exclusion in a given year. Further, to the
extent the contribution may exceed the exclusion, it may be taken into account ratably over the
subsequent five-year period.16
Limitations and Reductions

The $2,000 limit pertains to the total amount that may be contributed for one taxable year to all
accounts for the benefit of any one beneficiary, not to the amount that any one contributor may
contribute. Thus, if several contributors contribute to one or more Coverdell ESAs set up for a
particular beneficiary, their total contributions to all those accounts on that beneficiary’s behalf
for the taxable year are limited to $2,000. Amounts rolled over into an account from another
Coverdell ESA are not subject to this limitation.
OBSERVATION: The $2,000 contribution limit is not indexed for inflation.
Even if an individual is the only contributor to the Coverdell ESAs for a particular beneficiary,
the maximum amount an individual contributor may contribute may be reduced below the limit,
eventually to the point where a contribution is prohibited altogether, if the individual’s modified
adjusted gross income (AGI) reaches certain levels. Modified adjusted gross income is gross
income plus any amounts excluded from gross income as foreign earned income or income from
sources within Guam, American Samoa, the Northern Mariana Islands, or Puerto Rico.17
14
Code Section 530(b)(1)(A)(iii).
15
16
17
Code Section 530(c).
Generally, the amount that can be contributed is reduced for individuals with modified AGI
over $95,000, and contributions are completely prohibited for individuals with modified AGI of
$110,000 or higher (in the case of a joint return, the corresponding dollar amounts are $190,000
and $220,000).18 Individuals whose modified AGI is between the two phase-out levels must fig-
ure their contribution limit by multiplying the $2,000 limit by a fraction, and then subtracting the
result from the applicable limit. The fraction’s numerator is the amount by which the individual’s
modified AGI exceeds the lower phase-out level, and the denominator is the amount by which
the upper phase-out level exceeds the lower phase-out level.
EXAMPLE: John, a calendar-year taxpayer, is single and has modified adjusted gross
income of $96,500 for 2004. John can contribute up to $1,800 for 2004 for each of his
designated beneficiaries. John determines this limit by first calculating the appropriate
fraction:
$96,500 – $95,000 $1,500 1

–––––––––––––––– = ––––––– = –––
$110,000 – $95,000 $15,000 10
Then John multiplies the $2,000 limit by 1/10, which equals $200. Finally, John sub-
tracts the $200 from the $2,000 limit, which gives him a reduced limit of $1,800.
COMPLIANCE TIP: The Instructions for Form 8606, Nondeductible IRAs and
Coverdell ESAs, contain a worksheet that can be used to compute the amount an indi-
vidual can contribute.
Corporations and other entities, including tax-exempt organizations, are allowed to make con-
tributions to Coverdell ESAs. However, only contributions made by individuals are subject to
reduction based on modified AGI.19
PRACTICE TIP: High-income taxpayers who control corporations or other entities
may want to have these entities make contributions to avoid the modified AGI limita-
tion. However, the tax consequences of doing so are not entirely clear. The corporation
or other entity should be able to deduct the contributions as fringe benefit expenses, to
the extent otherwise allowable. However, the contributions probably would have to be in-
cluded in income either by the individual on whose behalf they are made, or, more likely
if the contributions are made in connection with the provision of services, the employee
or other person who provides the services in connection with which the contribution is
made.
18
19
✔ PLANNING POINTERS
Since there is no limitation on who can make contributions to a Coverdell ESA on behalf of any
individual, taxpayers who are prevented from making a contribution to a Coverdell ESA for a
child because of the modified AGI limitations can have other individuals make contributions on
behalf of the child or other beneficiaries, and can even make cash gifts to those individuals to
make the contributions possible.
EXAMPLE: George and Suzanne are married taxpayers with two children, Cindy
and Randy. They file a joint return and have modified adjusted gross income equal to
$240,000 in 2004. George and Suzanne cannot make contributions to Coverdell ESAs on
behalf of either child, because their modified adjusted gross income exceeds $220,000.
However, other relatives, such as grandparents, can make contributions for Cindy and
Randy, if their modified adjusted gross income permits. Alternatively, George and Su-
zanne could give Cindy and Randy each $2,000 and have them make the contributions
for themselves.
There is also nothing to prevent a parent from making a gift to her child under the Uniform Gifts
to Minor Act (UGMA) or the Uniform Transfers to Minor Act (UTMA) and, in turn, having the
child contribute the UGMA or UTMA funds to a Coverdell ESA.
Furthermore, since neither the beneficiary’s modified AGI nor the contributor’s modified AGI
when the funds are distributed is relevant, Coverdell ESAs are particularly valuable for couples
who have their children before they reach their peak earning years.
EXAMPLE: Sam and Diane, who are married and have a modified AGI of $100,000,
make $2,000 contributions for each of their two children (one 12 and one 8) in 2004, and
continue doing so for each of the next four years. In 2009, their modified AGI has in-
creased to $250,000, so that they are no longer eligible to make contributions. However,
when they use the distributions in 2009 to pay their older child’s tuition, the tax-favorable
treatment is available, regardless of their modified AGI.
Excess Contributions
If contributions in excess of the permitted amount are made to a Coverdell ESA in any taxable
year, a tax is imposed in the amount of 6 percent of the amount of the excess contribution deter-
mined as of the close of the taxable year.20 The tax must be paid by the holder of the account. The
tax is imposed in each year that the excess contribution remains in the account, not just in the
year that the contribution is made. The amount of excess contributions for any one beneficiary
is the total of the following amounts:
20
Code Section 4973(a).
(1) The amount by which the total contributions for the beneficiary for the taxable year
exceeds $2000, or, if less, the amount by which the total contributions for the benefi-
ciary for the taxable year exceeds the sum of the maximum amount each contributor
is allowed to contribute for the year under the modified AGI limit; and
(2) The amount determined to be an excess contribution for the preceding taxable year,
reduced by distributions out of the account and the excess (if any) of the maximum
amount that may be contributed for the taxable year over the amount contributed for
the year.21
PRACTICE TIP: Since excess contributions are defined in terms of aggregate amounts
contributed on behalf of the beneficiary, rather than in terms of amounts contributed by
one individual, a contributor to a Coverdell ESA can inadvertently cause an account to
be subject to the tax on excess contributions by not being aware of other contributions
to the same account. Therefore, anyone wishing to establish a Coverdell ESA for a child
should first check to see if other contributions to Coverdell ESAs on behalf of the child
have been made by other taxpayers.
Since the existence of an excess contribution is determined as of the close of a year, the tax on
excess contributions may be avoided if the excess amount is returned before the close of the
year. In addition, a contribution made during a taxable year will not be counted in determining
whether an excess contribution exists at the close of that taxable year if the contribution is dis-
tributed before June 1 of the following taxable year. However, the distribution must include any
income attributable to the excess contribution, and that income must be included in the income
of the contributor.22
COMPLIANCE TIP: Coverdell ESA beneficiaries should receive Form 5498-ESA,
Coverdell ESA Contribution Information, showing the amount contributed during the
year on their behalf. If the total amount contributed – as shown on all Form 5498-ESAs
received – exceeds $2,000, the excess contributions should be withdrawn before June 1
as described above.
COMPLIANCE TIP: A taxpayer who is subject to the penalty must file Form 5329,
Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.
Form 5329 generally is filed with Form 1040. A taxpayer who is not required to file a tax
return must file Form 5329 where and when Form 1040 would be required to be filed.
Finally, rollover contributions do not trigger the excess-contributions tax.23 See Rollover and
Change of Beneficiary, p. 19.
21
Code Section 4973(e)(1).
22
Code Section 4973(e)(2)(A).
23
Code Section 4973(e)(2)(B).
Distributions
A distribution is potentially included in the income of the beneficiary only to the extent it ex-
ceeds the contributions to the account.24 Since contributions are not deductible when made, tax
has already been paid on the amount contributed. Therefore, in effect, any tax that must be paid
on a distribution is paid only on the earnings of the account. To achieve this effect, distributions
from a Coverdell ESA are deemed to consist of pro rata shares of contributions and earnings.25
Thus, the portion of a distribution that is treated as paid from contributions is determined by
multiplying the distribution by the ratio that the total amount of contributions bears to the bal-
ance of the account at the time that the distribution is made.26
EXAMPLE 1: Joyce receives a $2,000 distribution from a Coverdell ESA. On the dis-
tribution date, the total account balance is $10,000, consisting of $6,000 in contributions
and $4,000 in earnings. The portion of the $2,000 distribution that is treated as a non-
taxable return of contributions is $1,200 ($2,000 × $6,000 ÷ $10,000). If Joyce’s quali-
fied education expenses are at least $2,000, then the $800 of earnings are also excludable
from income.
Any distribution from a Coverdell ESA is excluded from the income of the designated benefi-
ciary if that person’s qualified education expenses for the year (see Qualified Education Ex-
penses, p. 15) are equal to or more than the aggregate amount of the distributions in that year. If
the distributions exceed the expenses, the amount of the distributions that would otherwise be
included in income is reduced by an amount that bears the same ratio as the qualified education
expenses bear to the aggregate amount of the distributions.27
EXAMPLE 2: Same facts as in Example 1, except that Joyce’s qualified higher educa-
tion expenses are only $1,500. In that case, Joyce may exclude only $600 from income
($800 × 1,500 ÷ $2,000). Joyce must include the remaining $200 in income.
COMPLIANCE TIP: The beneficiary of a Coverdell ESA must file Form 8606, Nonde-
ductible IRAs and Coverdell ESAs, in any year in which he receives a distribution. Form
8606 is filed with Form 1040, 1040A, or 1040NR, or, if the beneficiary is not otherwise
required to file a tax return, it is filed at the same time or place Form 1040, 1040A, or
1040NR would be.
In determining if Coverdell ESA distributions exceed qualified expenses, the amount of quali-
fied expenses is reduced by any amount excluded from the beneficiary’s income as scholarships
or similar payments, as well as by any amount taken into account in determining the amount
of the Hope scholarship credit or lifetime learning credit. See Hope Scholarship and Lifetime
Learning Credits, p. 39. In addition, if the distributions from a Coverdell ESA and a 529 plan
exceed the amount of qualified expenses, the taxpayer must allocate the expenses between the
distributions from the two types of programs. See Qualified Tuition Programs (529 Plans), p. 21.
24
25
26
Code Section 72(e)(8)(B).
27
Code Section 530(d)(2)(A), (B).
If any qualified higher education expenses are taken into account in determining the amount of
the exclusion for a distribution from a Coverdell ESA, no other deduction, exclusion, or credit
will be allowed with respect to such expenses.28
In addition to the regular tax, a 10 percent additional tax generally applies to a distribution that
is included in income.29 See Additional Tax, p. 18. However, a distribution from a Coverdell
ESA that is includible in gross income solely because the student’s qualified higher education
expenses were reduced by an amount representing expenses used to claim an education credit is
not subject to the additional tax.30
COMPLIANCE TIP: Except with respect to any designated beneficiary with special
needs,31 any balance in the account to the credit of the designated beneficiary on the date
on which the beneficiary attains age 30 must be distributed within 30 days after that date
to the beneficiary or, if the beneficiary dies before attaining age 30, must be distributed
within 30 days after the death of the beneficiary.32 Any change in the beneficiary of a
Coverdell ESA is not treated as a distribution if the new beneficiary is a family member
of the prior beneficiary and, unless a beneficiary with special needs, has not reached the
age of 30.33 Distributions from any Coverdell ESA are reported on Form 1099-Q, Pay-
ments from Qualified Education Programs (Under Sections 529 and 530).
CAUTION: A Coverdell ESA is disqualified if the account owner is engaged in certain
prohibited transactions, generally involving an improper use of the account.34 In that
case, the entire account is treated as distributed on the first day of the taxable year in
which the prohibited transaction takes place. Furthermore, if an account owner uses
a Coverdell ESA as security for a loan, any portion of the account that is assigned or
pledged by the owner (or agreed to be assigned or pledged) is treated as a distribution to
the owner.35
Qualified Education Expenses

Coverdell ESAs can only be created to pay the “qualified education expenses” of the designated
beneficiary.36 Qualified education expenses includes both qualified higher education expenses
and qualified elementary and secondary education expenses.37
28
Code Section 530(d)(2)(C), (D).
29
Code Section 530(d)(4)(A).
30
Code Section 530(d)(4)(B)(v).
31
According to Congress, a special needs beneficiary is an individual who, because of a physical, mental, or emo-
tional condition (including a learning disability) requires additional time to complete his education. H. Conf. Rep.
107-84, 107th Cong., 1st Sess. 156 (2001).
32
Code Section 530(b)(1)(E).
33
34
See Code Section 4975 for the transactions triggering disqualification.
35
Code Section 530(e).
36
37
Code Section 530(b)(2)(A).
Qualified Higher Education Expenses

Qualified higher education expenses are defined as tuition, fees, books, supplies, and equipment
required for the enrollment or attendance of the designated beneficiary at an eligible educational
institution.38
OBSERVATION: An “eligible educational institution” is any college, university, voca-
tional school, or other post-secondary educational institution that is described in section
481 of the Higher Education Act of 1965 (20 U.S.C. 1088) and, therefore, eligible to
participate in the student aid programs administered by the Department of Education.
This definition includes virtually all accredited public, nonprofit, and proprietary post-
secondary institutions (including many foreign institutions).39
Reasonable room and board expenses incurred by students attending an eligible institution on at
least a half-time basis are also considered qualified higher education expenses. However, room
and board expenses are limited to the greater of (1) the student’s allowance for room and board
included in the costs of attendance for purposes of calculating federal financial aid,40 or (2) in
the case of a student living in housing owned or operated by an eligible educational institution,
the actual amount the institution charges the student for room and board.41
PRACTICE TIP: Room and board expenses must actually be paid in order to be treated
as qualified higher education expenses. Thus, presumably, a student living at home can-
not claim room and board expenses as education expenses unless he actually pays his
parents for the costs of housing and feeding the student. Proper records should be main-
tained to substantiate the claimed room and board expenses.
Qualified higher education expenses also include expenses of a “special needs beneficiary” that
are necessary in connection with his enrollment or attendance at the eligible educational insti-
tution.42 According to Congress, a special needs beneficiary is an individual who, because of
a physical, mental, or emotional condition (including a learning disability) requires additional
time to complete his education.43
Finally, contributions to a 529 plan on behalf of the Coverdell ESA’s designated beneficiary are
treated as qualified higher education expenses. Thus, distributions from a Coverdell ESA may be
used to participate in a 529 plan without having to include the amount distributed in income.44
The amount of qualified higher education expenses available for purposes of excluding Coverdell
ESA distributions from gross income is also reduced by certain amounts. For instance, the
amount of qualified higher education expenses is reduced by any tax-free scholarship, certain
veterans’ or member of the armed forces’ educational assistance under Title 38 of the U.S. Code,
or any other payment (except a gift, bequest, devise, or inheritance) used for the student’s edu-
cational expenses that is excludable from gross income (such as employer-provided educational
38
Code Section 530(b)(2)(A)(i).
39
Code Section 530(b)(3); Notice 97-60, 1997-2 C.B. 310.
40
Costs of attendance is defined in 20 U.S.C. 108711, as in effect on June 7, 2001.
41
42
43
H. Conf. Rep. 107-84, 107th Cong., 1st Sess. 156 (2001).
44
Code Section 530(b)(2)(B).
assistance).45 In addition, if a taxpayer claims a Hope scholarship or lifetime learning credit and
the Coverdell ESA distribution income exclusion, the amount of qualified higher education ex-
penses available to be paid with a distribution from a Coverdell ESA is reduced by the amount
of such expenses that were taken into account in determining the credit allowed to the taxpayer
or any other person.46
EXAMPLE: Mark enrolls as a freshman at State University in 2004 and must pay $3,000
in fees and other qualified expenses. He withdraws $1,000 from a Coverdell ESA (which
has a balance before the withdrawal of $5,000, consisting of $4,500 in contributions and
$500 in earnings), and his parents pay the remaining $2,000. Mark’s parents can use the
$2,000 they pay to claim a $1,500 Hope credit (the credit is equal to 100 percent of the
first $1,000 of tuition and 50 percent of the next $1,000). After subtracting the $2,000
used to determine the Hope credit from the total expenses, $1,000 in expenses remain.
Thus, Mark can exclude the full amount of the $1,000 from income.
Normally, if the total of qualified expenses is less than the amount for which an education credit
is claimed plus the amount withdrawn from the Coverdell ESA, a portion of the income distrib-
uted from the Coverdell ESA is included in income and subject to a 10 percent additional tax.
However, the additional tax does not apply if the distribution is included in income solely be-
cause the student’s qualified higher education expenses were reduced by an amount representing
expenses used to claim an education credit.47
EXAMPLE: Adam enrolls as a freshman at State University in 2004 and must pay
$2,500 in fees and other qualified expenses. His parents pay $2,000 and Adam withdraws
$1,000 from a Coverdell ESA (which has a balance before the withdrawal of $5,000,
consisting of $4,500 in contributions and $500 in earnings). Adam’s parents can claim
the full $1,500 Hope credit. However, after subtracting the $2,000 used to determine
the Hope credit from the total expenses, only $500 in expenses remains. Since Adam
withdrew more than this amount from his account, the excess is not considered to have
been withdrawn to pay qualified expenses, and the income portion (equal to 1/10, or
$500/$5,000) of the excess $500 is included in income, resulting in a taxable amount of
$50. However, the additional 10 percent penalty tax does not apply.
PRACTICE TIP: By electing not to claim a Hope or lifetime learning credit,48 the
taxpayer can avoid the potential tax attributable to the qualifying expenses being ab-
sorbed by the credits. However, since the qualifying expenses for the Hope scholarship
and lifetime learning credits are not identical to the qualifying expenses for Coverdell
ESAs, distributions from a Coverdell ESA might not be adversely affected by claiming
the credits.
45
Code Section 530(d)(2)(C)(i)(I).
46
Code Section 530(d)(2)(C)(i)(II).
47
Code Section 530(d)(4)(B)(v).
48
See Code Section 25A(e).
Qualified Elementary and Secondary Education Expenses

Qualified elementary and secondary education expenses include expenses for tuition, fees, aca-
demic tutoring, special need services, books, supplies, and other equipment incurred in connec-
tion with the enrollment or attendance of the beneficiary at a public, private, or religious school
providing elementary or secondary education (kindergarten through grade 12) as determined
under state law.49 Qualified elementary and secondary education expenses also include expenses
for room and board, uniforms, transportation, and supplementary items or services (including
extended day programs) required or provided by such a school in connection with such enroll-
ment or attendance of the beneficiary.
EXAMPLE: John, who is 9 years old, is enrolled in an after-school care program pro-
vided by his elementary school. Because John’s mother does not work, John’s parents
cannot claim the child care credit.50 However, John’s parents can use distributions from a
Coverdell ESA to pay for the program. The distributions are tax free whether or not both
of John’s parents are working.
In addition, expenses for the purchase of any computer technology or equipment (including
software, peripheral equipment, and fiber optic cable related to computer use) or internet access
and related services are considered qualified elementary and secondary education expenses if
the technology, equipment, or services are to be used by the beneficiary and the beneficiary’s
family during any of the years the beneficiary is in school. Computer software primarily involv-
ing sports, games, or hobbies is not considered a qualified elementary and secondary school
expense unless the software is predominantly educational in nature.
EXAMPLE: When Eric is three years old, his parents established a Coverdell ESA.
When he is eight years old, Eric’s parents withdraw enough money from the account
to purchase a computer and printer that the entire family uses. The proceeds from the
Coverdell ESA distribution are used for qualified education expenses.
Some taxpayers might not want to set up Coverdell ESAs to pay for higher education out of con-
cern that it might reduce their child’s financial aid eligibility. See Financial Aid Considerations,
p. 9. However, parents who are not inclined to use a Coverdell ESA to save for future college
costs should at least contribute sufficient amounts so that accrued tax-free earnings can be used
to make future home computer purchases and to pay for internet access costs. Currently, to
purchase a non-business-related home computer for $1,000, a taxpayer in the 28 percent federal
income tax bracket and 7 percent state income tax bracket must earn $1,539, and pay $539 in
federal and state income tax to have $1,000 available to purchase a computer. Using a Coverdell
ESA to make a similar computer purchase in the future will avoid the $539 federal and state
income tax liability.
49
50
See Code Section 21. See Kleinrock’s Analysis and Explanation, Ch. 53, for a discussion of the child care
credit.
Additional Tax
In addition to the tax on the income, a 10 percent additional tax generally applies to any distribu-
tion from a Coverdell ESA that is included in income (i.e., any distribution in excess of qualified
higher education expenses for the year).51 There are, however, several exceptions to this rule. For
instance, the additional tax will not apply if the distribution is:
(1) To the estate of a beneficiary after the beneficiary’s death;
(2) Attributable to the disability of the beneficiary;
(3) Made on account of a qualified scholarship, educational assistance allowance, or
other education-related payment excluded from income under any law of the United
States as long as the distribution does not exceed the amount of the scholarship, al-
lowance, or payment;
(4) Made on account of the attendance of the designated beneficiary at the United States
Military, Naval, Air Force, Coast Guard, or Merchant Marine Academies, to the ex-
tent that the amount of the distribution does not exceed the costs of advanced educa-
tion attributable to the attendance;
(5) Includible in gross income solely by application of the rule requiring a reduction
of qualified higher education expenses by the amount of such expenses that were
taken into account in determining the Hope scholarship or lifetime learning credit
allowed to the taxpayer or any other person (see Qualified Higher Education Credits,
p. 15).52
In addition, the 10 percent tax will not apply to the distribution of a contribution made during
a tax year if the contribution is returned before the first day of the sixth month of the following
tax year. For example, for calendar-year taxpayers, the 10 percent additional tax will not apply
to a distribution of a contribution made in 2004 if that contribution is withdrawn (with earnings)
by May 31, 2005.53
COMPLIANCE TIP: A taxpayer who is subject to the penalty must file Form 5329,
Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.
Form 5329 generally is filed with Form 1040. However, a taxpayer who is not required
to file a tax return must file Form 5329 where and when Form 1040 would be required
to be filed.
Rollover and Change of Beneficiary

A distribution from a Coverdell ESA is not included in the income of the beneficiary if the
amount is rolled over into another Coverdell ESA within 60 days after the distribution. For the
rollover exclusion to apply, the second account must be for the benefit of either the same benefi-
ciary or a member of the family of the first beneficiary. Generally, the rollover beneficiary must
not have attained age 30 by the rollover date. Only one such rollover is allowed each year.54
51
Code Section 530(d)(4)(A).
52
Code Section 530(d)(4)(B).
53
Code Section 530(d)(4)(C).
54
Similarly, a change in a Coverdell ESA’s beneficiary will not be treated as a distribution to be

included in income as long as the new beneficiary is a member of the family of the prior benefi-
ciary and has not attained age 30 by the date of the change.55
PRACTICE TIP: Both rollovers and changes in beneficiaries can be used to avoid taxa-
tion if a beneficiary does not use the full balance of an account for educational expenses
before attaining age 30, when amounts remaining in the account must be distributed.
PRACTICE TIP: The age 30 limitations under both the rollover rule and the change-
in-beneficiary rule do not apply to any designated beneficiary with special needs. Gener-
ally, an individual who, because of a physical, mental, or emotional condition (including
a learning disability) requires additional time to complete his education should be con-
sidered a special needs beneficiary.56
For purposes of the rollover and change-in-beneficiary provision, the following relatives of the
original beneficiary are treated as “members of the family”:
(1) Spouse;
(2) Son or daughter (or the descendant of either);
(3) Stepson or stepdaughter;
(4) Brother, sister, stepbrother, or stepsister;
(5) Father or mother (or the ancestor of either);
(6) Stepfather or stepmother;
(7) Nephew or niece;
(8) Uncle or aunt;
(9) Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-
in-law;
(10) Spouse of any of relative listed in (2) through (9) above;
(11) First cousin.57
OBSERVATION: The inclusion of first cousins in the list of eligible family members
allows grandparents who contribute to a Coverdell ESAs to move the funds among their
grandchildren.
A transfer of an interest in a Coverdell ESA to a spouse or former spouse as a result of a decree
of divorce or separation, or to a spouse or other family member as a result of death in which
the surviving spouse or family member is the designated beneficiary, is not a taxable transfer.
Instead, the spouse or family member will be treated as the new account holder.58
55
56
Code Section 530(b)(1); H. Conf. Rep. 107-84, 107th Cong., 1st Sess. 156 (2001).
57
Code Sections 529(e)(2); 530(d)(5), (6).
58
Qualified Tuition Programs (529

Plans)
Generally
Like Coverdell ESAs, 529 plans (formally known as a “qualified tuition programs”)1 provide
tax benefits for taxpayers saving for certain higher education expenses. See Qualified Higher
Education Expenses, p. 21, for a discussion of covered expenses. These plans are not established
by individuals. Instead, they are established and maintained by a state (or an agency or instru-
mentality of a state) or an eligible educational institution,2 and taxpayers make contributions
to individual accounts for the benefit of designated beneficiaries.3 See State 529 Plan Contact
Information, p. 125, for a list of state-sponsored 529 plans. Although contributions to 529 plan
accounts are not deductible, earnings on the contributions are not taxed as they accumulate
and distributions from an account are generally excluded from the beneficiary’s income.4 See
Income Tax Treatment of Distributions and Rollovers, p. 23. Contributions to 529 plans can be
made by an individual, corporation, partnership, association, trust, or estate.5
The main tax advantage of 529 plans (when compared to Coverdell ESAs) is that the ability to
make contributions is not phased out as the taxpayer’s adjusted gross income increases or re-
stricted by annual contribution limits. In addition, they also provide state tax benefits in many
instances.
PRACTICE TIP: The same federal tax rules govern all state plans, but each state’s plan
has unique features and investment options. For instance, several states offer income
tax deductions for contributions made to their plans. See States Offering Income Tax
Deductions for Contributions to Their 529 Plan(s), p. 129. To compare the various state
529 plans in terms of state tax benefits, covered expenses, non-resident eligibility, fee
structures, maximum or minimum contribution limits, enrollment periods, and various
other factors, go to www.savingforcollege.com.
There are two types of 529 plans – prepaid tuition plans and savings plans. Under a prepaid tu-
ition plan, a taxpayer pays a prospective student’s eligible higher education expenses in advance
with contributions to an account established by the taxpayer. The prepayment amounts are gen-
erally based on current higher education costs and are invested by the plan’s administrator. The
state or educational institution sponsoring the plan guarantees that the account funds will cover
certain educational expenses when the student attends college – regardless of the actual costs or
the success of the investments. This low-risk option allows taxpayers to lock into current tuition
and fee rates for a student who expects to attend college in the future.
1
Before 2002, 529 plans were formally known as “qualified state tuition programs.”
2
Private colleges and universities, as well as public educational institutions, can establish certain 529 plans. H. Rep.
107-84, 107th Cong. 1st Sess. (2001).
3
4
Code Section 529(c)(1), (3).
5
Prop. Reg. Section 1.529-1(c); Code Section 7701(a)(1).
CAUTION: A number of states, including Colorado, Kentucky, Ohio, Texas, and West
Virginia, have suspended enrollment in their prepaid tuition programs because of a com-
bination of rising costs and plummeting investments. In states where programs have
been suspended, individuals with money already invested in prepaid plans are being
allowed to keep the funds in the program or are being offered other investment options.
Individuals contemplating participation in such a program should check with the state
agency involved to explore the continuing viability of the program.
Under a savings plan, which can only be sponsored by a state, the taxpayer still makes contribu-
tions to an account and the contributions are still invested by the plan administrator. However,
there is no guaranty that the amount in the account will meet the student’s actual educational ex-
penses when the student attends college. Instead, the taxpayer relies on the success of the invest-
ments (which could either exceed or fall below the rate of increase in educational expenses) to
grow the account. See Determining Appropriate Contribution Amounts for 529-Plan Accounts,
p. 111.
PRACTICE TIP: Most state-sponsored 529 plans allow contributions from existing
Uniform Gifts to Minor Act (UGMA)/Uniform Transfers to Minor Act (UTMA) ac-
counts. However, special restrictions often accompany 529 plan accounts funded with
UGMA/UTMA assets. For example, rollovers to another beneficiary may be prohibited
and the minor/beneficiary usually becomes the account holder when she turns 18. Fur-
thermore, because contributions to a 529 plan must be made in cash (see Cash Contri-
butions, p. 31),6 investments in UGMA/UTMA accounts must be liquidated, which is
generally a taxable transaction, in order to invest the proceeds in a 529 plan account.
If a student is using a 529 plan to pay for educational expenses, the student or the student’s par-
ents may also claim a Hope credit or a lifetime learning credit for qualified expenses covered by
the 529 plan if the other eligibility requirements for the credits are met (but only to the extent
the 529 plan distribution is used for different educational expenses).7 See Planning Pointers, p.
26. In addition, contributions can be made to both 529 plans and Coverdell ESAs for a single
beneficiary in the same year. Distributions from a Coverdell ESA can also be used to make con-
tributions to a 529 plan (although the basis in the contract establishing the 529 plan account is
not increased for any portion of a contribution that is made with a non-taxable distribution from
a Coverdell ESA).8

A 529 savings plan is treated as an asset of the account owner in computing the expected family
contribution (EFC). The EFC is subtracted from the cost of attendance (COA) to determine a
6
7
Code Section 529(c)(3)(B)(v); Notice 97-60, 1997-2 C.B. 310.
8
Qualified Tuition Programs (529 Plans) 21
student’s financial need. See Financial Aid, p. 99, for a general discussion of the federal financial
aid system.
If a student’s parent is the owner of a 529 savings plan account, it is assessed at the parent’s as-
set rate (maximum rate of 5.64%). However, if the student is the owner of the account, it is as-
sessed at the student’s asset rate (35%). If a savings plan account is owned by anyone else (e.g.,
a grandparent), the account assets will not increase the EFC, since it is not included in either the
parent’s or the student’s asset base.
CAUTION: If a savings plan is funded with assets owned or deemed to be owned by
the student, such as assets held in a UGMA/UTMA account, the plan is treated as the
student’s asset and assessed at the 35 percent rate.
No taxable income is generated when the funds from a 529 savings plan are withdrawn. How-
ever, to the extent they consist of plan earnings, distributions from a savings plan are chargeable
to the student’s income for purposes of determining EFC (assessed at a 50 percent rate). This
reduces the student’s ability to receive financial aid in later years.
Prepaid tuition plans are not treated as an asset of either the parent or the student in calculating
EFC. However, colleges often include it as an asset in computing the student’s financial need. In
any event, tuition credits generated by the account reduce the student’s cost of attendance and,
therefore, any financial aid on a dollar-for-dollar basis.
Designated Beneficiaries
Contributions to a 529 plan must be made on behalf of a designated beneficiary. The beneficiary
must be designated at the commencement of participation in the program, although there may
be a change in beneficiaries. See Income Tax Treatment of Distributions and Rollovers, p. 23,
for a discussion of tax-free beneficiary changes. If a state or local government or a tax-exempt
organization purchases an interest in a 529 plan as part of a scholarship program it operates, the
individual receiving the scholarship is the designated beneficiary.9
OBSERVATION: There are no restrictions on who qualifies as the designated benefi-
ciary. The beneficiary does not have to be a dependent or even a relative of the account
owner. Even the account owner can be the beneficiary.
Qualified Higher Education Expenses

Only distributions from a 529 plan for the payment of the beneficiary’s qualified higher educa-
tion expenses are excluded from the beneficiary’s gross income. Qualified higher education
expenses are defined as tuition, fees, books, supplies, and equipment required for enrollment or
attendance at an eligible educational institution.10
9
10
Code Section 529(e)(3)(A)(i).

CAUTION: Distributions from 529 plans cannot be used to pay for elementary or sec-
ondary education expenses. Coverdell ESAs are the only vehicle that can be used to save
for these expenses. See Coverdell Education Savings Accounts — Qualified Elementary
and Secondary Education Expenses, p. 16.
Qualified expenses also include expenses of a special needs beneficiary that are necessary in
connection with his enrollment or attendance at the eligible educational institution.12 According
to Congress, IRS regulations should define a special needs beneficiary to include an individual
who, because of a physical, mental, or emotional condition (including a learning disability) re-
quires additional time to complete his education.13
Reasonable room and board expenses incurred by students attending an eligible institution on
at least a half-time basis are also considered qualified higher education expenses.14 What is con-
sidered “reasonable” can vary from plan to plan. However, under any 529 plan, room and board
expenses are limited to the greater of (1) the student’s allowance for room and board included in
the “costs of attendance” for purposes of calculating federal financial aid if the student lives off-
campus or at home,15 or (2) the actual amount the institution charges the student for room and
board if the student lives in housing owned or operated by an eligible educational institution.16
PRACTICE TIP: Room and board expenses must actually be paid in order to be treated
as qualified higher education expenses. Thus, presumably, a student living at home can-
not claim room and board expenses as education expenses unless he actually pays his
parents for the costs of housing and feeding the student. Proper records should be main-
tained to substantiate the claimed room and board expenses.
The total amount of qualified higher education expenses available for purposes of the exclusion
of 529 plan distributions are reduced if certain other tax benefits or educational funding tech-
niques are used. For instance, a designated beneficiary’s qualified higher education expenses are
reduced by the amount of any expense taken into account for purposes of claiming the Hope
credit or lifetime learning credit, even if the credit is claimed by another person (see Planning
Pointers, p. 26). Reductions for tax-free scholarships, certain educational assistance for vet-
erans or member of the armed forces, or any other payment (except a gift, bequest, devise, or
inheritance) used for the student’s educational expenses that is excludable from gross income
11
Code Section 529(e)(5); Notice 97-60, 1997-2 C.B. 310.
12
Code Section 529(e)(3)(A)(ii).
13
H. Conf. Rep. 107-84, 107th Cong., 1st Sess. 156 (2001).
14
Code Section 529(e)(3)(B)(i).
15
Costs of attendance is defined in 20 U.S.C. 108711, as in effect on June 7, 2001.
16
Code Section 529(e)(3)(B)(ii).
(e.g., employer-provided educational assistance) are also required.17 Furthermore, tax-free dis-
tributions from both a Coverdell ESA and a 529 plan can be taken in the same year. However,
if the total distributions exceed the beneficiary’s qualified higher education expenses for the
year (after reduction by amounts used in claiming the Hope credit or lifetime learning credit),
the beneficiary is required to allocate the expenses between the distributions to determine the
amount includible in income (as explained on p. 26).18
Income Tax Treatment of Distributions and Rollovers

Distributions from a 529 plan are excluded from the beneficiary’s income to the extent the distri-
bution is used to pay for qualified higher education expenses.19 See Qualified Higher Education
Expenses, p. 21, for a discussion of covered expenses.
CAUTION: The exclusion did not apply to distributions from 529 plans established
and maintained by educational institutions made in any taxable year beginning before
January 1, 2004.20 Distributions in such a year from plans sponsored by educational
institutions were subject to tax under the annuity rules. Thus, that portion of the distribu-
tion (including any benefit furnished to the beneficiary) that represented earnings on the
account was taxed.
In applying this exclusion, the amount of a beneficiary’s qualified higher education expenses for
a taxable year is reduced by:
(1) Any tax-free educational assistance received, including any tax-free scholarship, cer-
tain educational assistance for veterans or member of the armed forces, or any other
payment (except a gift, bequest, devise, or inheritance) used for education expenses
that is excludable from gross income; and
(2) The amount of any education expenses taken into account in calculating any Hope
credit or lifetime learning credit allowed to the taxpayer or any other person.21
If a cash distribution exceeds the beneficiary’s qualified higher education expenses, the amount
included in income is reduced by an amount that bears the same ratio to that amount as the ex-
penses bear to the distributions.22
EXAMPLE: Diane is the beneficiary of a 529 plan account. The account balance is
$10,000, consisting of $6,000 in contributions and $4,000 in earnings. Diane incurs
$5,000 in qualified higher education expenses, but takes a cash withdrawal of $6,000
from the plan. Four-tenths ($4,000/$10,000) of each distribution is subject to tax, since
4/10 of the amount in the account is earnings. Thus, the amount that would be included
in income if none of the $6,000 distribution were used to pay qualified expenses is
$2,400 (4/10 of $6,000). In addition, the ratio of the expenses to the distribution is 5/6
17
Code Section 529(c)(3)(B)(v).
18
Code Section 529(c)(3)(B)(vi).
19
Code Section 529(c)(3)(B).
20
Code Section 529(c)(3)(B)(iii).
21
Code Section 529(c)(3)(B)(v).
22
Code Section 529(c)(3)(B)(ii).
($5,000/$6,000). Consequently, since Diane’s distribution exceeds her qualified higher

education expenses, $400 is included in income. This equals $2,400 (the amount that
would otherwise be included) minus 5/6 of $2,400 (or $2,000).
No amount is included in income when a beneficiary receives a distribution consisting of the
provision of a benefit that, if paid for by the beneficiary, would be considered payment of a quali-
fied higher education expense.23
In addition, if a taxpayer receives distributions from a Coverdell ESA and a 529 plan in the same
year, and the total distributions exceed the total amount of qualified higher education expenses
that could otherwise be taken into account for purposes of the 529 plan exclusion, the taxpayer
must allocate the expenses among the distributions in calculating the amount excludable as a
distribution from a 529 plan and the amount excludable as a distribution from a Coverdell ac-
count.24
OBSERVATION: There is no indication as to how this allocation is to be made – unlike
the provisions that coordinate the education credits with the rule on Coverdell ESAs,
there is no ordering provision. However, Congress has stated that it expects the IRS to
exercise its authority to require reporting of the amount of distributions and the earn-
ings portions of distributions (taxable and non-taxable) from 529 plans and Coverdell
ESAs25 in order to facilitate, among other things, the allocation rules for excess distri-
butions.26 This would allow taxpayers to make the allocations based on the relative ratios
of the withdrawals. The IRS already requires information reporting by each officer or
employee (or their designee) having control of a 529 plan. Items that must be reported
include gross distributions and the amount of earnings distributed.27 These items are re-
ported on Form 1099-Q, Qualified Tuition Program Payments (Under Sections 529 and
530). See Form 1099-Q and Instructions, p. 156. In addition, 529 plans are required to
determine the earnings portion of each distribution as of the date of distribution.28
Tax-free rollovers of a distribution may be made to the account of another designated benefi-
ciary if the new beneficiary is a member of the original beneficiary’s family.29 The rollover must
be made within 60 days after the distribution. For purposes of the family member rollover provi-
sion, the following relatives of the original beneficiary are treated as family members:
(1) Spouse;
(2) Son or daughter (or the descendant of either);
(3) Stepson or stepdaughter;
(4) Brother, sister, stepbrother, or stepsister;
(5) Father or mother (or the ancestor of either);
23
Code Section 529(c)(3)(B)(i).
24
Code Section 529(c)(3)(B)(vi).
25
See Code Sections 529(d), 530(h).
26
See H. Rep. 107-84, 107th Cong. 1st Sess. (2001).
27
Code Section 529(d)(3); Prop. Reg. Section 1.529-4.
28
Notice 2001-81, 2001-2 C.B. 617.
29
Code Section 529(c)(3)(C)(i)(II).
(6) Stepfather or stepmother;

(7) Nephew or niece;
(8) Uncle or aunt;
(9) Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-
in-law;
(10) Spouse of any of relative listed in (2) through (9) above; and
(11) First cousin.30
Similarly, a change in the designated beneficiary of a 529 plan account is not treated as a tax-
able distribution if the new beneficiary is a member of the original beneficiary’s family (see the
list of qualifying family members above).31 Unless the new beneficiary is of the same or higher
generation as the old beneficiary and is a member of the family of the old beneficiary, however,
a transfer by a rollover or a change in beneficiary is subject to the gift tax (and, until its repeal,
the generation-skipping transfer tax).32
PRACTICE TIP: The inclusion of first cousins in the list of eligible family members
allows grandparents who contribute to a 529 plan to move the funds among their grand-
children.
COMPLIANCE TIP: A 529 plan must report trustee-to-trustee rollovers between pro-
grams on Form 1099-Q, Qualified Tuition Program Payments (Under Sections 529 and
530). See Form 1099-Q and Instructions, p. 156. In addition, the transferring program
must provide the recipient program with a statement setting forth the earnings portion
within the earlier of the 30 days after the transfer or January 10 of the following calendar
year.33 Form 1099-Q should not be filed for a change in the beneficiary if the new benefi-
ciary is a member of the former beneficiary’s family.
Tax-free rollovers from one 529 plan to another 529 plan established for the same designated
beneficiary are permitted if the rollover is made within 60 days of a distribution. However, only
one such rollover is allowed within any 12-month period.34 This rule permits transfers between
prepaid tuition plans and savings plans, as well as transfers from a plan sponsored by one state
to a plan sponsored by another state. However, the one-rollover-per-year limit prevents the use of
multiple rollovers to circumvent the rules against allowing contributors or beneficiaries to direct
the investment of any contribution to a 529 plan account. See No Investment Direction, p. 32.
CAUTION: Where a person is the designated beneficiary of more than one 529 plan
account, all rollovers made by the various account owners must be carefully monitored
to avoid multiple rollovers within any 12-month period. For instance, if a child is the
designated beneficiary of two 529 plan accounts – one opened by his parents and the
other opened by a grandparent – and the grandparent transfers the funds in the account
30
31
Code Section 529(c)(3)(C).
32
33
Notice 2001-81, 2001-2 C.B. 617.
34
Code Section 529(c)(3)(C).
he opened to a different 529 plan account for the child without telling the child’s parents,
any distribution or rollover from the account opened by the parents within the 12-month
period will be subject to taxation.
To ensure that a Hope credit or lifetime learning credit is not claimed for any amount paid with
a 529 plan distribution, the amount of qualified expenses taken into account in determining the
tax treatment of a distribution is reduced by any amount of expense that was taken into account
in determining the education credits claimed by the taxpayer or any other person.35
EXAMPLE: Andrew enrolls as a freshman at Northern University in 2004 and pays
$3,000 in fees and other qualified expenses. He withdraws $1,000 from a 529 plan ac-
count and his parents pay the remaining $2,000. Andrew’s parents can use the $2,000
they pay to claim a $1,500 Hope credit (the credit is equal to 100 percent of the first
$1,000 of tuition and 50 percent of the next $1,000). After subtracting the $2,000 used
to determine the Hope credit from the total expenses, $1,000 in expenses remain. Thus,
Andrew can exclude the full amount of the $1,000 distribution from income.
If a portion of the 529-plan distribution is not used to pay qualified higher education expenses,
and part of the distribution is therefore taxable, the tax can be avoided in some instances by
electing not to claim the Hope credit or lifetime learning credit.36
EXAMPLE: Nicholas enrolls as a freshman at Southern University in 2004 and pays
$2,500 in fees and other qualified expenses. His parents pay $2,000 of these costs. Nich-
olas withdraws $1,000 from a 529 plan account, but uses only $500 of that amount for to
pay for qualified higher education expenses. If Nicholas’ parents use the $2,000 they pay
to claim a Hope credit, only $500 in qualified expenses remains. Thus, since Nicholas
withdrew more than this amount from his account, the excess ($500) is not considered to
have been withdrawn to pay qualified expenses and a portion of the distribution is taxed.
However, if Nicholas’ parents elect not to claim the Hope credit, then the entire $2,500
of education expenses can be used to exclude the 529 plan distribution. In that case, the
entire $1,000 distribution would be excluded since it is less than $2,500.
However, in almost all situations, the full Hope credit or lifetime learning credit should be
claimed, even if it results in a portion of a benefit or distribution from a qualified tuition program
being included in income, since the credit provides a benefit of at least 50 percent of the ex-
penses, while the tax on distributions cannot be more than the top tax rate (35 percent for 2004)
and applies only to the taxable portion of the distribution.
The exclusion from income for distributions from 529 plans is also coordinated with other tax
benefits, as follows:
35
Code Section 529(c)(3)(B)(v); Notice 97-60, 1997-2 C.B. 310.
36
See Code Section 25A(e).
(1) The amount of education expenses taken into account in determining the amount that
can be excluded as a 529 plan distribution and as a Coverdell ESA distribution must
be allocated between the distributions to determine the amount includible in income
if the total distributions exceed the beneficiary’s qualified higher education expenses
for the year;37
(2) The amount of education expenses taken into account in determining the amount
that can be excluded is reduced by any amounts paid with tax-free income, such as
qualified scholarships, educational assistance allowances, or other amounts excluded
from income, other than gifts, bequests, and devises;38
(3) The amount of expenses taken into account in determining the amount of interest on
U.S. Savings Bonds that is excluded from income because it is used to pay for higher
education is reduced by any amount taken into account in determining the exclusion
for distributions from 529 plans (see Exclusion for Bond Interest Income, p. 67);39
(4) The amount of expenses considered incurred for higher education for purposes of
determining the amount of a loan for which the student loan interest deduction is
available is reduced by the amount excluded from gross income by reason of these
expenses (see Student Loan Interest Deduction, p. 91);40
(5) The amount of qualified higher education expenses for which the deduction for these
expenses is allowed is reduced by the amount of expenses taken into account in de-
termining the exclusion from income for distributions for a 529 plan (see Deduction
for Qualified Higher Education Expenses, p. 53). However, the amount taken into
account does not include that portion of the distribution that represents a return of
any contributions to the plan.41
EXAMPLE: A taxpayer receives a distribution of $100 from a 529 plan that is used for
tuition. $90 represents contributions to the account, and $10 represents earnings under
the plan. Qualified expenses would be reduced only by that $10. Thus, the taxpayer
would be entitled to claim the deduction with respect to the $90 representing a return of
contributions. In contrast, if the distribution were from a Coverdell ESA, the $90 would
not be eligible for the deduction.
Estate and Gift Tax Treatment of Contributions

Contributions to a 529 plan are treated as completed gifts to the beneficiary, not as future in-
terests in property.42 As such, the contributions are eligible for the annual gift tax exclusion
amount, which is indexed for inflation (to $11,000 for 2004).43 However, contributions to a 529
37
Code Section 529(b)(3)(B)(vi).
38
Code Section 529(b)(3)(B)(v). See also Code Section 25A(g)(2).
39
Code Section 135(d)(2)(B).
40
Code Section 221(e)(2)(A).
41
42
Code Section 529(c)(2)(A)(i).
43
Code Section 2503(b); Rev. Proc. 2003-85, 2003-2 C.B. 1184. See Kleinrock’s Analysis and Explanation, Section
759.5(a), for a detailed review of the annual gift tax exclusion.
plan are not eligible for the unlimited exclusion for qualified transfers of amounts paid on behalf
of an individual for educational expenses.44
PRACTICE TIP: Tuition paid directly to an educational institution on behalf of a stu-
dent is exempt from gift tax through the unlimited exclusion for qualified transfers.45 The
exclusion is permitted for tuition expenses of full-time or part-time students, but is not
available for amounts paid for books, supplies, dormitory fees, board, or other similar
expenses that do not constitute direct tuition costs.46
OBSERVATION: The portion of a contribution excludable from the gift tax is also ex-
cludable for purposes of the generation-skipping transfer tax.47
If the amount of contributions exceeds the annual exclusion amount, the donor can elect to take
the aggregate amount into account ratably over a five-year period beginning with the calendar
year of the contributions. The election is available for joint gifts by spouses. The election is
limited to contributions not in excess of five times the annual exclusion amount available in the
calendar year of the contributions (i.e., $55,000 in 2004). Any excess is treated as a taxable gift
in the calendar year of the contribution.48
COMPLIANCE TIP: The election is made by checking the box on line B at the top of
Schedule A of Form 709, Federal Gift Tax Return, for the year of the contribution. In
addition, an election statement must be attached to the Form 709. The statement must
include the total amount contributed per individual beneficiary, the amount for which the
election is being made, and the name of the individual for whom the contribution was
made.49 See Planning and Practice — Sample Election Statement to Treat Contributions
to a 529 Plan as Made Over a Five-Year Period, p. 130.
If the annual exclusion amount is increased to account for inflation after the first year of the five-
year period, the donor can make an additional contribution in any one or more of the remaining
years. The additional contribution cannot exceed the difference between the exclusion amount as
increased and the original exclusion amount for the year or years in which the original contribu-
tion was made.50
EXAMPLE: In 2004, Fred makes a contribution of $75,000 to a 529 plan for the ben-
efit of his son. Fred elects to account for the gift ratably over a five-year period. Fred is
treated as making a taxable gift of $20,000 and an excludable gift of $11,000 in each year
from 2004 through 2008. In 2005, when, hypothetically, the annual exclusion amount is
increased to $12,000, Fred makes an additional contribution for the benefit of his
44
Code Section 529(c)(2)(A)(ii). See Kleinrock’s Analysis and Explanation, Section 759.5(b), for a detailed re-
view of the gift tax exclusion for educational expenses.
45
46
Reg. Section 25.2503-6(b)(2). Se e also TAM 199941013, where a grandparent’s payment of $180,000 to a private
school that her grandchildren were attending to cover specified tuition costs qualified for the Code Section 2503(e)
exclusion.
47
Prop. Reg. Section 1.529-5(b)(1).
48
Code Section 529(c)(2)(B); Prop. Reg. Section 1.529-5(b)(2).
49
Prop. Reg. Section 1.529-5(b)(2)(iii).
50
Prop. Reg. Section 1.529-5(b)(2)(iv).
grandson in the amount of $5,000. Fred is treated as making an excludable gift of $1,000
and a taxable gift of $4,000 in that year.
There are no gift tax consequences to rollovers and beneficiary changes if the old and new ben-
eficiaries are members of the same generation. However, if the new beneficiary is one generation
lower, the transfer is treated as a taxable gift by the old beneficiary. When the new beneficiary is
two or more generation lower, generation-skipping rules apply.51
EXAMPLE: In 2004, Jim makes a contribution to a 529 plan on behalf of Holly, his
daughter. In 2007, Jim directs that a distribution from the account established for Holly
be made to an account for the benefit of Holly’s son Ed. The rollover distribution is
treated as a taxable gift by Holly to Ed, because Ed is a generation below Holly.
For estate tax purposes, the gross estate of a decedent generally does not include the value of any
interest in a 529 plan attributable to contributions made by the decedent on behalf of any des-
ignated beneficiary. However, if a taxpayer’s contributions exceed the annual exclusion amount
and he elects to take the aggregate amount into account ratably over a five-year period, that por-
tion of the contribution allocable to calendar years beginning after the taxpayer’s death is includ-
ible in his gross estate if he dies before the close of the five-year period. The gross estate of a
designated beneficiary of a 529 plan account includes the value of any interest in the account.52
Additional Tax
An additional 10 percent tax is imposed on the amount of a distribution from a 529 plan that is
includible in gross income. The additional tax is the same tax, computed in the same way, as the
additional tax that applies to such distributions from Coverdell ESAs. Thus, the amount of the
penalty is equal to 10 percent of the amount that is included in income when a taxpayer receives
a payment or a distribution (or is provided a benefit) under a 529 plan. However, the tax does not
apply if the payment or distribution is made to a beneficiary or a beneficiary’s estate on or after
the beneficiary’s death; is attributable to the beneficiary’s being disabled; is made on account of
a scholarship, allowance, or payment received by the account holder to the extent the amount of
the payment or distribution does not exceed the amount of the scholarship, allowance, or pay-
ment; or is made on account of the attendance of the designated beneficiary at the United States
Military, Naval, Air Force, Coast Guard, or Merchant Marine Academies, to the extent that the
amount of the distribution does not exceed the costs of advanced education attributable to the
attendance. It also does not apply if the amount is included in income because the taxpayer elects
to claim a Hope credit or lifetime learning credit instead of the exclusion for distributions from
a 529 plan.53 See Planning Pointers, p. 26.
OBSERVATION: Conforming the 529 plan penalty to the Coverdell ESA provisions
makes it easier for taxpayers to allocate expenses between the various education tax in-
51
Code Section 529(c)(5)(B); Prop. Reg. Section 1.529-5(b)(3).
52
Code Section 529(c)(4); Prop Reg. Section 1.529-5(d).
53
Code Sections 529(c)(6), 530(d)(4).
centives. For example, a taxpayer who receives distributions from a Coverdell ESA and
a 529 plan in the same year must allocate qualified expenses to determine the amount
excludable from income. A taxpayer also may need to know the amount excludable from
income due to a distribution from a 529 plan in order to determine the amount of ex-
penses eligible for the tuition deduction (see Deduction for Qualified Higher Education
Expenses, p. 53).
Because the exclusion for earnings does not apply to distributions from 529 plans sponsored by
educational institutions made in any taxable year beginning before January 1, 2004, the addi-
tional tax will not apply to any distribution made in such a year that is includible in gross income
despite being used to pay the designated beneficiary’s qualified higher education expenses.54 For
example, the earnings portion of a distribution from a 529 plan sponsored by an educational
institution that is made in taxable year beginning before January 1, 2004, and that is used for the
designated beneficiary’s qualified higher education expenses will not be subject to the additional
tax, even though the earnings are includible in gross income.
529 Plan Requirements
Plan Sponsors
A state (or an agency or instrumentality of a state) or one or more eligible educational institu-
tions can establish and maintain a 529 plan.55 For state-sponsored plans, the state (or its agency
or instrumentality) must be actively involved on an ongoing basis in the administration of the
plan, including supervising all decisions relating to the investment of assets contributed to the
plan.56
OBSERVATION: Factors that are relevant in determining whether a state (or agency
or instrumentality of the state) is actively involved in the administration of a 529 plan
include, but are not limited to, whether it (1) provides services or benefits (such as tax,
student aid, or other financial benefits) to account owners or designated beneficiaries that
are not provided to persons who are not account owners or designated beneficiaries; (2)
establishes detailed operating rules for administering the plan; (3) authorizes its officials
to play a substantial role in the operation of the plan, including selecting, supervising,
monitoring, auditing, and terminating any private contractors that provide services under
the plan; (4) holds the private contractors that provide services under the plan to the same
standards and requirements that apply when private contractors handle funds that belong
to the state or provide services to the state; (5) provides funding for the plan; and (6) acts
as trustee or holds plan assets directly or for the benefit of the account owners or desig-
nated beneficiaries. If the state exercises the same authority over the funds invested in
the plan as it does over the investments in or pool of funds of a state employees’ defined
benefit pension plan, then the state will be considered actively involved on an ongoing
basis in the administration of the plan.
54
55
56
Prop. Reg. Section 1.529-2(b)(2)(ii).
Eligible educational institutions can only establish prepaid tuition plans.57 An “eligible educa-
tional institution” is any college, university, vocational school, or other post-secondary educa-
tional institution that is described in section 481 of the Higher Education Act of 1965 (20 U.S.C.
1088) and, therefore, eligible to participate in the student aid programs administered by the
Department of Education. This definition includes virtually all accredited public, nonprofit, and
proprietary post-secondary institutions (including many foreign institutions).58
The assets of a 529 plan established by one or more educational institutions must be held in a
trust created or organized in the United States for the exclusive benefit of designated beneficia-
ries. The trustee must be a bank or other person who demonstrates that it will administer the trust
in accordance with applicable requirements, and the assets of the trust may not be commingled
with other property except in a common trust fund or common investment fund. In addition,
a plan maintained by an educational institution will not be treated as a 529 plan unless it has
received a ruling or determination from the IRS that the program satisfies applicable require-
ments.59
Cash Contributions
To be treated as a 529 plan, a program must provide that purchases or contributions may only be
made in cash, and not in property.60 Payments by check, money order, credit card, or a similar
method satisfy this requirement.61 Payments made in the form of payroll deductions and auto-
matic deductions from a bank account are considered cash payments.62
OBSERVATION: Because of the cash contributions requirement, investments in
UGMA/UTMA accounts must be liquidated before they can be rolled over into a 529
plan.
Separate Accounting
A 529 plan must provide a separate accounting for each designated beneficiary.63 Separate ac-
counting requires that contributions for the benefit of a designated beneficiary and any earnings
attributable to them must be allocated to the appropriate account.64
In the case of a rollover contribution (such as a transfer from a Coverdell ESA, a transfer of
proceeds from U.S. Savings Bonds, or a transfer from another qualified tuition program), the
recipient plan must determine the basis and earnings part of the amount contributed.65 Final
regulations will clarify that, when accepting a contribution, a 529 plan must ask whether the
contribution is a rollover contribution from a Coverdell ESA, a qualified U.S. Savings Bond,
57
58
Code Section 529(e)(5); Notice 97-60, 1997-2 C.B. 310.
59
Code Section 529(b)(1) (flush language).
60
61
Prop. Reg. Section 1.529-2(d).
62
PLR 9825035.
63
64
Prop. Reg. Section 1.529-2(f).
65
Prop. Reg. Section 1.529-3(a)(2).
or another 529 plan. If it is, the recipient plan must determine the earnings portion of the con-
tribution and add that amount to the earnings recorded in the account to which the roll-over
contribution is made. Until the recipient plan receives appropriate documentation showing the
earnings portion of the contribution, it must treat the entire amount of the contribution as earn-
ings.66
COMPLIANCE TIP: Appropriate documentation for purposes of showing the earn-
ings portion of the contribution means: (1) in the case of a rollover contribution from
a Coverdell ESA, an account statement issued by the financial institution that acted as
trustee or custodian of the account that shows basis and earnings in the account, (2) in
the case of a rollover contribution from the redemption of qualified U.S. Savings Bonds,
an account statement or Form 1099-INT, Interest Income, issued by the financial institu-
tion that redeemed the bonds showing interest from the redemption of the bonds; and
(3) in the case of a rollover contribution from another 529 plan, a statement issued by
the distributing plan that shows the earnings portion of the distribution (the statement
must be provided within 30 days after the distribution, or by January 10 of the next year,
whichever is earlier).67
If a 529 plan does not ordinarily provide each account owner an annual account statement show-
ing the total account balance, the investment in the account, earnings, and distributions from
the account, it must give this information to the account owner or designated beneficiary upon
request. In the case of a prepaid tuition plan, the total account balance may be shown as credits
or units of benefits instead of fair market value.68
OBSERVATION: Most state-sponsored plans provide quarterly statements reflecting
the activity in the account, including the current account balance. Access to account
information is often available by telephone or on-line as well.
No Investment Direction
A 529 plan cannot allow any contributor or designated beneficiary to direct the investment of
any contribution to the plan or the investment of any earnings attributable to contributions.69
A plan does not violate this requirement if a contributor is permitted to select among different
and exclusively designed investment strategies at the time the initial contribution establishing
the account is made.70
OBSERVATION: The IRS expects that final regulations, when issued, will provide that
a change in investment strategy will be permitted once per calendar year and upon a
change in the account’s designated beneficiary. The final regulations are also expected
to provide that (1) 529 plan participants must be allowed to select only from among
exclusively designed, broad-based investment strategies, and (2) procedures must be es-
66
Notice 2001-81, 2001-2 C.B. 617.
67
Notice 2001-81, 2001-2 C.B. 617.
68
Prop. Reg. Section 1.529-2(f).
69
70
Prop. Reg. Section 1.529-2(g).
tablished and appropriate records maintained to prevent a change in investment options

from occurring more frequently than permitted.71
PRACTICE TIP: Taxpayers looking for more control over their investments should
consider opening a Coverdell ESA. See Coverdell Education Savings Accounts, p. 5. Al-
though annual contributions to Coverdell ESAs are limited, taxpayers have more control
over the account and, thus, more investment options.
No Pledging of Interest as Security

A 529 plan may not allow any interest in the plan to be used as security for a loan.72 This in-
cludes, but is not limited to, a prohibition on the use of any interest in the plan as security for a
loan used to purchase such interest in the plan.73
Safeguards Against Excess Contributions

A 529 plan must provide adequate safeguards to contributions in excess of those necessary to
provide for the qualified higher education expenses of the designated beneficiary.74 According to
the IRS, this requirement is met by plans that limit the number of credit hours that can be pur-
chased to those required to obtain a degree,75 that limit the total contributions to five times the
average cost of tuition at eligible colleges and universities,76 or that limit the total contributions
to the lower of seven times the average cost of tuition at all independent colleges and universities
or the beneficiary’s reasonably anticipated higher education expenses.77
In addition, the IRS has established a “safe harbor” that is satisfied if a 529 plan bars any ad-
ditional contributions to an account as soon as the account reaches a specified account balance
limit applicable to all accounts of designated beneficiaries with the same expected year of en-
rollment. The total contribution may not exceed the amount determined by actuarial estimates
that is necessary to pay the tuition, fees, room, and board of the designated beneficiary for five
years of undergraduate enrollment at the highest cost institution allowed by the program.78
OBSERVATION: The safe harbor limit ignores the possibility that the contributions
are intended to fund the designated beneficiary’s graduate education as well. However,
in a private letter ruling involving the New York plan, the IRS approved the plan’s maxi-
mum balance limit of four times one year’s undergraduate expenses, plus three times one
year’s graduate school expenses, and a cap of $235,000.79
71
See Notice 2001-55, 2001-2 C.B. 299.
72
73
Prop. Reg. Section 1.529-2(h).
74
75
PLR 9812037.
76
PLR 200024055
77
PLR 200030030.
78
Prop. Reg. Section 1.529-2(i)(2).
79
PLR 200134032.
Hope Scholarship and Lifetime

Learning Credits
Generally
Low-to-moderate-income taxpayers can claim two types of non-refundable credits for quali-
fied educational expenses: the Hope scholarship credit (Hope credit) and the lifetime learning
credit.1 The Hope credit, which can be as high as $1,500, is available for the first two years
of post-secondary education. The lifetime learning credit, which can be as high as $2,000, is
available for post-secondary education, including technical or remedial training to acquire or
improve the job skills of the individual.
OBSERVATION: The Hope and lifetime learning credits are available unless the tax-
payer elects not to take them.2
Both credits are available for the educational expenses of the taxpayer, the taxpayer’s spouse,
and the taxpayer’s dependents. Both credits are phased out above certain adjusted gross income
levels. See Phaseouts, p. 45.
PRACTICE TIP: Education tax credits are non-refundable, and no carryforward of an
unused education tax credit or carryforward of excess qualified tuition or other educa-
tion expenses is allowed. Thus, a Hope or lifetime learning credit should be claimed in
a year in which the taxpayer’s tax liability exceeds the amount of the credit. Otherwise,
some or all of the credit will be lost. In addition, like most other non-refundable credits,
the education credits can be claimed fully against regular income tax only to the extent
it exceeded the taxpayer’s alternative minimum tax liability. Special provisions allowed
the non-refundable credits to be claimed without regard to the alternative minimum tax
after 1998 and before 2006, but while permanent relief was enacted for some credits, it
does not apply to the education credits.3
The credits are allowable for expenses paid during a tax year for a course of instruction that
begins during the year. There is an exception to this rule for prepayment of qualified expenses
for an academic period that begins during the first three months following the taxable year. The
academic period is treated as beginning during the taxable year.4 Thus, if classes begin in Janu-
ary, and the educational institution requires that tuition be paid in November, the taxpayer can
claim the credit for the year the tuition was paid.
1
Code Section 25A.
2
Code Section 25A(e).
3
Code Section 26(a). See also Kleinrock’s Analysis and Explanation, Section 52.1, for a discussion of the non-re-
fundable personal tax credits.
4
Code Section 25A(g)(4).
PRACTICE TIP: Since the time of payment, not the date an academic semester begins,
determines when a Hope or lifetime learning credit can be claimed, it may be worth
delaying an end-of-the-year tuition payment for an academic semester beginning in the
following year if the later year is the more beneficial year to claim the credit (e.g., if the
credit will be phased out in the earlier year) and the educational institution allows pay-
ment to be deferred.
If the payment is made with the proceeds of a loan, it is creditable in the tax year the loan pro-
ceeds are used to make the payment (rather than in the year the loan is repaid). If the loan pro-
ceeds are disbursed directly to the eligible institution, they are treated as paid when the proceeds
are actually credited to the student’s account. If the taxpayer does not know the date the proceeds
are credited to the student’s account, the tuition is treated as paid on the last date for payment
prescribed by the educational institution.5
COMPLIANCE TIP: No credit is allowed for the qualified expenses of an eligible
student unless the taxpayer includes the name and taxpayer identification number of the
student on his tax return for the taxable year.6
If a taxpayer pays for qualified expenses through a third party installment plan, the time of pay-
ment by the taxpayer depends on the terms of the installment payment agreement. If the third
party installment agent is the agent for the taxpayer, the taxpayer pays the qualified expenses at
the time the third party agent pays the educational institution. If the third party installment agent
is the agent for the educational institution, the taxpayer pays the qualified expenses at the time
the taxpayer pays the third party agent.7
The expenses paid during a taxable year with respect to any student for whom a Hope credit is
claimed may not be taken into account in computing the amount of that credit with respect to any
other student or the lifetime learning credit. Thus, a taxpayer may not claim both a Hope credit
and a lifetime learning credit with respect to the same student in the same taxable year. However,
a taxpayer who claims the Hope credit for the expenses of one eligible student may still claim the
lifetime learning credit for payment of another student’s qualified expenses.8
EXAMPLE: In 2004, Alice pays $2,000 in qualified tuition and related expenses for her
dependent daughter Diane to attend City College during 2004. In that same year, Alice
also pays $500 in qualified tuition to attend a computer course during 2003 to improve
her own job skills. Assuming all other relevant requirements are met, Alice may claim
a Hope credit for the $2,000 of qualified tuition and related expenses attributable to Di-
ane and a lifetime learning credit for the $500 of qualified tuition expenses incurred to
improve her job skills. If, however, she had paid $3,000 for Diane’s tuition, Alice would
not add the $1,000 of excess expenses that she incurred for Diane’s tuition to her $500 of
qualified tuition and related expenses in computing the amount of the lifetime learning
credit.
5
Reg. Section 1.25A-5(e)(3).
6
7
Reg. Section 1.25A-5(e)(4).
8
Code Section 25A(c)(2)(A); Reg. Section 1.25A-1(b).3
Hope Scholarship and Lifetime Learning Credits 37
In addition, no credit is permitted for any education expense for which a deduction is allowed
under any other provision of the income tax laws.9 This includes expenses qualifying for the
Code Section 222 deduction for higher education expenses (see Deduction for Qualified Higher
Education Expenses, p. 53) or deductible as ordinary and necessary business expenses (see
Business Deductions for Educational Expenses, p. 59). Thus, taxpayers may have to determine
whether a deduction or an education tax credit provides greater tax benefits.
EXAMPLE: Jim, who expects to be in the 28 percent tax bracket, incurs $3,000 of tu-
ition expenses in 2004 for courses he takes at a local college to acquire new job skills. If
Jim claims the lifetime learning credit he will reduce his 2004 tax liability by $600 (20%
× $3,000). However, if he takes the deduction for qualified higher education expenses,
he will reduce his 2004 tax liability by $840 (28% × $3,000).
On the other hand, a taxpayer may claim a Hope or lifetime learning credit for a tax year and
exclude from gross income amounts distributed from a Coverdell ESA or a 529 plan on behalf
of the same student as long as the distribution is not used for the same educational expenses for
which a credit was claimed.10 See Coverdell Education Savings Accounts, p. 5; Qualified Tuition
Programs (529 Plans), p. 19).
PRACTICE TIP: Taxpayers must be careful to incur sufficient education expense to
both exhaust the available education credits and the entire amount of any withdrawals
from a Coverdell ESA or a 529 plan. If not, a portion of the Coverdell ESA or 529 plan
withdrawal for the year will be treated as taxable income.
To maximize the benefits of the education tax incentives with respect to a single student, a
taxpayer should normally claim the Hope credit for the first two years of that student’s higher
education since this credit is only available for the first two years of post-secondary education.
In the following years, the lifetime learning credit should be used. However, if the Hope credit
cannot be fully utilized in the first year of college, use of the lifetime learning credit for that year
may result in an overall tax savings.
EXAMPLE: Carol starts college in September 2004. Her qualified tuition and related
expenses are such that she can only claim a $500 Hope credit for her freshman year.
For each of the next three years, her qualified tuition and related expenses are $2,500. If
Carol claims the Hope credit in 2004 and 2005, and the lifetime learning credit in 2006
and 2007, her credits over the four year period will amount to $3,000 ($500 + $1,500 +
$500 + $500).11 If she claims the lifetime learning credit in 2004 and 2007, and the Hope
credit in 2005 and 2006,12 her overall education credits over the same four year period
will equal $3,600 ($100 + $1,500 + $1,500 + $500).
9
10
Code Sections 529(c)(3)(B)(v), 530(d)(2)(C).
11
For purposes of this example, future inflation adjustments to the maximum Hope scholarship credit amount are
disregarded.
12
In the example, Carol can claim the Hope scholarship credit in 2006 because she will not have completed her
second year of college before January 1, 2006. See Reg. Section 1.25A-3(d)(1)(iii).
Hope Scholarship Credit

The Hope credit is available for the first $1,000 in qualified tuition and related expenses for
an eligible student and for 50 percent of the next $1,000 in qualified expenses. The credit al-
lows $1,500 per eligible student, not per return. Thus, a taxpayer paying the qualified expenses
of multiple eligible students may take the full credit of up to $1,500 for each student.13 These
amounts are indexed for inflation, although there was no adjustment for the 2004 tax year.14
EXAMPLE: In 2004, Bob’s two dependent children, Robert and Alexander, are eli-
gible students enrolled in eligible educational institutions. Robert’s qualified tuition and
related expenses are $1,600 at a City College. Alexander’s qualified tuition and related
expenses are $5,000 at State University. Bob may claim a Hope credit of $1,300 ($1,000
plus 50 percent times $600) for Robert and the maximum $1,500 Hope credit for Alex-
ander, for a total Hope credit of $2,800.
The Hope credit is allowed only for two taxable years per student.15 It is also allowed only for
the first two years of post-secondary education at an eligible educational institution.16 Two years
of post-secondary education may include two one-year certificate programs. The determination
as to whether a student has completed the first two years of post-secondary education depends
on whether the institution awards the student two years of academic credit prior to the beginning
of the tax year. If a student has not completed the first two years of undergraduate study as of
the beginning of a taxable year, qualified expenses paid during the entire taxable year may be
included in computing the Hope credit.
EXAMPLE: In 2001 and 2002, Diane attended City College on a full-time basis. Di-
ane transfers to State University for the 2004 Spring semester. State University awards
Diane credit for some (but not all) of the courses she previously completed at City Col-
lege and classifies Diane as a first-semester sophomore. During both the Spring and Fall
semesters of 2004, Diane enrolls in half the normal full-time work load for her degree
program. Because State University does not classify Diane as having completed the first
two years of post-secondary education as of the beginning of 2004, Diane is an eligible
student for the 2004 tax year.
Academic credit that is awarded on the basis of the student’s performance on proficiency exami-
nations is disregarded.17 Thus, for example, a student cannot lose the opportunity to claim the
Hope credit because she takes advanced placement courses.
The Hope credit is not allowed for any student who has been convicted of a federal or state
felony drug offense before the end of the taxable year with or within which his academic year
ends.18
13
Code Section 25A(b)(1).
14
Code Section 25A(h)(1). See Rev. Proc. 2003-85, 2003-2 C.B. 1184.
15
Code Section 25A(b)(2)(A).
16
Code Section 25A(b)(2)(C).
17
Reg. Section 1.25A-3(d)(1)(iii).
18
Code Section 25A(b)(2)(D).
An individual must be at least a half-time student (carrying at least half the normal full-time
work load for the course of study the student is pursuing) for at least one academic period of the
year to be an eligible student for purposes of the Hope credit.19
PRACTICE TIP: Part-time students who are not eligible students for purposes of the
Hope credit are eligible students for purposes of the lifetime learning credit.
COMPLIANCE TIP: Educational institutions are required to indicate whether the half-
time student requirement is met on Form 1098-T, Tuition Payments Statement.20
To be an eligible student, the individual must also meet the requirements of Section 484(a)(1)
of the Higher Education Act of 1965 (20 U.S.C. Section 1091(a)(1)), as in effect on August 5,
1997.21 Among other things, the Higher Education Act requires that a student be enrolled or
accepted for enrollment in a degree, certificate, or other program leading to a recognized educa-
tional credential at an eligible institution of higher learning and not be enrolled in an elementary
or secondary school.
OBSERVATION: Because this provision excludes a student enrolled in a secondary
school from the definition of an eligible student, it appears that the credit is not available
for the expenses of a high school student taking courses at a college or university.22
Lifetime Learning Credit

The lifetime learning credit is available for an amount equal to 20 percent of the qualified tuition
and related expenses paid during the year that do not exceed $10,000, thereby allowing a maxi-
mum credit of up to $2,000 per year.23 The amount is not indexed for inflation.
The lifetime learning credit amount is calculated on a per-taxpayer, rather than a per-student ba-
sis. Although a taxpayer may claim the credit for several persons, the amount of the credit does
not change.24 Thus, a taxpayer who pays $8,000 in qualified expenses for himself and $5,000 in
qualified expenses for a dependent – or a taxpayer who pays $6,000 tuition each for two depen-
dent students – may claim only a $2,000 credit.
EXAMPLE: In 2004, Mike paid qualified tuition and related expenses of $7,000 for
his dependent son Sam and $6,000 for his dependent daughter Mary to attend eligible
educational institutions. Mike does not claim a Hope credit with respect to either of his
children. Although Mike paid $13,000 of qualified tuition and related expenses during
the taxable year, he may claim the lifetime learning credit with respect to only $10,000
of such expenses. Therefore, the maximum lifetime learning credit Mike may claim for
2004 is $2,000 (20 percent times $10,000).
19
Code Section 25A(b)(2)(B).
20
Reg. Section 1.6050S-1(b)(2).
21
Code Section 25A(b)(3)(A).
22
See Reg. Section 1.25A-3(d)(2), Example 5.
23
Code Section 25A(c)(1).
24
Code Section 25A(c)(1).
Expenses paid with respect to a student for whom the Hope credit is claimed are not
eligible for the lifetime learning credit.25
EXAMPLE: In 2004, Arnold paid $6,000 of qualified tuition and related expenses for
his dependent son Bill and $2,000 for his dependent daughter Cindy to attend eligible
educational institutions. Cindy has already completed the first two years of post-sec-
ondary education. Thus, she is ineligible for the Hope credit, but Arnold may claim the
lifetime learning credit for her. Arnold may claim the maximum $1,500 Hope credit with
respect to Bill, but in computing the amount of the lifetime learning credit, he may not
include any of the $6,000 he paid for Bill. Arnold may only include the $2,000 of quali-
fied tuition and related expenses he paid for Cindy.
There is no limit on the number of years the lifetime learning credit may be claimed for an in-
dividual.26 A taxpayer who continues to pay qualified expenses for herself or a dependent may
continue to claim the credit for the relevant amount of the expenses.
The lifetime learning credit is available for qualified expenses relating to any course of instruc-
tion at an eligible educational institution to acquire or improve job skills.27 A student may take
as little as one course, as opposed to the requirement of the Hope credit that an individual be at
least a half-time student.
PRACTICE TIP: The allowance of the credit for courses taken to acquire job skills is
in sharp contrast to the Code Section 162 business expenses deduction, which is allowed
only for educational expenses incurred where required for a current position, not those
incurred to qualify the taxpayer for a new position (see Business Deductions for Educa-
tional Expenses, p. 59). However, when both the deduction and the credit are available,
the taxpayer should consider which is more advantageous. The choice is easy for em-
ployees who do not itemize, since they receive no benefit from the deduction. Similarly,
for those that do not have miscellaneous itemized deductions that exceed 2 percent of
adjusted gross income, the credit also provides the greater benefit.
The lifetime learning credit is not, however, available for all educational expenses. The expenses
still must be incurred in education related to acquiring or improving job skills so that a taxpayer
who is in school only for personal, non-business related purposes cannot claim the credit.
EXAMPLE: Christy, a professional photographer, enrolls in an advanced photography
course at a local community college. Although the course is not part of a degree program,
Christy enrolls in the course to improve her job skills. The course fee paid by Christy is
a qualified tuition and related expense for purposes of the lifetime learning credit.
EXAMPLE: Brad, a doctor, plans to travel abroad on a “photo-safari” for his next vaca-
tion. In preparation for the trip, Brad enrolls in a non-credit photography class at a local
25
Code Section 25A(c)(2)(A).
26
Reg. Section 1.25A-4(b).
27
Code Section 25A(c)(2)(B).
community college. Because Brad is not taking the photography course as part of a de-
gree program or to acquire or improve his job skills, amounts paid for the course are not
qualified tuition and related expenses for purposes of the lifetime learning credit.
Rules Applicable to Both Credits
Phaseouts
The Hope and lifetime learning credits are both phased out ratably for taxpayers with a modi-
fied adjusted gross income (AGI) exceeding $40,000 ($80,000 for a joint return). The credits
are fully phased out for taxpayers with a modified AGI of $50,000 or more ($100,000 for a joint
return).28 These amounts are adjusted for inflation.29 For the 2004 tax year, the beginning phase-
out amount is $42,000 ($85,000 for a joint return), and the credit is fully phased out at $52,000
($105,000 for joint returns).30
Modified AGI is calculated by increasing adjusted gross income by any amount excluded from
gross income under Code Sections 911, 931, or 933 (foreign earned income; income from
sources within Guam, American Samoa, or the Northern Mariana Islands; and income from
sources within Puerto Rico).31
The limitation operates by reducing the credit allowable (but not below zero) by the amount that
bears the same ratio to the credit as the excess (if any) of the taxpayer’s modified AGI for the tax
year over the phase-out amount bears to $10,000 ($20,000 for joint returns).32 Thus, a full credit
is potentially available in 2004 for taxpayers whose modified AGI is $42,000 or less ($85,000 for
joint returns); a partial credit is available for taxpayers whose modified AGI is between $42,000
and $52,000 ($85,000 and $105,000 for joint returns); and no credit may be taken by taxpayers
whose modified AGI is more than $52,000 ($105,000 for joint returns).
EXAMPLE: In 2004, Bob, a single taxpayer, pays the $9,000 tuition for his daughter
Charlotte’s third year of college. Bob is entitled to a dependency deduction with respect
to her. His adjusted gross income is $45,000; he has no exclusions of foreign or posses-
sions income. Under the lifetime learning credit, Bob is entitled to a maximum credit of
$2,000 (20 percent times $10,000).
STEP 1:
Taxpayer’s Limitation
Modified AGI Minus Amount Equals Numerator
$45,000 – $42,000 = 3,000
28
Code Section 25A(d)(2).
29
Code Section 25A(h)(2).
30
Rev. Proc. 2003-85, 2002-3 C.B. 1184.
31
32
STEP 2:
Statutory Applicable
Numerator Divided By Amount Equals Percentage
3,000 ÷ $10,000 = 30%
STEP 3:
Maximum
Applicable Available Credit
Percentage Times Credit Equals Limitation
30% × $2,000 = $600
STEP 4:
Maximum Credit
Available Credit Amount
Credit Minus Limitation Equals Available
$2,000 – $600 = $1,400
Thus, in this example, Bob’s maximum available tentative credit is $1,400. It is tenta-
tive only in the sense that he could be denied the credit this year if the sum of his other
credits plus this credit exceeded the tax liability on his return. There are no carryover
provisions.
Qualified Expenses
The Hope and lifetime learning credits may be claimed only for qualified tuition and related ex-
penses (“qualified expenses”). Qualified expenses consist of tuition and fees required for the en-
rollment or attendance of the taxpayer, the taxpayer’s spouse, or any dependent of the taxpayer,
at an eligible educational institution for courses of instruction at the institution.33 A taxpayer
cannot claim a credit for paying the tuition and expenses of persons other than the taxpayer,
the taxpayer’s spouse, or a dependent of the taxpayer, even if those expenses would otherwise
qualify for the credits.
The test for determining whether any fee is a qualified expense (including fees for books, sup-
plies, and equipment used in a course of study) is whether the fee must be paid to the eligible
educational institution as a condition of the student’s enrollment or attendance at the institu-
tion.34 Thus, even if a course requires the use of supplies or equipment (e.g., a computer), its cost
33
Code Section 25A(f)(1)(A).
34
Reg. Section 1.25A-2(d)(2).
is not a qualified expense unless it is required as a condition of the student’s enrollment, not just
a condition of participation in the class.
EXAMPLE: State University offers a degree program in dentistry. In addition to tuition,
all students enrolled in the program are required to pay a fee to State University for the
rental of dental equipment. Because the equipment rental fee must be paid to State Uni-
versity for enrollment and attendance, the tuition and the equipment rental fee are quali-
fied tuition and related expenses.
EXAMPLE: All students who attend City College are required to pay a separate student
activity fee in addition to their tuition. The student activity fee is used solely to fund
on-campus organizations and activities run by students, such as the student newspaper
and the student government (no portion of the fee covers personal expenses). Although
labeled as a student activity fee, the fee is required for enrollment or attendance at City
College. Therefore, the fee is a qualified tuition and related expense.
Qualified expenses do not include student activity fees, athletic fees, insurance expenses, medi-
cal expenses, or other expenses unrelated to an individual’s academic course of instruction such
as room and board, transportation, or personal, living, or family expenses, even if such fees are
required as a condition of enrollment. Student health fees are regarded as medical expenses and
therefore are not qualified expenses.35 In addition, qualified expenses do not include expenses
with respect to any course or education involving sports, games, or hobbies, unless such course
or other education is part of the individual’s degree program.36
If a student is required to pay a comprehensive fee or a bundled fee to an eligible educational
institution that includes charges for tuition, fees, and personal expenses, the portion of the com-
prehensive or bundled fee that is allocable to personal expenses is not a qualified tuition and
related expense. An allocation between the qualified and non-qualified portion must be made by
the educational institution using a reasonable method.37
EXAMPLE: Eastern College requires all students to live on campus. It charges a single
comprehensive fee to cover tuition, required fees not allocable to personal expenses, and
room and board. Based on Eastern College’s reasonable allocation, 60 percent of the
comprehensive fee is allocable to tuition and other required fees not allocable to personal
expenses, and the remaining 40 percent of the comprehensive fee is allocable to charges
for room and board. Therefore, only 60 percent of Eastern College’s comprehensive fee
is a qualified tuition and related expense.
The amount of qualified expenses is reduced by any tax-free educational assistance received,
including any tax-free scholarship, certain veterans’ or member of the armed forces’ educa-
tional assistance under Title 38 of the U.S. Code, or any other payment (except a gift, bequest,
35
36
Code Section 25A(f)(1)(B), (C).
37
devise, or inheritance) excludable from gross income and used for educational expenses (e.g.,
employer-provided educational assistance).38
A scholarship is treated as allocated to qualified expenses and thus as a qualified scholarship that
reduces qualified expenses, unless the student includes the scholarship in income or the terms of
the scholarship require that it be applied to non-qualified expenses.39
EXAMPLE: City College charges Cindy $3,000 for tuition and $5,000 for room and
board. City College awards a $2,000 scholarship to Cindy and applies it against her
$8,000 total bill. The terms of the scholarship permit it to be used to pay any of a stu-
dent’s costs of attendance at City College, including tuition, room, and board. Cindy
pays the $6,000 balance of her bill from City College with a combination of savings and
amounts she earns from a summer job. City College does not require Cindy to pay any
additional fees beyond the $3,000 in tuition in order to enroll in classes. Cindy does not
report any portion of the scholarship as income on her tax return because it is excludable
as a qualified scholarship (see Scholarships and Fellowships, p. 79, for a discussion of
excludable scholarships). However, it is allocable first to Cindy’s qualified tuition and
related expenses. For purposes of calculating the education credit, Cindy is treated as
having paid only $1,000 ($3,000 tuition – $2,000 scholarship) in qualified tuition and
related expenses to City College.
Any reduction in tuition provided by an eligible educational institution to its employees or
spouses or dependents of employees does not reduce qualified expenses and may be included
in determining the amount of an allowable credit only if the amount of the tuition reduction is
included in the employee’s gross income.40
The amount of qualified expenses is also reduced by any refund of previously paid qualified
expenses by the educational institution.41 Any refund of loan proceeds used to pay qualified ex-
penses back to the lender on behalf of the borrower is treated as a refund of qualified expenses.42
Qualified expenses are not reduced, however, to the extent that they are not refunded if the stu-
dent withdraws.
COMPLIANCE TIP: If the refund or tax-free assistance is received in the same year
in which the expenses are paid or in the following year before the taxpayer files his tax
return for that year, the taxpayer reduces the amount of qualified expenses by the as-
sistance or refund and computes the credit using the reduced amount.43 If the refund or
tax-free assistance is received in a later year, the rules on recapture apply.44 See Credit
Recapture, p. 50.
EXAMPLE: In January 2004, Andrew, a full-time freshman at State University, pays
$2,000 for qualified tuition and related expenses for a 16-hour work load for the 2004
Spring semester. Prior to beginning classes, Andrew withdraws from six course hours.
38
39
Reg. Section 1.25A-5(c).
40
Reg. Section 1.25A-5(b)(2).
41
Reg. Section 1.25A-5(f)(1).
42
43
44
On February 15, 2004, Andrew receives an $800 refund from State University. In Sep-
tember 2004, Andrew pays State University $1,000 to enroll half-time for the 2004 Fall
semester. Prior to beginning classes, Andrew withdraws from a two-hour course and re-
ceives a $200 refund in October 2004. Andrew computes the amount of qualified tuition
and related expenses he may claim for 2004 by:
(1) Adding all qualified expenses paid during the taxable year ($2,000 + 1,000
= $3,000);
(2) Adding all refunds of qualified tuition and related expenses received during
the taxable year ($800 + $200 = $1,000); and, then
(3) Subtracting (2) from (1) ($3,000 – $1,000 = $2,000). Therefore, Andrew’s
qualified tuition and related expenses for 2004 are $2,000.
A scholarship or fellowship grant is excludable from gross income to the extent that it is used for
qualified tuition and related expenses.45 Therefore, to the extent it is not used for qualified tuition
and related expenses, a scholarship or fellowship grant is taxable income and will not be used to
reduce the amount of qualified expenses for purposes of the Hope and lifetime learning credits.
As a result, if a student’s tuition, room, board, etc., exceed the scholarship amount, taxpayers can
take the position that the scholarship funds (or a at least a portion of them) were used for items
that do not fall within the definition of “qualified tuition and related expenses” (if the scholar-
ship can be used for such costs). This will prevent or lessen the reduction of other expenses that
are available for purposes of claiming the credits (there are no tracing rules).
EXAMPLE: State University charges Robin $3,000 for tuition and $5,000 for room and
board. Robin receives a $4,000 scholarship to be used to pay any of her costs of atten-
dance at State University, including tuition, room, and board. Robin reports the scholar-
ship funds as taxable income on her tax return, claiming that the $4,000 was used to pay
for room and board (using Line 7 of Form 1040, U.S. Individual Income Tax Return,
with the notation “SCH” on the dotted line preceding the entry).
CAUTION: A scholarship that is restricted by its terms to paying qualified expenses
is excludible from income and therefore reduces the amount of qualifying expenses for
purposes of the Hope Scholarship and lifetime learning credits, regardless of whether the
student includes the amount in income.
Eligible Institution and Academic Period

The Hope and lifetime learning credits are available only for expenses incurred to attend an eli-
gible educational institution for an academic period beginning in the same year the payment is
made or in the first three months of the following year.46 An eligible institution is one described
45
Code Section 117(b).
46
Code Section 25A(b)(1), (c)(1).
in Section 481 of the Higher Education Act of 1965 (20 U.S.C. 1088), as in effect on August
5, 1997, and that is eligible to participate in a program under Title IV of the Higher Education
Act.47 This includes virtually all accredited public, nonprofit, and proprietary post-secondary
institutions (including many foreign institutions).48
OBSERVATION: As noted above, there is an exception to the rule that the academic
period must begin in the same year that the payment is made. Under that exception,
prepayment of qualified expenses for an academic period that begins during the first
three months following the taxable year can be counted as expenses for that year.49 See
Generally, p. 35.
An academic period means a quarter, semester, trimester, or other period of study (such as a
summer school session) as reasonably determined by an eligible educational institution. In the
case of an institution that uses credit hours or clock hours instead of academic terms, each pay-
ment period may be treated as an academic period.50
Claiming a Credit for a Dependent

Special rules apply for claiming the Hope and lifetime learning credits in the case of a depen-
dent. If the student is claimed as a dependent by another taxpayer, the student may not claim
the credit. Instead, the person claiming the dependent is treated as having paid the tuition and is
entitled to the credit for the student’s qualified tuition and related expenses – regardless of who
actually pays the tuition and related expenses.51
EXAMPLE: In 2004, Randy pays qualified tuition and related expenses for his depen-
dent, Josh, to attend Southern University during 2004. Randy claims Josh as a dependent
on his federal income tax return. Therefore, assuming all other relevant requirements are
met, Randy is allowed an education credit on his federal income tax return. Josh is not
allowed an education credit on his federal income tax return. The result would be the
same if Josh paid the qualified tuition and related expenses.
If the taxpayer is eligible to claim the student as a dependent, but does not, only the student may
claim the education credit for his qualified tuition and related expenses.52
EXAMPLE: Ron has one dependent, Casey. In 2004, Casey pays qualified tuition and
related expenses to attend Western University during 2004. Although Ron is eligible to
claim Casey as a dependent on his federal income tax return, he does not do so. There-
fore, assuming all other relevant requirements are met, Casey is allowed an education
credit on her federal income tax return. Ron is not allowed an education credit on his
federal income tax return with respect to Casey’s education expenses. The result would
be the same if Ron paid the qualified tuition and related expenses on behalf of Casey.53
47
Code Section 25A(f)(2).
48
Notice 97-60, 1997-2 C.B. 310.
49
50
Reg. Section 1.25A-2(c).
51
52
53
OBSERVATION: If a parent chooses not to claim a deduction for a dependent for whom
the deduction is allowable, the dependent may not claim a personal exemption on his
income tax return.54 If a student is not claimed by his parents as a dependent, the student,
assuming all other relevant eligibility requirements are met, is entitled to claim a Hope
Scholarship credit on his own return.55
If the parents’ Hope or lifetime learning credit is reduced or eliminated because of the AGI
phaseout (see Phaseouts, p. 41) and/or their personal exemption deductions are phased out,56 the
parents should consider electing not to claim the child as a dependent if the child has income.
In that case, even though the parents cannot take advantage of the credits or deduction, the child
becomes eligible to claim either the Hope or lifetime learning credit for herself – thereby avoid-
ing loss of the credits entirely.57
An unmarried college student may report up to $29,050 of taxable income in 2004 at the 15
percent bracket (the first $7,150 is taxed at the 10 percent rate). If the student provides over half
of her support for the year, she can claim a $3,100 personal exemption and a $4,850 standard de-
duction in 2004. Accordingly, the $1,500 Hope credit will eliminate the tax liability of a student
who has $12,383 of ordinary taxable income (10% of $7,150 + 15% of $5,233), or $30,000 of
capital gain income if the 5 percent rate applies. Taking into account the $4,850 standard deduc-
tion and the $3,100 personal exemption, she can have $20,333 of ordinary income or $37,950 of
capital gain income before incurring any tax.
EXAMPLE: Ralph, who provides more than half of his own support, has $22,000 of
ordinary income in 2004. Ralph is also a freshman in college and pays $10,000 in tuition
and fees. Ralph’s 2004 tax liability is $250, computed as follows:
Income $22,000
Less:
Standard Deduction $4,850
Personal Exemption $3,100 ($7,950)
Taxable Income $14,050
Tax on $7,150 at 10% rate $715
Tax on $6,900 at 15% rate $1035
Tax Before Hope Credit $1,750
Hope Credit ($1,500)
Tax Liability $250
54
55
CCM 200236001.
56
See Kleinrock’s Analysis and Explanation, Section 3.2, for a discussion of the personal exemption deduction
phase-out ranges.
57
Under Code Section 151(d)(2), the child would not be able to claim a personal exemption if she is still eligible to
be claimed as a dependent on her parent’s return as a student.
If half of Ralph’s income had been derived from the sale of securities held in a trust
established by his parents since 2002 (i.e., for more than one year) 11,000 of Ralph’s
$14,050 of taxable income would be taxed at the 5 percent capital gains rate and the re-
maining $3,050 at the ordinary income rate of 10 percent, for a pre-credit tax of $855. In
2004 and 2005, the $855 would be offset by the Hope credit. In 2006 and 2007, it would
be offset by the lifetime learning credit.
Similarly, the $2,000 lifetime learning credit will eliminate the tax liability of a student who has
$15,717 of ordinary taxable income (10% of $7,150 + 15% of $8,567), or $40,000 of capital
gain income if the 5 percent rate applies. Taking into account the $4,850 standard deduction and
the $3,100 personal exemption, she can have $23,667 of ordinary income or $47,950 of capital
gain income before incurring any tax in 2004.
OBSERVATION: If a student has a mix of ordinary income and capital gain income, the
$4,850 standard deduction and the $3,100 personal exemption are applied against ordi-
nary income before they reduce capital gain income.58 Accordingly, if ordinary income
does not exceed $7,950, the remainder will only be subject to the applicable capital gain
rate.

For purposes of determining a student’s expected family contribution (EFC), the amount of any
Hope or lifetime learning credit claimed is subtracted from either the parents’ or the student’s
income, depending on who claims the credit. Thus, electing not to claim a student as a dependent
so that the student can claim a Hope or lifetime learning credit can also affect the student’s abil-
ity to obtain financial aid. For instance, if a parent’s adjusted available income for the 2004-2005
award year is $20,000 with a $1,500 Hope credit, allowing the student to take the credit would
increase the parent’s contribution by $510 ($4,926 – $4,416). This is because the parent’s con-
tribution is increased by 22 to 47 percent of the credit. However, since the student’s contribution
from income for purposes of calculating EFC is decreased by 50 percent of the allowable credit,
permitting the student to take the $1,500 Hope credit would decrease the student’s contribution
by $750 ($1,500 × 50%). Thus, since the parent’s contribution and the student’s contribution
from income are equally weighted in determining EFC, the overall effect of allowing the student
to take the Hope credit is a $240 decrease in EFC ($750 – $510), which means that the student’s
financial aid eligibility is increased. See Financial Aid – Financial Need, p. 107, for a detailed
discussion of EFC calculations.
Third-Party Payments
If a third party (someone other than the taxpayer, the taxpayer’s spouse, or a dependent) makes a
payment directly to an eligible educational institution to pay for a student’s qualified tuition and
related expenses, the student is treated as receiving the payment from the third party and, in turn,
paying the qualified tuition and related expenses to the institution.59
58
Code Section 1(h)
59
Reg. Section 1.25A-5(b)(1). See also PLR 199917036 (distributions from a settlement trust for educational ex-
penses that are included in student’s gross income may be used to compute credits even if they are paid directly to
an educational institution).
EXAMPLE: Grace makes a direct payment to an eligible educational institution for her
grandson’s qualified tuition and related expenses. Grace does not claim her grandson as
a dependent. For purposes of claiming a Hope or lifetime learning credit, the grandson is
treated as receiving the money from Grace and, in turn, paying his qualified tuition and
related expenses.
If a student is claimed as a dependent on another person’s return, the expenses are deemed to be
paid by the person claiming the dependency deduction.60 See Claiming a Credit for a Depen-
dent, p. 46.
EXAMPLE: Under a court-approved divorce decree, Fred is required to pay Kevin’s
college tuition. Fred makes a direct payment to City College for Kevin’s 2004 tuition.
Kevin is treated as receiving the money from Fred and, in turn, paying his qualified
tuition and related expenses. Fred’s former wife, Sue, properly claims Kevin as a depen-
dent on her 2004 federal income tax return. Sue may claim an education credit for the
qualified tuition and related expenses paid directly to City College by Fred. Similarly, if
Sue were still married, but either legally separated or simply living apart from Fred for
more than six months so as to be treated as not married pursuant to Code Section 7703,
she could claim an education credit for the qualified tuition and related expenses paid
directly to City College by Fred.
PRACTICE TIP: If the parties in the above example agree that Fred, the non-custodial
parent, has the right to claim the dependency exemption, then Fred can claim an educa-
tion credit for Kevin’s education tuition. To do so, Sue would attach Form 8332, Release
of Claim to Exemption for Child of Divorced or Separated Parents, to her return. Alter-
natively, the divorce decree could state that Sue’s custody ends when Kevin reaches 18
years of age. Thus, once Kevin turns 18, the normal rules of support would apply and the
parent paying the tuition would be entitled to the education credits.
PRACTICE TIP: It may be to a parent’s benefit not to claim a student as a dependent if
the parent cannot claim the education credit because of the credit phase-out rules and the
student pays (or is treated as paying) the expense and has sufficient tax liability to claim
the credit. See Planning Pointers, p. 47.
Joint Return Required of Married Taxpayers

If a taxpayer is married, the Hope and lifetime learning credits are allowed only if the taxpayer
and her spouse file a joint return for the taxable year.61
OBSERVATION: Marital status is generally determined as of the close of the taxable
year. If the taxpayer’s spouse dies during the year, marital status is determined as of the
time of death. An individual legally separated from her spouse is not considered mar-
60
Reg. Section 1.25A-5(a).
61
ried. An individual also is not considered married if she lived apart from her spouse for
the last six months of the taxable year, maintained a household that was the principal
place of abode for more than half the year of a child with respect to whom the individual
is entitled to a personal exemption deduction, and furnished over one-half the cost of
maintaining the household.62
Non-Resident Aliens
The Hope and lifetime learning credits are generally limited to United States citizens and resi-
dent aliens. A non-resident alien can claim the credits only if he is considered a resident alien
due to an election under Code Section 6013(g) or 6013(h).63 Those provisions allow a non-resi-
dent alien married to a United States citizen or resident alien to elect to be treated as a resident
for income tax purposes.64 A limited number of tax treaties also allow individuals to elect to be
treated as a resident and thus eligible to claim the credits.
If the student is a non-resident alien, a taxpayer may not claim an education credit with respect
to his qualified tuition and related expenses unless he is a dependent.65 Thus, among other re-
quirements, a non-resident alien student must be a resident of a country contiguous to the United
States in order to claim the Hope or lifetime learning credit.66
COMPLIANCE TIP: Payments to educational institutions by or for non-resident aliens
need not be reported by the institution. However, non-resident aliens who are eligible for
the Hope or lifetime learning credits can request reporting.67 See Reporting, p. 52.
Credit Recapture
The amount of qualified expenses for which the Hope and lifetime learning credits are allowed
is reduced by any tax-free assistance or refunds of expenses the student receives. If the refund or
tax-free assistance is received in the same year in which the expenses are paid, or in the follow-
ing year before the tax return for the year in which the expenses are paid is filed, the qualified
expenses are reduced by the refund or tax-free assistance (see Qualified Expenses, p. 42). If a
refund is received later, the benefit of the credit is recaptured. Tax-free assistance received in a
later year for expenses paid earlier is treated as a refund for this purpose.68
When a refund is received in a later year and recapture occurs, the tax for the subsequent taxable
year is increased by the recapture amount. The recapture amount is the difference between the
credit claimed in the prior taxable year and the redetermined credit. The redetermined credit is
computed by reducing the amount of the qualified tuition and related expenses for which a credit
was claimed in the prior taxable year by the amount of the refund of the qualified tuition and
related expenses (redetermined qualified expenses) and computing the credit using the redeter-
62
See Kleinrock’s Analysis and Explanation, Sections 2.2 and 4.5, for discussions of joint returns and filing status.
63
64
See Kleinrock’s Analysis and Explanation, Section 164.6, for a discussion of alien individuals who elect to be
treated as U.S. residents.
65
See Code Section 152 for the definition of a dependent.
66
Reg. Section 1.25A-1(h). See also Code Section 152(b)(3).
67
Reg. Section 1.6050S-1(a)(2)(i).
68
Reg. Section 1.25A-5(f).
mined qualified expenses and the relevant facts and circumstance of the prior taxable year, such
as modified adjusted gross income.69
EXAMPLE: In December 2003, Tom, a senior at City College, pays $2,000 for quali-
fied tuition and related expenses for a 16-hour work load for the 2004 Spring semester,
which begins on January 20, 2004. On January 13, 2004, Tom files his 2003 income tax
return and claims a $400 lifetime learning credit for the $2,000 qualified expenses paid
in 2003. On January 15, 2004, Tom withdraws from a four-hour course and receives a
$500 refund. Tom has a $100 increase in 2004 taxes, as determined by:
(1) Calculating the redetermined qualified expenses ($2,000 – $500 = $1,500);
(2) Calculating the redetermined credit for the redetermined qualified expenses
($1,500 × 20% = $300); and
(3) Subtracting the redetermined credit from the credit claimed in 2002 ($400
– $300 = $100).
OBSERVATION: A refund will only affect the amount of a Hope or lifetime learning
credit if the total qualified tuition and related expenses after the reduction for the refund
are below the maximum amount eligible for the credit (i.e., $2,000 for the Hope credit
and $10,000 for the lifetime learning credit).
The computation is the same if excludable educational assistance is received for the qualified
tuition and related expenses paid during a prior taxable year.70
EXAMPLE: In September 2003, Jerry, a student at State University, pays $1,200 in
qualified tuition and related expenses to attend evening classes during the 2003 Fall
semester. Jerry is an employee of X Corp. On January 15, 2004, Jerry files his 2003
federal income tax return and claims a lifetime learning credit of $240 ($1,200 × 20%).
In February 2004, X Corp. reimburses Jerry under a Code Section 127(b) educational
assistance program for the $1,200 of qualified tuition and related expenses paid by Jerry
in 2003. Thus, the $240 education credit claimed by Jerry for 2003 is subject to recap-
ture. Because Jerry paid no net qualified tuition and related expenses in 2003, the rede-
termined credit for 2003 is zero. Jerry must increase the amount of his 2004 taxes by the
recapture amount, which is $240 (the education credit claimed for 2003 ($240) minus
the redetermined credit for 2003 ($0)). Because the $1,200 reimbursement is taken into
account in calculating the $240 recapture amount for 2004, the reimbursement does not
reduce the amount of any qualified tuition and related expenses that Jerry paid in 2004.
COMPLIANCE TIP: The amount of the recapture is reported on the tax return of the
person who claimed the credit as an “additional tax” for the year the refund or tax-free
assistance was received. It is labeled “ECR.”
69
70
Reporting
Educational institutions that enroll any students for an academic period are required to file a
Form 1098-T, Tuition Payments Statement, for each individual for whom payments or grants
were received or reimbursements or refunds were paid, and to provide a copy to that individ-
ual.71 The form must include the name, address, and social security number for students who
are enrolled or have been enrolled in the institution during the calendar year, or to whom pay-
ments were made or received, along with the aggregate amount of the payments or grants and
the amounts of any adjustments, refunds, or reimbursements.72 Institutions may elect to report
either the aggregate amount of payments received or the aggregate amount billed, for qualified
expenses. The aggregate amount of scholarships and grants received for each individual’s costs
must be included.
COMPLIANCE TIP: Institutions that are required to file 250 or more Forms 1098-T,
Tuition Payments Statement, must file on magnetic media.73 The copy required to be pro-
vided to each individual may, with the individual’s consent, be provided electronically.74
Reporting is not required with respect to any individual who is a non-resident alien, although
non-resident aliens can request that amounts be reported.75 Institutions also are not required
to report with respect to courses for which no academic credit is offered, even if the student
is enrolled in a degree program.76 Reporting is not required as well for formal billing arrange-
ments, whereby the institution bills a company or governmental entity directly for the qualified
expenses of employees of the company or entity and does not maintain a separate account with
respect to any individual student.77
71
Code Section 6050S.
72
Code Section 6050S(b)(2), as amended by Pub. L. 107-131, Section 101.
73
Reg. Section 301.6011-2(b)(1).
74
Reg. Section 1.6050S-2(a).
75
Reg. Section 1.6050S-1(a)(2)(i).
76
Reg. Section 1.6050S-1(a)(2)(ii).
77
Reg. Section 1.6050S-1(a)(2)(iv).
Deduction for Qualified Higher

Education Expenses
Generally
For taxable years beginning in 2004 and 2005, taxpayers with modified adjusted gross income
that does not exceed $65,000 ($130,000 in the case of married taxpayers filing joint returns) can
deduct up to $4,000, and taxpayers with adjusted gross income that is greater than $65,000 but
does not exceed $80,000 (greater than $130,000 but does not exceed $160,000 in the case of
married taxpayers filing joint returns) can deduct up to $2,000 of qualified tuition and related
expenses they pay during a tax year for educational expenses of the taxpayer, the taxpayer’s
spouse, or any individual for whom the taxpayer is allowed to claim a dependency deduction.1
For taxable years beginning in 2003, the deduction was limited to $3,000, and is available only
for taxpayers with adjusted gross income that does not exceed $65,000 ($130,000 in the case
of married taxpayers filing joint returns). The deduction (commonly referred to as the “tuition
deduction”) is an above-the-line deduction; thus, taxpayers may claim the deduction whether or
not they itemize.2 The deduction is not available for payments made in taxable years beginning
after 2005.3
COMPLIANCE TIP: Married taxpayers must file a joint return to claim the deduction;
the deduction cannot be claimed on a separate return filed by a married taxpayer.4
PRACTICE TIP: Work-related education expenses (i.e., those required by an employer
to maintain current employment status or to improve current job skills) continue to be
deductible as itemized deductions subject to the 2 percent limitation.5 See Business De-
ductions for Educational Expenses, p. 59.
The deduction cannot be claimed by any individual who can be claimed as a dependent by an-
other taxpayer in the same tax year.6
PRACTICE TIP: Parents with adjusted gross income exceeding the limitation gener-
ally cannot avoid the limitation by having their child pay the expenses and claim the de-
duction. However, parents generally cannot claim a dependency exemption for children
after the year in which they attain age 19 (or age 24, in the case of full-time students),
even if they provide substantial support for them.7 It could be advantageous to have these
children pay at least $4,000 of expenses and claim the deduction, if they have some tax-
able income to offset.
1
Code Section 222.
2
Code Section 62(a)(18).
3
4
5
See Reg. Section 1.162-5(a).
6
7
Code Section 151. See Kleinrock’s Analysis and Explanation, Sections 3.4 and 3.5, for discussions of exemptions
for dependents.
The deduction for higher education expenses also cannot be claimed by any taxpayer who is a
non-resident alien for any part of the tax year, other than a spouse of a U.S. citizen or resident
who elects to be treated as a resident alien.8
OBSERVATION: The IRS is authorized to require recordkeeping and reporting in con-
nection with this deduction.9 It seems likely that reporting requirements similar to those
imposed in connection with the Hope and lifetime learning credits and the deduction
for student loan interest will be imposed. See Hope Scholarship and Lifetime Learning
Credits – Reporting, p. 52.
Qualified Expenses
Qualified tuition and related expenses are defined for purposes of the deduction for higher edu-
cation expenses in the same manner they are for the Hope scholarship credit.10 See Hope Schol-
arship and Lifetime Learning Credits – Qualified Expenses, p. 42. Thus, qualified expenses
consist of tuition and fees required for the enrollment or attendance of the taxpayer, the taxpay-
er’s spouse, or any dependent of the taxpayer, at an eligible educational institution for courses
of instruction at the institution.11 A taxpayer cannot claim a deduction for paying the tuition and
expenses of other persons even if those expenses would otherwise qualify for the deduction. The
cost of books, supplies, and equipment also qualify as education expenses if they are required
and are paid to the eligible education institution.12
COMPLIANCE TIP: No deduction will be allowed to a taxpayer with respect to the
qualified expenses of an individual unless the taxpayer includes the individual’s name
and taxpayer identification number on the taxpayer’s tax return for the year for which he
is claiming the deduction.13
Qualified expenses do not include expenses with respect to any course or education involving
sports, games, or hobbies, unless such course or other education is part of the individual’s degree
program.14 In addition, qualified expenses do not include student activity fees, athletic fees, in-
surance expenses, or other expenses unrelated to an individual’s academic course of instruction
such as room and board, transportation, or personal, living, or family expenses.15
If a student is required to pay a comprehensive or bundled fee to an eligible educational institu-
tion that includes charges for tuition, fees, and personal expenses, the portion of the comprehen-
sive or bundled fee that is allocable to personal expenses is not a qualified tuition and related
expense. An allocation between the qualified and non-qualified portion must be made by the
educational institution using a reasonable method.16
8
Code Section 222(d)(5). See Kleinrock’s Analysis and Explanation, Section 164.6, for a discussion of alien indi-
viduals who elect to be treated as U.S. residents.
9
10
11
See Code Section 25A(f)(1)(A).
12
See Reg. Section 1.25A-2(d)(2).
13
14
See Code Section 25A(f)(1)(B).
15
See Code Section 25A(f)(1)(C).
16
See Reg. Section 1.25A-2(d)(4).
Deduction for Qualified Higher Education Expenses 55
The amount of qualified expenses for purposes of the deduction is also reduced in the same
manner as such expenses are reduced for purposes of the Hope credit and lifetime learning
credit.17 Thus, they are reduced by any tax-free educational assistance received, including any
tax-free scholarship, certain educational assistance for veterans or members of the armed forces
provided under Title 38 of the U.S. Code, or any other payment (except a gift, bequest, devise, or
inheritance) used for education expenses that is excludable from gross income.18 The amount of
qualified expenses used for purposes of the deduction is also reduced by the amount of qualified
expenses that are taken into account for purposes of the exclusions for:
(1) Interest income from U.S. savings bonds used to pay higher education tuition and
fees (see Exclusion for Bond Interest Income, p. 67);
(2) Distributions from a 529 plan (see Qualified Tuition Programs (529 Plans) – Income
Tax Treatment of Distributions and Rollovers, p. 23); and
(3) Distributions from Coverdell ESAs (see Coverdell Education Savings Accounts,
p. 5).
However, the reduction for amounts taken into account in determining an exclusion for distribu-
tions from a 529 plan applies only to the amount of the distribution that is attributable to earn-
ings, and not to the return of contributions.19
EXAMPLE: A taxpayer receives a distribution of $100 from a 529 plan that is used for
tuition. $90 represents contributions to the account, and $10 represents earnings under
the program. Qualified expenses would be reduced only by that $10. Thus, the taxpayer
would be entitled to claim the deduction with respect to the $90 representing a return of
contributions. In contrast, if the distribution were from a Coverdell ESA, the $90 would
not be eligible for the deduction.
Deduction Limits
For taxable years beginning in 2004 and 2005, taxpayers with adjusted gross income that does
not exceed $65,000 ($130,000 in the case of married taxpayers filing joint returns) are entitled to
a maximum deduction of $4,000, and taxpayers with adjusted gross income that is greater than
$65,000 but does not exceed $80,000 (greater than $130,000 but does not exceed $160,000 in
the case of married taxpayers filing joint returns) are entitled to a maximum deduction of $2,000.
Taxpayers with adjusted gross income above these thresholds are not entitled to a deduction.20
For taxable years beginning in 2003, taxpayers with adjusted gross income that does not exceed
$65,000 ($130,000 in the case of married couples filing joint returns) are entitled to a maximum
deduction of $3,000 per year. Taxpayers with adjusted gross income above these thresholds are
not entitled to a deduction.21
17
18
See Code Section 25A(g)(2).
19
20
21
Code Section 222(b)(2)(A).
OBSERVATION: Unlike most deductions that are limited, there are no phase-out ranges
for the qualified higher education expense deduction limits applicable to taxable years
beginning in 2003.
PRACTICE TIP: A taxpayer who has qualified tuition and related expenses in excess of
the deduction limitation amount can still claim the expenses as a miscellaneous itemized
deduction subject to the 2% AGI limitation if they qualify as work-related education ex-
penses required by the taxpayer’s employer in order for the taxpayer to retain his current
position.22 See Business Deductions for Educational Expenses, p. 59.
For this purpose, adjusted gross income is determined without taking into account the exclusion
for foreign earned income and housing cost amounts; the exclusion for income from sources
within Guam, American Samoa, or the Northern Mariana Islands; or the exclusion for income
from sources within Puerto Rico. On the other hand, for purposes of the deduction, adjusted
gross income is determined after applying the rules relating to:
(1) Taxation of certain social security benefits;
(2) Exclusion of income from U.S. savings bonds used to pay higher education tuition
and fees (see Exclusion for Bond Interest Income, p. 67);
(3) Exclusion of amounts paid or expenses incurred by the employer for qualified adop-
tion expenses;
(4) Deduction for amounts contributed to individual retirement accounts (IRAs);
(5) Deduction for interest on education loans (see Student Loan Interest Deduction, p.
91); and
(6) Limit on passive activity losses and credits.23
OBSERVATION: Calculating modified AGI without taking into account the listed
deductions and exclusions, increases the taxpayer’s modified AGI and, therefore, the
chances of having the deduction for qualified higher education expenses phased-out. On
the other hand, allowing modified AGI to be computed after the application of certain
other deductions and exclusions decreases both the taxpayer’s modified AGI and the
chances of having the qualified higher education expense deduction limited.
In addition, no deduction will be allowed for any expense for which the taxpayer is allowed a
deduction under any other provision.24 Finally, a taxpayer cannot claim the deduction if he or
any other person claims a Hope or lifetime learning credit in the same taxable year with respect
to the same student.25
22
See Reg. Section 1.162-5(a).
23
Code Section 222(b)(2)(C).
24
25
Code Section 222(c)(2)(A).
Deduction for Qualified Higher Education Expenses 57
Determining whether to take the deduction or one of the education credits when both are avail-
able requires consideration of the amount of the expenses incurred and the taxpayer’s marginal
tax rate. It generally is more advantageous to claim the Hope scholarship credit, if available,
rather than the deduction, because $4,000 in expenses results in the full $1,500 credit, which
is more valuable than the maximum $4,000 deduction for all taxpayers. In contrast, since the
lifetime learning credit is only available for 20 percent of expenses, up to $10,000, the deduc-
tion is more valuable for any taxpayer with $4,000 or less in expenses who has a marginal tax
rate of more than 20 percent, but the credit may be more valuable for taxpayers who incur larger
amounts of expenses.
Assuming that a taxpayer has at least $10,000 in qualifying expenses in 2004, taking a credit
generally results in more tax savings when the taxpayer’s AGI is low, while the deduction be-
comes more advantageous as AGI increases. For example, the 2004 tax savings for a married
couple filing a joint return are as follows if they paid $10,000 in qualifying expenses, have one
child, and do not itemize (i.e., they claim three personal exemptions of $3,100 each and the
$9,700 standard deduction):
Savings From:
AGI Lifetime
(Joint Filers) Hope Credit* Learning Credit* Deduction
$0 – $33,300 $1,500 $2,000 $400
$33,301 – $77,100 $1,500 $2,000 $600
$77,101 – $85,000 $1,500 $2,000 $1000
$85,001 – $95,000 $1,500 – $750 $2,000 – $1,000 $1000
$95,001 – $105,000 $750 – $0 $1,000 – $0 $1000
$105,001 – $130,000 $0 $0 $1000
$130,001 and over $0 $0 $0
*Credits are phased out ratably for married taxpayers filing a joint return with AGI from $85,000 to $105,000
Timing of Deduction
The deduction generally is allowed for a tax year only to the extent the expenses are in connec-
tion with enrollment at an institution of higher education during the tax year. However, a limited
amount of prepayment is allowed – expenses in connection with an academic term that begins
during that tax year or during the first three months of the next taxable year are allowed.26
EXAMPLE: State University requires tuition to be paid by December 15 for a semester
beginning in February of the following year. A taxpayer who pays the tuition by the due
date can claim the deduction for this payment, even though the expenses are for enroll-
ment in the following year, because the semester starts in the first three months of that
year.
26
Since the timing of the deduction is determined by the timing of the payment, not the education
for which the payment is made, it may be worth deferring any tuition payments due near the
end of the year until the following year, if the educational institution permits it. This could be
particularly advantageous in the case of payments on behalf of individuals who are not expected
to incur additional educational expenses in the following year, such as students graduating in
June of the following year.
Planning when to pay qualified tuition is also important if the taxpayer’s modified AGI is close to
$80,000 ($160,000 in the case of married couples filing joint returns) since the entire deduction
is lost if the taxpayer’s modified AGI is even $1 over the applicable limitation amount. There-
fore, if the taxpayer expects an increase in his modified AGI that will put him over the deduction
limit, he should consider prepaying tuition if possible. On the other hand, if the taxpayer expects
a decrease in his modified AGI that will put him under the deduction limit, he should consider
deferring tuition payments until the following year if possible.
Business Deductions for

Educational Expenses
Generally
The cost of education that is an ordinary and necessary expense in carrying on a taxpayer’s trade
or business is deductible, in the year it is paid or incurred, under the rules generally applicable
to business expenses. However, to be deductible, education must maintain or improve skills re-
quired in the taxpayer’s present trade or business or employment, must meet the express require-
ments of the taxpayer’s employer, or be necessary for the taxpayer to retain her salary, status, or
job.1 See Maintaining or Improving Skills, p. 60; Meeting Requirements of Employer or Law, p.
61. The cost of education that represents a capital expenditure or a personal expenditure is not
deductible.2
A taxpayer can deduct all expenses incurred in obtaining education that qualifies under these
rules, including (among other things) amounts spent for tuition, fees, books, supplies and equip-
ment, and certain travel and transportation costs.3 See Transportation and Travel Expenses, p.
68. In addition, the deduction is not limited to “traditional” higher education expenses paid to
accredited colleges or universities. The deduction has been allowed for the cost of correspon-
dence courses,4 career counseling,5 research and typing,6 flight training,7 and psychoanalysis.8
Education costs are not deductible if the training either (1) meets the minimum educational
requirements for qualification in the taxpayer’s trade or business, or (2) is part of a program of
study that would qualify the taxpayer for a new trade or business, regardless of whether the tax-
payer ever intends to enter this new trade or business. See Non-Deductible Education Expenses,
p. 62. In addition, educational expenses are not deductible to the extent they are paid for with
tax-exempt income. See Use of Tax-Exempt Income to Pay for Education, p. 65.
COMPLIANCE TIP: Employees can deduct the education costs as a business expense
only they are not reimbursed by their employer or if the costs exceed their reimburse-
ment. If an employee does not claim a reimbursement that she is entitled to receive from
her employer, she cannot deduct the expenses that apply to the reimbursement. Amounts
paid by an employer under a non-accountable plan and included in Box 1 of Form W-2,
Wage and Tax Statement, are not considered reimbursements.9
1
See Code Section 162; Reg. Section 1.162-5. See Kleinrock’s Analysis and Explanation, Ch. 25, for a detailed
discussion of the deduction for business expenses.
2
Code Sections 262, 263; Reg. Section 1.162-5(b)(1).
3
Reg. Section 1.162-5.
4
Rev. Rul. 76-62, 1976-1 C.B. 12.
5
Rev. Rul. 78-93, 1978-1 C.B. 38.
6
Rev. Rul. 67-421, 1967-2 C.B. 84.
7
Boser v. Commissioner, 77 T.C. 1124 (1981).
8
Voigt v. Commissioner, 74 T.C. 82 (1980).
9
See Kleinrock’s Analysis and Explanation, Section 29.5, for a discussion of accountable and non-accountable
reimbursement plans.
Maintaining or Improving Skills

In general, education that maintains or improves skills required by an individual in her employ-
ment or other trade or business is deductible. The skills required by the taxpayer in her employ-
ment or other trade or business are those that are appropriate, helpful, or needed.10 This includes
refresher courses and courses dealing with current developments, as well as academic or voca-
tional courses that are required in the individual’s employment, trade, or business.11 Education
to maintain or improve skills needed in a taxpayer’s present work is not deductible if it will also
qualify the taxpayer for a new trade or business.12 See Qualifying for a New Trade or Business,
p. 62. A pastor could not deduct educational expenses for courses that were not required for him
to continue as a local pastor but that ultimately led to a bachelor’s degree because the courses
provided him with a background in a variety of social issues that could have prepared him for
employment with several public agencies and private non-profit organizations outside of the
ministry.13
EXAMPLE: Phil is a freelance computer programmer. To keep up with the latest
changes, Phil takes special courses in newly developed programming languages. The
courses maintain and improve skills required in Phil’s work, but do not qualify Phil for a
new trade or business. Therefore, Phil can deduct the costs of the courses.
Whether education is undertaken primarily for the purpose of maintaining or improving the
skills required by the taxpayer in her employment is to be determined on a case-by-case basis
according to the particular facts and circumstances. Education that is customary for other es-
tablished members of a profession, trade, or business is generally considered to satisfy these
requirements.
PRACTICE TIP: Taxpayers should postpone taking specialized courses until after com-
mencing work. Once the taxpayer has satisfied the minimum requirements for her occu-
pation and is engaged in her trade or business, the courses she takes become deductible
as maintaining or improving skills.
Education gained during a temporary absence from work is deductible if it maintains or im-
proves skills needed in the employee’s present employment. If a taxpayer stops working for a
year or less in order to obtain additional such an education and then returns to the same work,
the taxpayer’s absence is considered temporary.
EXAMPLE: John quits his biology research job to become a full-time biology gradu-
ate student for one year. If John returns to work in biology research after completing the
courses, the education is related to his present work even if he does not go back to work
with the same employer.
10
Rev. Rul. 60-97, 1960-1 C.B. 69, obsoleted by Rev. Rul. 72-619, 1972-2 C.B. 650. But see Watson v. Commis-
sioner, 31 T.C. 1014 (1959) (customariness is not absolutely necessary).
11
Reg. Section 1.162-5(c).
12
Reg. Section 1.162-5(b)(3).
13
Winterheld v. Commissioner, T.C. Memo. 2003-175.
Business Deductions for Educational Expenses 61
If a taxpayer stops work for more than a year, his absence is considered indefinite. Education
during an indefinite absence is considered non-deductible education to qualify for a new trade
or business, even if it maintains or improves skills needed in the work from which the taxpayer
is absent.
Meeting Requirements of Employer or Law

Education undertaken by a taxpayer to meet the express requirements of her employer (or the
requirements of applicable law or regulations) in order to keep her present salary, status or job is
deductible. However, the deduction is allowed only if the requirement serves a business purpose
of the employer and the education is not part of a program that will qualify the taxpayer for a
new trade or business. Mere encouragement or cooperation by the employer does not constitute
a requirement.14 Likewise, an obscure or unproven condition will not support a deduction.15
EXAMPLE: Jack is a teacher who has satisfied the minimum requirements for teach-
ing. Jack’s employer requires him to take an additional college course each year to keep
his teaching job. If the courses will not qualify Jack for a new trade or business, they are
qualifying education even if Jack eventually receives a master’s degree and an increase
in salary because of his extra education.
PRACTICE TIP: Only the minimum education necessary for an employee to retain his
established employment relationship, status, or rate of compensation may be considered
as undertaken to meet the express requirements of his employer. However, education in
excess of such minimum education may be deductible as education undertaken in order
to maintain or improve skills required by an individual in his employment, trade, or busi-
ness.16
A financial consultant could not deduct educational expenses for courses leading to an M.B.A.
degree undertaken between periods of employment because, having left his former employment
before he started the program and having not yet started the new employment until after he fin-
ished the program, he did not have a job, status in a job, or a rate of compensation that he could
retain through the education.17
14
Reg. Section 1.162-5(c)(2). See, e.g., Kinch v. Commissioner, T.C. Memo. 1971-117 (taxpayer could not deduct
expenses relating to obtaining a bachelor’s degree that he claimed was a condition for his retention in the Air
Force since there was no official Air Force requirement of a degree in order to receive or retain a commission).
15
See, e.g., Sud v. Commissioner, T.C. Memo. 1965-102 (teaching assistant could not deduct expenses for graduate
studies where the was not an express requirement that he proceed with his graduate studies).
16
Reg. Section 1.162-5(c)(2).
17
Zhang v. Commissioner, T.C. Summary 2003-58.
Non-Deductible Education Expenses
Qualifying for a New Trade or Business

Expenditures for education that is part of a program of study being pursued by the taxpayer that
will qualify the taxpayer for a new trade or business are not deductible.18 This rule applies even
if the taxpayer does not plan to enter that trade or business.
EXAMPLE: Andrew is an accountant, but his employer requires him to get a law de-
gree at his own expense. Andrew registers at a law school for the regular curriculum that
leads to a law degree. Even if Andrew does not intend to become a lawyer, the costs of
the legal education are not deductible because the law degree will qualify Andrew for a
new trade or business.
OBSERVATION: Review courses to prepare for the bar examination or the certified
public accountant (CPA) examination are not deductible since they are part of a program
of study that can qualify the student for a new profession.
Two tests are used to determine whether the education qualifies the taxpayer for a new trade or
business – the objective test and common sense approach. The objective test states that the court
should look only to whether the education qualifies the taxpayer for the practice of a new trade
or business.19 Whether the taxpayer intended to enter a new business, or even whether this was
realistically possible, is not considered pertinent.20
The “common sense approach” states that the court should determine whether the education
qualifies the taxpayer for significantly different tasks than previously qualified to perform.21 The
primary difference is that the common sense approach allows consideration of subjective infor-
mation, which has resulted in decisions that are more beneficial to individual taxpayers.22
OBSERVATION: A change of duties does not constitute a new trade or business if
the new duties involve the same general type of work as is involved in the individual’s
present employment. For this purpose, all teaching and related duties are considered to
involve the same general type of work. Thus, for example, changing from an elementary
school teacher to a secondary school classroom teacher; from a teacher in one subject
(such as mathematics) to a teacher in another subject; from a classroom teacher to guid-
ance counselor; or from a classroom teacher to principal does not constitute a new trade
or business.23
18
19
See O’Donnell v. Commissioner, 62 T.C. 781 (1974), aff’d, 519 F.2d 1406 (7th Cir. 1975).
20
Meeks v. Commissioner, 208 F.3d 221 (9th Cir. Feb. 22, 2000).
21
See Diaz v. Commissioner, 70 T.C. 1067 (1978), aff’d without published opinion, 607 F.2d 995 (2d Cir. 1979).
22
See, e.g., Wiertzema v. United States, 747 F. Supp. 1363 (D.N.D. 1989) (farmer allowed to deduct educational
expenses associated with a certified welding program, even though the education would qualify the farmer for
employment in a new occupation as a welder, because the farmer intended to continue farming indefinitely); PLR
8324068 (business representative and financial secretary allowed to deduct expenses associated with a non-accred-
ited law school program because completion of the program would not make the taxpayers eligible to take any state
bar examination).
23
Minimum Education Requirements

Education that is required of a taxpayer in order for the taxpayer to meet the minimum educa-
tional requirements for qualification in her employment or other trade or business is not deduct-
ible. The minimum educational requirements for a position are determined by such factors as
the requirements of the employer, the applicable law and regulations, and the standards of the
profession, trade, or business involved.
EXAMPLE: Derek is a full-time engineering student. Although he has not received his
degree or certification, Derek works part time as an engineer for a firm that will employ
him as a full-time engineer after he finishes college. Although Derek’s college engineer-
ing courses improve his skills in his present job as a part-time engineer, they are also
needed to meet the minimum job requirements for a full-time engineer. Thus, the costs
of the engineering courses are not deductible.
Employment status does not, in itself, provide that the minimum standards have been satisfied.
However, once an individual has met the minimum educational requirements for her employ-
ment or other trade or business, she is treated as continuing to meet those requirements even
when they are changed.24 In this case, any education required to meet the new standards would
be considered education for the purpose of maintaining or improving skills in the taxpayer’s
trade or business.
EXAMPLE: Nicholas is an accountant and has met the minimum educational require-
ments of his employer. Nicholas’ employer later changes the minimum educational re-
quirements and requires him to take college courses to keep his job. The costs of the
additional courses are deductible because Nicholas already satisfied the minimum re-
quirements that were in effect when he was hired.
OBSERVATION: For teachers (including college professors), the minimum educational
requirements for qualification is the minimum level of education (in terms of aggre-
gate college hours or degree) that is normally required of an individual initially being
employed as a teacher under the applicable laws or regulations. If there are no normal
requirements as to the minimum level of education, then a teacher is considered to have
met the minimum educational requirements for qualification when he becomes a mem-
ber of the faculty. The determination of whether an individual is a member of the faculty
is made on the basis of the particular practices of the educational institution. However, an
individual will ordinarily be considered to be a member of the faculty if (1) he has tenure
or his years of service are being counted toward obtaining tenure, (2) the educational
institution is making contributions to a retirement plan (other than Social Security or a
similar program) in respect of his employment, or (3) he has a vote in faculty affairs.25
24
Reg. Section 1.162-5(b)(2)(i).
25
Reg. Section 1.162-5(b)(2)(ii).
Transportation and Travel Expenses

A taxpayer who is regularly employed and goes to school directly from work is allowed a deduc-
tion for the transportation costs of going directly from work to school if the education otherwise
qualifies for the business expense deduction. This rule applies regardless of the location of the
school or the distance traveled. Likewise, a taxpayer who is regularly employed and goes to
school on a temporary basis, such as six consecutive Saturdays, can deduct the round-trip trans-
portation costs of going between home and school if the education otherwise qualifies for the
business expense deduction, even if school is on non-working days.26
Transportation expenses include the actual costs of bus, subway, cab, or other fares, as well as
the taxpayer’s costs of using his car. Transportation expenses do not include amounts spent for
travel, meals, or lodging while away from home overnight.
PRACTICE TIP: If an automobile is used, the standard mileage rate is available (37.5
cents per mile for 2004).27
If an individual travels away from home primarily to obtain education, the expenses of which
are deductible to the individual, expenses for travel, meals, and lodging while away from home
also are deductible as long as the individual is away from home for a temporary period of time
(i.e., 12 months or less).28 If, as part of the trip, the individual engages in personal activity (e.g.,
sightseeing), the portion of the expenses attributable to such personal activity is not deductible.
If the individual’s travel away from home is primarily personal, the individual’s expenses for
travel, meals, and lodging (other than meals and lodging during the time spent participating in
deductible educational pursuits) are not deductible. The facts and circumstances of each case
determine whether a particular trip is primarily personal or primarily to obtain education. An
important factor in making this determination is the relative amount of time devoted to personal
activity as compared with the time devoted to educational pursuits.29
OBSERVATION: Deductions for travel as a form of education are prohibited if the
travel itself is educational.30 For example, a French language teacher cannot deduct
travel expenses incurred in touring France simply because it improves her knowledge of
the French language. However, an individual may deduct expenses for travel that are a
“necessary adjunct” to engaging in an activity that is otherwise deductible as an educa-
tional business expense.31
COMPLIANCE TIP: Employees claiming unreimbursed transportation, travel, or meal
expenses are generally required to file Form 2106, Employee Business Expenses, or
Form 2106-EZ, Unreimbursed Employee Business Expenses.
26
IRS Publication 508, Tax Benefits for Work-Related Education.
27
Rev. Proc. 2003-76, 2003-2 C.B. 924. See Kleinrock’s Analysis and Explanation, Section 32.5, for a discussion
of the standard mileage rate.
28
29
Reg. Section 1.162-5(e). See Kleinrock’s Analysis and Explanation, Ch. 27, for a detailed discussion of the deduc-
tion for business travel.
30
Code Section 274(m)(2). Note that Reg. Section 1.162-5(d) states that expenditures for travel as a form of educa-
tion are deductible to the extent such expenditures are attributable to a period of travel that is directly related to the
duties of the individual in her employment or other trade or business. However, Congress legislatively overruled
that provision when it enacted Code Section 274(m)(2).
31
See Jorgensen v. Commissioner, T.C. Memo. 2000-138.
Use of Tax-Exempt Income to Pay for Education

A deduction is not allowed for educational expenses that are paid from tax-exempt income
provided for purposes of paying for the education.32 This includes amounts received as tax-ex-
empt:
(1) Scholarships or fellowships (see Scholarships and Fellowships, p. 73);
(2) Educational assistance provided to certain veterans and members of the armed forces
under Title 38 of the U.S. Code;
(3) Interest on U.S. Savings Bonds used to pay higher education expenses (see Exclusion
for Bond Interest Income, p. 67);
(4) Educational assistance program payments to employees (see Educational Assistance
Programs, p. 85); and
(5) Qualified tuition reduction program payments to employees of an educational orga-
nization (see Qualified Tuition Reduction Programs, p. 81).
EXAMPLE: Eric is taking night classes that qualify for a business expense deduction.
Eric’s tuition for the classes is $3,000. Eric receives a $1,000 tax-exempt scholarship to
help pay for the classes. Eric can deduct only $2,000 ($3,000 – $1,000) as a business-
related educational expenses.
If only part of the income provided for purposes of paying educational expenses is tax exempt,
only the tax-exempt part is subtracted from the education costs for purposes of the business
expense deduction.
EXAMPLE: Mary’s tuition for education qualifying for a business deduction is $8,000.
Mary receives a $6,000 scholarship of which $4,000 is tax exempt and $2,000 is tax-
able. Mary can deduct only $4,000 ($8,000 – $4,000) as business-related educational
expenses.
If only part of education costs qualify for a business expense deduction, then only part of the
tax-exempt income is subtracted from the education costs. To determine the part of the tax-
exempt income that must be subtracted from the education costs for purposes of the business
expense deduction, the tax-exempt income is multiplied by a fraction. The fraction’s numerator
is the portion of the tuition qualifying for a business expense education and the denominator is
the total tuition.33
32
See Code Section 265(a)(1). See also Manocchio v. Commissioner, 78 T.C. 989 (1982); Rev. Rul. 83-3, 1983-1
C.B. 72, modified by Rev. Rul. 87-32, 1987-1 C.B. 131, and Rev. Rul. 85-96, 1985-2 C.B. 87.
33
IRS Publication 508, Tax Benefits for Work-Related Education.
EXAMPLE: Woody is taking a correspondence course that costs $8,000. However, only
$3,200 of the course’s tuition qualifies for a business expense deduction. Woody receives
a tax-exempt scholarship for $6,000. As a result, Woody can only deduct $800 of the
tuition as a business expense because he had to subtract $2,400 from the portion of the
total tuition that qualified for the deduction.
$3,200
$6,000 × = $2,400
$8,000
$3,200 – $2,400 = $800
Claiming the Deduction

Self-employed persons and employees report their educational expenses differently. Self-em-
ployed taxpayers report educational expenses on the appropriate form used to report business
income and expenses. For example, sole proprietors and independent contractors use Schedule
C, Profit or Loss from Business (Sole Proprietorship), Schedule C-EZ, Net Profit from Business
(Sole Proprietorship), or Schedule F, Profit or Loss from Farming.
Employee business expenses, including qualifying educational expenses, can only be claimed as
miscellaneous itemized deductions subject to the 2 percent of AGI floor.34 Thus, they are gener-
ally reported on Line 20 of Schedule A of Form 1040, U.S. Individual Income Tax Return.
COMPLIANCE TIP: Employees claiming unreimbursed transportation, travel, or meal
expenses are generally required to file Form 2106, Employee Business Expenses, or
Form 2106-EZ, Unreimbursed Employee Business Expenses.
Certain performing artists and state (or local) government officials who are paid in whole or in
part on a fee basis can deduct their qualified education expenses as an above-the-line deduction
rather than as a miscellaneous itemized deduction subject to the 2 percent AGI limit.35 Instead,
they include qualified education expenses with any other employee business expenses on Form
1040. They must, however, also file either Form 2106 or 2106-EZ.
In addition, taxpayers who are disabled and have impairment-related work expenses that entitle
them to a qualifying education expense deduction can claim them on Schedule A as “other
miscellaneous deductions,” which are not subject to the 2 percent AGI limit. They must also file
either Form 2106 or 2106-EZ.
34
See Code Section 67(a). See Kleinrock’s Analysis and Explanation, Ch. 45, for a detailed discussion of miscel-
laneous itemized deductions subject to the 2 percent AGI floor.
35
See Code Section 62(a)(2)(B), (C). See Kleinrock’s Analysis and Explanation, Sections 27.3 and 45.4, for discus-
sions of when compensation received by a public official is fee based and when a performing artist is eligible for
the above-the-line deduction, respectively.
Exclusion for Bond Interest

Income
Generally
The interest on certain U.S. Savings Bonds is exempt from tax if the bond proceeds are used to
pay qualified higher education expenses for a taxpayer, the taxpayer’s spouse, or his dependents.1
Limitations on this exclusion, however, significantly reduce its usefulness. See Limit Based on
Qualified Expenses, p. 70; AGI Phaseout, p. 71.
Interest on Series EE and Series I Savings Bonds issued after 1989 are eligible for the exclusion
if purchased by individuals who are at least 24 years of age before the date of issuance.2 The
exclusion is available only to the taxpayer who purchases the bond (or his spouse). Thus, bonds
purchased by children or purchased by parents and transferred to children are not eligible for the
exclusion. Bonds purchased by grandparents or others are similarly not eligible, unless the child
is a dependent of the bond owner at the time of redemption. No exclusion is available to married
taxpayers unless they file joint returns.3
PRACTICE TIP: Allowing the U.S. Savings Bond interest exempting only for edu-
cational expenses of the taxpayer, his spouses, or his dependents can create a problem
where a student’s parents are divorced and the bonds were purchased by the non-custodial
parent. In that situation, the non-custodial parent is not entitled to the exclusion when he
redeems the bonds to pay his child’s college tuition since he cannot claim the child as a
dependent. To avoid this problem, the custodial parent can release the exemption to the
non-custodial parent, or the divorce decree can award the dependency exemption to the
non-custodial parent.
COMPLIANCE TIP: Taxpayers use Form 8815, Exclusion of Interest from Series EE
and I U.S. Savings Bonds Issued After 1989, to figure the interest exclusion upon re-
deeming bonds and paying qualified higher education expenses during the same year.
Form 8815 must be attached to the taxpayer’s return. Form 8818, Optional Form to Re-
cord Redemption of Series EE and I U.S. Savings Bond Issued After 1989, can be used
to maintain the information required to make the computation. It should be retained for
the taxpayer’s records.
PRACTICE TIP: Individuals interested in using U.S. Savings Bonds to save for their
own or a spouse’s education are restricted by the age at purchase limitation. The tax ben-
efit of these bonds is greatest at the time the bonds mature, which may be many years
after purchase. However, the bonds do not qualify for the exclusion if they are purchased
before the individual’s twenty-fourth birthday. To take maximum advantage of the exclu-
sion, an adult would have to be planning a later return to school.
1
Code Section 135(a), (c)(2)(A).
2
Code Section 135(c)(1). Bonds obtained as part of a tax-free rollover of matured Series E bonds do not qualify for
the exclusion. H.R. Conf. Rep. No. 104, 100th Cong., 2d Sess. 142 (1988).
3
Parents might want to put U.S. Savings Bonds in the child’s name so that the child may elect to
include the bond interest in income on a yearly basis rather than at the time of redemption.4 The
child may then use his annual standard deduction to eliminate or reduce the tax that would have
to be paid. See Sample Election to Recognize Current Income on Non-Interest Bearing Discount
Bonds Under Code Section 454, p. 131. Unfortunately, the bond interest exclusion is lost alto-
gether if the bonds are put in a child’s name.
If a parent keeps U.S. Savings Bonds in his own name, but still elects to accrue the interest rat-
ably as it is earned, he may want to revoke the election if he plans to redeem the bonds in the
same year that he pays for his child’s higher education expenses because he must use the cash
method for reporting the interest income. Revoking the election will allow him to claim the tax
benefit for bonds that are purchased subsequent to the revocation.
The revocation is tantamount to a change in accounting method, which ordinarily requires the
filing of Form 3115, Application for Change Accounting Method. However, the IRS has pro-
vided an expeditious procedure to secure automatic consent for the change. Under the automatic
consent procedures, the taxpayer files a revocation statement (in lieu of Form 3115) with the
return for the tax year in which the revocation is desired. The statement must be identified at
the top as follows: “Change in Method of Accounting under Section 6.01 of the Appendix of
Rev. Proc. 2002-9.” The statement must also set forth (1) the Series E, EE, or I U.S. Savings
Bonds for which this change in accounting method is requested; (2) an agreement to report all
interest on any bonds acquired during or after the year of change when the interest is realized
upon disposition, redemption, or final maturity, whichever is earliest; and (3) an agreement to
report all interest on the bonds acquired before the year of change when the interest is realized
upon disposition, redemption, or final maturity, whichever is earliest, with the exception of any
interest income previously reported in prior taxable years.5 See Sample Statement for Automatic
Consent of Accounting Method Change upon Redemption of Savings Bonds, p. 132. No user fee
is required.
The revocation has no effect on the interest income previously recognized. It is only effective
for any unrecognized interest on all Series E, EE, or I bonds held at the beginning of the year in
which the election is made and with regard to all Series EE and I bonds acquired thereafter.

Bonds are treated as an asset for purposes of computing a student’s expected family contribution
(EFC). See Financial Aid – Expected Family Contribution, p. 101. If a student’s parents own
bonds, they are assessed at the parent’s asset rate (maximum rate of 5.6%). However, if the stu-
dent owns bonds, they are assessed at the student’s asset rate (35%). Since the exclusion for bond
4
See Code Section 454.
5
Rev. Proc. 2002-9, Appendix, Section 6.01, 2002-1 C.B. 327.
Exclusion for Bond Interest Income 69
interest only applies when a person 24 years of age or older purchase the bonds, interest eligible
for the exclusion will be paid on bonds owned by the parents in most cases. Where the parents
own the bonds, the interest paid upon redemption will be assessed the at a 22 to 47 percent rate
for purposes of determining the parents’ contribution towards the student’s EFC in the following
year. If the bonds are owned by the student, the paid interest will be assessed at a 50 percent rate
for purposes of determining the student’s contribution from income in the following year.
Qualified Expenses
Qualified higher education expenses are tuition and fees required for the enrollment or atten-
dance of the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependent at an eligible educa-
tional institution. Contributions to 529 plans and Coverdell ESAs are also considered qualified
higher education expenses for purposes of the bond interest exclusion.6 See Qualified Tuition
Programs (529 Plans), p. 19; Coverdell Education Savings Accounts, p. 5.
Room and board are not included in the definition of qualified higher education expenses. Nei-
ther are expenses for any course involving sports, games, or hobbies unless they are part of a
degree program.8
In addition, for purposes of the bond interest exclusion, qualified higher education expenses are
reduced by the amount of any:
(1) Scholarship excluded from gross income (see Scholarships and Fellowships, p. 73);
(2) Educational assistance payment to a veteran or member of the armed forces;
(3) Expense taken into account in determining a Hope scholarship or lifetime learning
credit (see Hope Scholarship and Lifetime Learning Credits, p. 35);
(4) Expense taken into account in determining the exclusion for distributions from a
Coverdell ESA or 529 plan (see Coverdell Education Savings Accounts, p. 5; Quali-
fied Tuition Programs (529 Plans), p. 19);
(5) Payment, waiver, or reimbursement of expenses under a 529 plan; and/or
(6) Other exempt payment (other than a gift, bequest, devise, or inheritance) for educa-
tional expenses or attributable to attendance at an eligible education institution.9
6
Code Section 135(c)(2)(A), (C).
7
Code Section 135(c)(3). See also Code Section 529(e)(5); Notice 97-60, 1997-2 C.B. 310.
8
9
Code Section 135(d)(1), (2).
The reductions are taken into account before application of the limit based on qualified higher
education expenses (see below).
Limit Based on Qualified Expenses

The full amount of interest on redeemed bonds is excludable from income in any year in which
an individual’s qualified higher educational expenses exceed the aggregate redemption amount
(principal plus interest) for bonds redeemed during the year (subject to the AGI phaseout – see
AGI Phaseout, p. 71). However, if the redemption amount is larger than the qualified educational
expenses, the exclusion is limited to the “applicable fraction” of the bond interest. The appli-
cable fraction is computed by dividing the qualified education expenses by the total redemption
proceeds.10
EXAMPLE: In 1997, Al purchased several Series EE U.S. Savings Bonds having a
combined face value of $50,000. He paid $25,000 for the bonds, which were due to
mature in 2004. In 2004, Al’s son entered college and Al incurred $10,000 of qualified
higher education expenses. If Al redeems $25,000 worth of bonds in 2004, his exclusion
will be $5,000.
$10,000
× $12,500 = $5,000
$25,000
A taxpayer who has bonds with a redemption value in excess of one year’s qualified higher edu-
cation expenses should spread the redemption over more than one year. This will also reduce the
effect of the AGI phaseout. See AGI Phaseout, p. 71.
EXAMPLE 1: In 1997, Tom purchased, for $15,000, Series EE bonds having a face
amount of $30,000, which were due to mature in 2004 (eight years). In 2004, Tom’s
daughter entered college and Tom incurred $18,000 of qualified higher education ex-
penses. If Tom redeems all of the bonds for $30,000 in 2004, his exclusion will be
$9,000, determined as follows:
$18,000
× $15,000 = $9,000
$30,000
The remaining $6,000 is taxable as interest income.
10
Exclusion for Bond Interest Income 71
EXAMPLE 2: The facts are the same as in Example 1, except that instead of redeeming
all the bonds in 2004, Tom redeems $18,000 worth of bonds in 2004 and the remain-
ing bonds in 2005 for $13,000 (the $1,000 increase in value from 2004 is additional
accrued interest). In 2004, the entire $9,000 of interest income is excluded because the
redemption proceeds of $18,000 equal qualified higher education expenses. In 2005,
Tom will have $7,000 of interest income from the $13,000 redemption, but if his daugh-
ter continues in school and incurs qualified expenses of $13,000 or more, the $7,000 of
income will also be excluded. If Tom’s daughter does not continue in school, however,
this amount will be taxed, but this result is no worse than that from redeeming all of the
bonds in 2004.
AGI Phaseout
The exclusion provided for bonds redeemed for qualified higher education expenses is phased
out for upper-income taxpayers. The phaseout ranges are based on a taxpayer’s modified ad-
justed gross income (AGI) and are annually adjusted for inflation. For 2004, the phase-out be-
gins for single and head of household filers when AGI exceeds $59,850 and is complete when
AGI exceeds $74,850. For joint filers, the 2004 tax year phase-out begins when AGI exceeds
$89,750 and is complete when AGI exceeds $119,750.11 Married taxpayers filing separately do
not qualify for any exclusion.12
For taxpayers falling within the phaseout range, excludable interest is reduced by a fraction,
where the numerator is the excess modified AGI (i.e., the excess of modified AGI over the low
figure of the phaseout range) and the denominator is the number of dollars in the phaseout range
($30,000 for joint returns and $15,000 for single taxpayers).13
penses. To pay for his daughter’s education expenses, Tom redeems $18,000 worth of
bonds in 2004 and the remaining bonds in 2005 for $13,000 (the $1,000 increase in value
from 2004 is additional accrued interest). Tom has a modified AGI of $98,750 in 2004
(joint return). Although Tom would otherwise be entitled to exclude all $9,000 of the
bond interest income received in 2004 (see Example 2, above), the phaseout reduces the
exclusion by $2,700 (to $6,300).
$98,750 – $89,750
× $9,000 = $2,700
$30,000
11
Code Section 135(b)(2); Rev. Proc. 2003-85, 2003-2 C.B. 1184.
12
13
Code Section 135(b)(2)(A). The $15,000 and $30,000 amounts are not indexed for inflation. Code Section
135(b)(2)(B).
penses. To pay for his daughter’s education expenses, Tom redeems all of the bonds in
2004. Tom now has a modified AGI of $104,750 ($98,750 + $6,000 of additional income
from non-excludable portion of bond interest). Although Tom would otherwise be en-
titled to exclude $9,000 of the bond interest income received in 2004 (see Example 1,
above), the phaseout reduces the exclusion by $4,500 (to $4,500).
$104,750 – $89,750
× $9,000 = $4,500
$30,000
For purposes of calculating the bond interest exclusion’s AGI phaseout, a taxpayer’s modified
AGI is determined after the partial inclusion of social security and Tier I Railroad Retirement
benefits, the deduction for contributions to IRAs, and the limitations of passive activity losses
and credits are taken into account, and includes:
(1) Bond interest excluded from gross income;
(2) Adoption assistance excluded from gross income;
(3) Interest on education loans deducted;
(4) Tuition and related expenses deducted;
(5) Foreign earned income excluded from gross income; and
(6) Income from sources within Guam, American Samoa, the Northern Mariana Islands,
and Puerto Rico excluded from gross income.14
14
Scholarships and Fellowships

Generally
Gross income does not include any amount received as a scholarship or fellowship by an indi-
vidual who is a candidate for a degree at an educational organization to the extent it is used for
qualified tuition and related expenses.1 The exclusion generally does not apply, however, to any
portion of a scholarship or fellowship that represents payment for teaching, research, or other
services provided by the student as a condition of receiving the scholarship or grant.2 See Com-
pensation for Services, p. 75.
OBSERVATION: Educational assistance that is not excludable as a scholarship or fel-
lowship because it represents payment for services may nevertheless be excluded if it is
furnished under a qualified educational assistance program (see Educational Assistance
Programs, p. 85) or qualified tuition reduction program (see Qualified Tuition Reduction
Programs, p. 81), or may be deductible as a trade or business expense (see Business De-
ductions for Educational Expenses, p. 59).
OBSERVATION: Many scholarships allow the recipient to study in a foreign country.
Although these scholarships are often paid in foreign currency, any U.S. tax owned must
be paid in U.S. currency. With the exception of Fulbright Scholarships, this rule applies
even if the foreign currency cannot be converted to U.S. dollars (i.e., the scholarship is
paid in “blocked income”).
Generally, a “scholarship or fellowship” is a cash amount paid or allowed to, or for the benefit
of, an individual to aid him in the pursuit of study or research. An amount need not be formally
designated as a scholarship or fellowship to qualify for the exclusion. A scholarship or fellow-
ship also may be in the form of a reduction in the amount charged by an educational organization
for tuition, room and board, or any other fee. However, an amount provided by an individual to
aid a relative, friend, or other individual in the pursuit of study or research cannot be excluded
from the recipient’s gross income if the grantor is motivated by family or philanthropic consid-
erations. In addition, educational and training allowances to veterans pursuant to the GI Bill and
appointments to an armed service academy are not considered scholarships for purposes of the
exclusion.3
“Qualified tuition and related expenses” include tuition and fees required for the enrollment or
attendance at an educational organization, as well as fees, books, supplies, and equipment.4 The
fees, books, supplies, and equipment must be required of all students in the particular course of
instruction. Incidental expenses, such as room and board, travel, research, clerical help, equip-
ment, and other expenses that are not required for either enrollment or attendance at an educa-
tional organization are not considered related expenses. Therefore, a scholarship that is used for
such incidental expenses is not excluded from income.5
1
Code Section 117(a), (b)(1).
2
3
Prop. Reg. Section 1.117-6(c)(3).
4
5
EXAMPLE: In 2004, Stephen receives a scholarship from City College for the 2004-
2005 academic year. A computer is a suggested item for a writing course that Stephen
will take, but students in the course are not required to obtain a computer. Stephen may
not treat the cost of a computer as a related expense in determining the amount excluded
from income as a qualified scholarship.
If the amount to be excluded cannot be determined when the scholarship or fellowship is re-
ceived because expenditures have not yet been incurred, any amount that is not used for qualified
tuition and related expenses within the academic period to which the scholarship or fellowship
applies must be included in the gross income of the recipient for the taxable year in which the
academic period ends.6
OBSERVATION: The terms of a scholarship or fellowship need not expressly require
that the amounts received be used for tuition and related expenses. However, to the ex-
tent that the terms specify that any portion of the scholarship or fellowship cannot be
used for tuition and related expenses or designate any portion for purposes other than
tuition and related expenses (such as for room and board or for a meal allowance), such
amounts are not amounts received as a qualified scholarship.7
A “candidate for a degree” is a student at a primary or secondary school or an undergraduate
or graduate student at a college or university who is pursuing studies or conducting research to
meet the requirements for an academic or professional degree. The term also includes (1) full-
time or part-time students at an educational organization that provides a program for full credit
toward a bachelor’s or higher degree, or (2) offers a program of training to prepare students for
gainful employment in a recognized occupation, is authorized under federal or state law to pro-
vide such a program, and is accredited by a nationally recognized accreditation agency.8
An “educational organization” is any organization that has as its primary function the presenta-
tion of formal instruction, normally maintains a regular faculty and curriculum, and normally
has a regularly enrolled body of pupils or students in attendance at the place where its educa-
tional activities are regularly carried on.9
EXAMPLE: In 2004, Donna receives a $500 scholarship to take a course from Corre-
spondence College. Donna receives and returns all lessons through the mail. No students
physically attend Correspondence College. Donna is not attending an educational orga-
nization and, thus, the $500 scholarship must be included in her gross income.

The amount of any scholarship or fellowship that is included in a student’s AGI is subtracted
from his income for purposes of calculating his “expected family contribution.” This will reduce
the student’s contribution from income and, consequently, increase his eligibility for financial
6
Prop. Reg. Section 1.117-6(b)(2).
7
8
Prop. Reg. Section 1.117-6(c)(4). But see, e.g., Streiff v. Commissioner, T.C. Memo. 1999-84 (doctor training for
board certification was not a degree candidate).
9
Code Sections 117(a), 170(b)(1)(A)(ii); Prop. Reg. Section 1.117-6(c)(5).
Scholarships and Fellowships 75
aid. In addition, tax-exempt scholarships and fellowships are taken into account for purposes of
determining a student’s financial aid eligibility by reducing the student’s “cost of attendance”
by the amount of any scholarship or other aid he receives. Thus, when a student receives a com-
pletely tax-exempt scholarship, his financial aid eligibility is decreased because his educational
costs are lowered. See Financial Aid – Financial Need, p. 99, for a discussion of a student’s cost
of attendance and expected family contribution.
Compensation for Services
General Rules
The exclusion for scholarships and fellowship is generally not available for any amounts re-
ceived as payment for teaching, conducting research, or providing other services as a condition
to receiving the award, regardless of whether all candidates for the particular degree are required
to perform such services.10
EXAMPLE: Cory is awarded a fellowship for the 2004-2005 academic year to pursue a
research project, the nature of which is determined by the grantor, Southern University.
Cory must submit a paper to Southern University that describes the research results. The
paper does not fulfill any course requirements. Under the terms of the fellowship, South-
ern University may publish Cory’s results or otherwise use the results of Cory’s research.
Cory is treated as performing services for Southern University. Thus, Cory’s fellowship
represents payment for services and must be included in Cory’s gross income.
Under an exception to this rule, amounts received under the National Health Service Corps
Scholarship Program or the Armed Forces Health Professions Scholarship and Financial Assis-
tance program are eligible for tax-free treatment as qualified scholarships without regard to any
service obligation.11 Furthermore, scholarships and fellowships conditioned on the performance
of a public service do not violate the compensation for services limitation.12
COMPLIANCE TIP: Any scholarship or fellowship amount representing payment for
services is considered wages for withholding and information reporting purposes. The
amount may also represent wages for Federal Insurance Contributions Act (FICA) and
Federal Unemployment Tax Act (FUTA) purposes, depending on the nature of the ser-
vices performed.13 On the other hand, scholarships and fellowships are not subject to
self-employment taxes.14
10
Code Section 117(c); Prop. Reg. Section 1.117-6(d)(1).
11
Code Section 117(c)(2). Recipients of National Health Service Corps Scholarships must agree to provide medical
services for a certain length of time in a geographic area identified as having a shortage of health care professionals.
Similarly, recipients of Armed Forces Health Profession Scholarshops and Financial Assistance must agree to serve
a certain number of years in the military at an armed forces medical facility.
12
See PLR 9645021; PLR 9526020.
13
Prop. Reg. Section 1.117-6(d)(4). See Kleinrock’s Analysis and Explanation, Ch. 111, for a discussion of income
tax withholding; Ch. 113, for Wage and Tax Statements (Form W-2); Section 618.2, for reporting payments of $600
or more in the course of a trade or business; Ch. 102, for FICA taxes; and Ch. 114, for FUTA taxes.
14
See Spiegelman v. Commissioner, 102 T.C. 394 (1994); Rev. Rul. 60-378, 1960-2 C.B. 38.
A scholarship or fellowship represents payment for services when the recipient is required to
perform services in return for the granting of the scholarship or fellowship. A requirement that
the recipient pursue studies, research, or other activities primarily for the benefit of the grantor is
treated as a requirement to perform services, but a requirement that a recipient furnish periodic
reports to the grantor for the purpose of keeping the grantor informed as to the general progress
of an individual is not. A scholarship or fellowship conditioned upon either past, present, or fu-
ture teaching, research, or other services by the recipient represents payment for services.15
EXAMPLE: Burt receives a $10,000 scholarship from X Corp. for the 2004-2005 aca-
demic year. As a condition of receiving the scholarship, Burt agrees to work for X Corp.
after graduation. Burt has no previous relationship with X Corp. Since the $10,000
scholarship represents payment for future services, it must be included in Burt’s gross
income.
OBSERVATION: The IRS has ruled that stipends paid to fellows under research and
training programs modeled after the National Institutes of Health National Research
Service Awards program can be excluded from income (and are not wages subject to
employment taxes), because the focus of the programs is research training, the activities
of the fellows during their training do not materially benefit the institution, and fellows
are not required to perform services in the future.16 Because the training stipends do
not represent payment for services, the amounts received by the individuals also are not
subject to self-employment tax.
If only a portion of a scholarship or fellowship represents payment for services, the grantor
must determine the amount allocated to payment for services. Factors to be taken into account
in making this allocation include, but are not limited to, the amount of compensation paid by
the grantor for similar services performed by full-time or part-time employees or by students
with comparable qualifications who do not receive a scholarship or fellowship, and the amount
paid by educational organizations other than the grantor of the scholarship for similar services
performed either by students or other employees.17
EXAMPLE: Cindy receives a $6,000 scholarship from Northern University for the
2004-2005 academic year. As a condition of receiving the scholarship, Cindy performs
services as a researcher for Northern University. Researchers who are not scholarship
recipients receive $2,000 for similar services. Therefore, Northern University allocates
$2,000 of the scholarship amount to compensation for services performed by Cindy,
which must be included in Cindy’s gross income as wages. However, if Cindy establishes
expenditures of $4,000 for qualified tuition and related expenses, $4,000 of the scholar-
ship is excludable from her gross income as a qualified scholarship.
If a recipient includes in gross income the amount allocated by the grantor to payment for ser-
vices (and this amount represents reasonable compensation for those services) any additional
scholarship received from the same grantor that is a qualified scholarship is excludable from
gross income.
15
Prop. Reg. Section 1.117-6(d)(2).
16
PLR 200010033.
17
OBSERVATION: Athletic scholarships can be excluded from income if the athlete is

admitted to the educational institution under generally applicable admission standards, is
a full-time student, the scholarship is awarded by the same agency that awards academic
scholarships, and once awarded, the scholarship cannot be terminated due to injury or a
unilateral decision not to participate in sports (and the student is not required to engage
in any activity in lieu of sports).18
Scholarships Granted by Employer

Since scholarships that are made available to or for the benefit of employees on a preferential
basis appear to provide additional compensation or employment incentives, they are generally
included in the recipient’s gross income unless they are shown to fall outside the pattern of em-
ployment. This is true even if the scholarship is given by an independent third party, such as a
private foundation or a voluntary employee beneficiary association (VEBA).
OBSERVATION: Whether an employer-related scholarship is excludable from the em-
ployee’s gross income, if there is no intermediary private foundation distributing the
award, is an area in which the IRS will not issue rulings or determination letters.19
OBSERVATION: Educational assistance provided by an educational organization to
its own employees (or family members of employees) may be excludable from gross in-
come if it is provided under a qualified tuition reduction program. See Qualified Tuition
Reduction Programs, p. 81.
Scholarships awarded under employer-related programs to employees and/or children of em-
ployees are considered to fall outside the pattern of employment only if seven conditions and at
least one of two percentage tests are satisfied.20 The seven conditions are:
(1) The program must not be used to recruit employees or to induce employees to con-
tinue their employment or otherwise follow a course of action sought by the em-
ployer.
(2) Selection of scholarship recipients must be made by an independent committee.
(3) The program must impose identifiable minimum requirements for eligibility that are
related to the purpose of the program.
(4) Selection of scholarship recipients must be based solely upon substantial objective
standards that are completely unrelated to the employment of the recipients or their
parents and to the employer’s line of business (e.g., academic performance or finan-
cial need).
(5) A scholarship may not be terminated because the recipient or the recipient’s parent
terminates employment with the employer subsequent to the awarding of the scholar-
18
Rev. Rul. 77-263, 1977-2 C.B. 47.
19
Rev. Proc. 2004-3, 2004-1 I.R.B. 114, Section 3.01(11).
20
Rev. Proc. 76-47, 1976-2 C.B. 670. Although the guidelines by their terms apply only to scholarships awarded
by private foundations, the IRS has indicated that they serve to illustrate the type of analysis involved in determin-
ing whether grants awarded under any employer-related program fall outside the pattern of employment. TAM
200049007.
ship regardless of the reason for the termination of employment; and, if a scholarship
is awarded for one academic year and the recipient must reapply for a subsequent
year, the recipient may not be considered ineligible for a further scholarship simply
because that individual or the individual’s parent is no longer employed by the em-
ployer.
(6) The courses of study for which scholarships are available must not be limited to
those that would be of particular benefit to the employer (or other party providing the
scholarship).
(7) The terms of the scholarship and the courses of study for which scholarships are
available must meet all other requirements for the exclusion and must be consistent
with a disinterested purpose of enabling the recipients to obtain an education in their
individual capacities solely for their personal benefit and must not include any com-
mitments, understandings or obligations suggesting that the studies are undertaken
by the recipients for the benefit of the employer (or third party) or have as their ob-
jective the accomplishment of any purpose of the employer other than enabling the
recipients to obtain an education in their individual capacities and solely for their
personal benefit.
Under the percentage tests, the number of scholarships awarded under the program to children
of employees must not exceed 25 percent of the children who (1) were eligible for such scholar-
ships, (2) were applicants for the scholarships, and (3) were considered by the selection com-
mittee making such scholarships, or 10 percent of the number of employees’ children who can
be shown to be eligible for scholarships (whether or not they submitted an application) in that
year.
For purposes of determining how many employees’ children are eligible for a scholarship or
loan under the 10 percent test, an employer (or third party) may include as eligible only those
children:
(1) who submit a statement in writing (or on whose behalf a statement is submitted by
his/her authorized representative), or
(2) for whom information is maintained sufficient to demonstrate, other than by statisti-
cal or sampling techniques, that (i) they meet the foundation’s eligibility require-
ments; and (ii) they are enrolled in or have completed a course of study preparing
them for admission to an educational institution at the level for which the scholar-
ships or loans are available, have applied or intend to apply to such an institution,
and expect, if accepted, to attend such an educational institution in the immediately
succeeding academic year; or (iii) they currently attend an educational institution for
which the scholarships or loans are available but are not in the final year for which
an award may be made.21
21
Rev. Proc. 85-51, 1985-2 C.B. 717.
If, in applying any of the percentage tests, an organization determines that the maximum number
of allowable scholarships is a mixed number with a fraction of 1/2 or greater, the organization
may round upward the number of allowable scholarships to the nearest whole number, if in that
year, the maximum number of allowable scholarships, as determined under the percentage tests,
is at least four without the benefit of rounding up.22
If a taxpayer meets all of the conditions but is unable to show that it meets one of the percent-
age tests, the program’s scholarships can still be excludable from income if all the relevant facts
and circumstances show that the purpose of the scholarship is to educate scholarship recipients
rather than provide extra compensation. However, the facts and circumstances are considered in
the context of the probability that a scholarship will be available to any eligible applicant.23
Record-Keeping Requirements
To qualify for the exclusion, the recipient of a scholarship or fellowship must maintain records
that establish amounts used for qualified tuition and related expenses as well as the total amount
of qualified tuition and related expenses. Adequate records include copies of relevant bills, re-
ceipts, cancelled checks, or other documentation, or records that clearly reflect the use of the
scholarship. These records must be provided to the IRS on request. The recipient must also
submit, upon request, documentation that establishes receipt, the notification date, and the con-
ditions and requirements of the particular scholarship or fellowship. Scholarship or fellowship
amounts are excludable without the need to trace particular dollars to particular expenditures for
qualified tuition and related expenses.24
COMPLIANCE TIP: Taxpayers should include the taxable amount of scholarships or
fellowships on their income tax returns as “wages, salaries, tips, etc.,” and enter “SCH”
and any taxable amount not reported on a Form W-2, Wage and Tax Statement, on the
dotted line preceding the entry.
22
Rev. Proc. 94-78, 1994-2 C.B. 833.
23
Rev. Proc. 76-47, 1976-2 C.B. 670.
24
Prop. Reg. Section 1.117-6(e).
Qualified Tuition Reduction

Programs
Generally
Any amount provided to an employee of an educational organization under a qualified tuition
reduction program is excluded from the recipient’s gross income.1 It is also excluded from treat-
ment as wages for purposes of income tax withholding, FICA, and FUTA, and need not be re-
ported on Form W-2, Wage and Tax Statement, or other information returns.2 The exclusion does
not apply, however, if the program discriminates in favor of highly compensated employees3 or
compensates the employee for services as a condition of receiving the tuition reduction.4 See
Non-Discrimination Requirement, p. 82; Compensation for Services, p. 84.
OBSERVATION: The exclusion for qualified tuition reduction payments is not limited
solely to individuals providing teaching services for an educational organization, but ex-
tends to the employees generally, including secretarial, managerial, administrative, and
support function employees.5
To qualify for the exclusion, the educational organization must normally maintain a regular fac-
ulty and curriculum and have a regularly enrolled body of pupils or students in attendance at the
place where its educational activities are regularly carried on.6
EXAMPLE: Casey is an employee of Correspondence College. In 2004, Casey is given
$500 by Correspondence College to use towards any course offered by Correspondence
College. No students physically attend Correspondence College and all courses are
taught through the mail. Casey is not attending an educational organization for purposes
of the tuition reduction exclusion and, therefore, must include the $500 provided by Cor-
respondence College in her gross income.
Although this requirement prevents correspondence school employees from claiming the exclu-
sion, it does not necessarily limited use of the exclusion to employees of traditional colleges and
universities. Unincorporated schools operated by a church, museum schools, the school system
of a diocese, and state bodies overseeing state educational systems can qualify as educational
organizations for purposes of the exclusion.7
The tuition reduction must also be for the employee’s own education or the education of a per-
son treated as an employee (or whose use is treated as employee use) under the fringe benefit
rules. This means that a qualified tuition reduction may be provided to active, retired, or disabled
1
Code Section 117(d).
2
Code Sections 3121(a)(20), 3306(b)(16), 3401(a)(19).
3
4
5
PLR 200029051.
6
Code Section 117(d)(2). See also Code Section 170(b)(1)(A)(ii).
7
See PLR 200029051.
employees, as well as spouses, surviving spouses, dependent children, or orphaned children of

those employees.8
OBSERVATION: Tuition reduction benefits provided to a school faculty or staff mem-
ber’s domestic partner are not excluded from income.9
The exclusion generally does not apply to tuition reductions for any graduate level course.10 A
graduate level course is a course taken by an individual who has received a bachelor’s degree (or
equivalent) or is receiving credit toward a more advanced degree.11 Graduate students, however,
who are engaged in teaching or research activities at an educational organization may exclude
qualified tuition reduction for education at the graduate level.12
OBSERVATION: Amounts excludable from gross income as a qualified tuition reduc-
tion are not subject to the $5,250 limitation for the exclusion on amounts received under
a qualified education assistance program.13 See Education Assistance Programs, p. 85.
A qualified tuition reduction program can provide benefits by one educational organization with
respect to attendance at another educational organization.14 For example, the IRS has ruled that
tuition reductions provided by a state body overseeing all public universities and colleges in the
state qualified for the exclusion even though they could be used at the employer school, any
other state college or university, a school in another university system, or a private institution.15

For purposes of calculating a student’s “expected family contribution” (EFC), both the parents’
and the student’s contribution from income is calculated using taxable and non-taxable income.
Thus, any payment from a qualified tuition reduction program that is excluded from the recipi-
ent’s gross income will still increase the student’s EFC and, therefore, reduce her eligibility for
financial aid. If the payment is used for the educational expenses of the employee’s dependent
child, between 22 and 47 percent of the payment is added to the employee/parent’s contribution
from income. If the payment is used for the employee’s own educational expenses, 50 percent
of the payment will count towards his EFC if he is married without children, while between 22
and 47 percent of the payment will count towards his EFC if he is married with children. See
Financial Aid – Financial Need, p. 99, for a discussion of a dependent student’s EFC.
Non-Discrimination Requirement
A qualified tuition reduction is excludable from the gross income of a highly compensated em-
ployee only if the tuition reduction is made available on substantially the same terms to each
8
Code Section 117(d)(2)(B). See also Code Section 132(h)(1).
9
PLR 9431017. See also the Defense of Marriage Act, Pub. L. 104-199, which provides, among other things, that
the word “spouse” refers only to a person of the opposite sex who is a husband or a wife for federal tax purposes.
10
11
H. Conf. Rep. 1104, 100th Cong., 2d Sess. 78 (1988).
12
13
Code Section 127(c)(6); Rev. Rul. 86-69, 1986-1 C.B. 78.
14
15
PLR 20029051.
Qualified Tuition Reduction Programs 83
member of a group of employees that has been defined under a reasonable classification, set up
by the employer, that does not discriminate in favor of officers, owners, or highly compensated
employees.16
OBSERVATION: A tuition reduction program may provide benefits that are not quali-
fied tuition reductions and are not eligible for the exclusion without jeopardizing the
exclusion for benefits that do qualify. Whether the exclusion is available is determined
on an individual-by-individual basis, rather than on the basis of the entire program. Thus,
for example, a program may provide benefits both for individuals who are eligible for the
exclusion and those who are not.17
For purposes of the exclusion, an employee is a highly compensated employee if he (1) was
a 5 percent owner at any time during the current or preceding year; or (2) had compensation
from the employer for the preceding year in excess of $80,000, adjusted for inflation ($90,000
for 2004).18 However, the employer can elect to limit employees treated as highly compensated
employees under (2) to those who are in the group consisting of the top 20 percent of employees
when ranked on the basis of compensation paid during the year (the top-paid group).19 A former
employee counts as a highly compensated employee if he qualified as a highly compensated
employee when he separated from service or at any time after attaining age 55.20
An employee is a 5 percent owner for a year if, at any time during the year, she owns more than
5 percent of the corporation’s outstanding stock or stock possessing more than 5 percent of the
total combined voting power of all stock of the corporation, in the case of an employer that is a
corporation; or more than 5 percent of the capital or profits interest of the employer, in the case
of a non-corporate employer. Constructive ownership rules apply in making this determina-
tion.21
The employees considered in identifying highly compensated employees include common law
employees and self-employed individuals. However, an employer can elect to exclude the fol-
lowing employees both in identifying highly compensated employees and in identifying the
top-paid group:
(1) Employees who have not completed six months of service;
(2) Employees who normally work less than 17 1/2 hours per week;
(3) Employees who normally work not more than six months during any year;
(4) Employees who have not attained age 21; and
(5) Except as provided in regulations governing Code Section 414, collectively bargained
employees.
16
17
PLR 200029051.
18
Code Sections 117(d)(3), 414(q). For the 2004 inflation adjusted amount, see Notice 2003-73, 2003-2 C.B.
1017.
19
See Code Section 414(q)(1).
20
21
Employers can also elect to exclude employees based on shorter periods of service,
smaller numbers of hours or months worked, or lower age.22
Compensation for Services

In addition, the exclusion for qualified tuition reduction is subject to the same restriction as
scholarships and fellowships with respect to payments for the services. See Scholarships and
Fellowships – Compensation for Services, p. 75. Thus, the tuition reduction exclusion is gen-
erally not available for any tuition reduction received as payment for teaching, conducting re-
search, or providing other services as a condition to receiving the reduction.23
EXAMPLE: Andrew is employed as a research assistant to a faculty member at Western
University in 2004. Andrew receives a salary from Western University that represents
reasonable compensation for the position of research assistant. In addition to his salary,
Andrew receives reduced tuition for any undergraduate course at Western University. An-
drew includes the salary in gross income. Thus, the tuition reduction does not represent
payment for services and, therefore, is not includible in Andrew’s 2004 gross income.
COMPLIANCE TIP: Any tuition reduction representing payment for services is
considered wages for withholding and information reporting purposes. The reduction
amount may also represent wages for Federal Insurance Contributions Act (FICA) and
Federal Unemployment Tax Act (FUTA) purposes, depending on the nature of the ser-
vices performed.24
A tuition reduction represents payment for services when the employee is required to perform
services in return for the reduction. A requirement that the employee pursue studies, research,
or other activities primarily for the benefit of the educational organization is treated as a re-
quirement to perform services, but a requirement that an employee furnish periodic progress
reports to the educational organization is not. A tuition reduction conditioned upon either past,
present, or future teaching, research, or other services by the employee represents payment for
services.25
EXAMPLE: Nicholas is an employee of Eastern University and receives a $10,000
tuition reduction from Eastern University for the 2004-2005 academic year. As a con-
dition of receiving the reduction, Nicholas agrees to work for Eastern University after
graduation. Since the tuition reduction represents payment for future services, it must be
included in Nicholas’ gross income.
If only a portion of a tuition reduction represents payment for services, the educational orga-
nization must determine the amount allocated to payment for services. Factors to be taken into
account in making this allocation include, but are not limited to, the amount of compensation
paid for similar services performed by full-time or part-time employees and the amount paid by
other educational organizations for similar services.26
22
23
Code Section 117(c); Prop. Reg. Section 1.117-6(d)(1).
24
Prop. Reg. Section 1.117-6(d)(4). See Kleinrock’s Analysis and Explanation, Ch. 111, for a discussion of income
tax withholding; Ch. 113, for Wage and Tax Statements (Form W-2); Section 618.2, for payments of $600 or more
in the course of a trade or business; Ch. 102, for FICA taxes; and Ch. 114, for FUTA taxes.
25
26
Educational Assistance Programs

Generally
An employee can exclude up to $5,250 from her gross income for amounts paid or expenses
incurred by her employer for educational assistance furnished under a qualified educational as-
sistance program.1 See Maximum Exclusion, p. 86; Educational Assistance, p. 87.
PRACTICE TIP: An employer can deduct the cost of the educational assistance pro-
vided to its employees as an ordinary and necessary business expense.2
An educational assistance program must be a separate written plan of an employer for the ex-
clusive benefit of its employees. Reasonable notification of the availability and terms of the
program must also be provided to eligible employees. The educational assistance program does
not have to be funded or approved in advance by the IRS.3 Furthermore, a program that provides
employees with a choice between educational assistance or another benefit that is includible
in the employee’s gross income is not a qualified program. For these purposes, the business
practices of an employer (as well as the written program) are taken into account in determining
whether an employee has this choice.4
In addition, a program may not discriminate in favor of highly compensated employees (or
their spouses and dependents) and may not pay out more than 5 percent of the amounts paid or
incurred during any one year to its employees who collectively have an ownership interest in
excess of 5 percent.5 See Non-Discrimination Requirements, p. 88.
The exclusion is available for employer-provided educational assistance to:
(1) Retired, disabled, or laid-off employees;
(2) Current employee who are on leave, or
(3) Self-employed individuals.6
Self-employed individuals who would have had earned income except that their trades or busi-
nesses did not have net profits for the taxable year are eligible for the exclusion.7 The exclusion
is not, however, available to a spouse or a dependent of an employee or self-employed indi-
vidual.8
1
Code Section 127(a).
2
Code Section 162(a); Reg. Section 1.162-10.
3
Code Section 127(b); Reg. Section 1.127-2(a). Note, however, that an employer may request that the IRS deter-
mine whether a plan is a qualified program.
4
5
Code Section 127(b)(2), (3).
6
Code Section 127(c)(2); Reg. Section 1.127-2(h)(1). Self-employed is defined by reference to Code Section
401(c)(1). A plan does not fail to qualify as a qualified educational assistance program merely because eligible
participants include former employees, regardless of the reason for termination of employment. Rev. Rul. 96-41,
1996-2 C.B. 8.
7
See Code Section 401(c)(1)(B).
8
Reg. Section 1.127-2(d).
OBSERVATION: An individual who owns the entire interest in an unincorporated trade

or business is treated as her own employer. A partnership is treated as the employer of
each partner who qualifies as an employee.9
No other exclusion or deduction is available to an employee for any amount excluded from
income under the educational assistance program rules. However, the educational assistance
program rules do not affect the deduction or inclusion in income of amounts paid or incurred
(or received as a reimbursement) for educational expenses under the Code provisions governing
exclusions for scholarships and fellowships (see Scholarships and Fellowships, p. 73), deduc-
tions for ordinary and necessary business expenses (see Business Deductions for Educational
Expenses, p. 59), and deductions for investment expenses.10

Payments under a qualified educational assistance program that are excluded from a student’s
gross income are taken into account for purposes of determining the student’s financial aid eli-
gibility by reducing his “cost of attendance” by the amount of any such payment. This decreases
the student’s financial need and, therefore, his ability to obtain financial aid. See Financial Aid
– Financial Need, p. 99, for a discussion of a student’s cost of attendance.
Maximum Exclusion
The maximum amount of assistance that an employee may exclude from his gross income dur-
ing any calendar year under the educational assistance program rules is $5,250.11 The excluded
amount is exempt from both income and employment taxes.12
COMPLIANCE TIP: Education assistance payments that are excluded from an em-
ployee’s income are generally included in Box 14 (Other) of the employee’s Form W-2,
Wage and Tax Statement. Payments that do not qualify or that exceed the $5,250 limita-
tion are included as wages on the employee’s Form W-2.
PRACTICE TIP: Assistance that is not excludable under the education assistance pro-
gram rules (i.e., that is in excess of $5,250 or is not a qualifying expense) is nevertheless
excludable if it qualifies as a working condition fringe benefit.13
Where an employee works for more than one employer, the $5,250 limitation applies to the ag-
gregate amount of educational assistance benefits received from all employers.14 However, the
employer is not required to withhold income tax or pay or withhold employment taxes if it is
reasonable to assume that an amount is excludable.15
9
10
Code Section 127(c)(6), (7). See Kleinrock’s Analysis and Explanation, Ch. 26, for a discussion of deductions for
investment expenses.
11
12
Code Section 3121(a)(18); Code Section 3306(b)(13); and Code Section 3401(a)(18).
13
See Code Section 132(j)(8). See Kleinrock’s Analysis and Explanation, Section 23.4, for a discussion of working
condition fringe benefits.
14
H.R. Rep. 1049, 98th Cong., 2d Sess. 6 (1984).
15
See Reg. Sections 31.3121(a)(18)-1, 31.3306(b)(13)-1, 31.3401(a)(18)-1.
Educational Assistance Programs 87
To determine the amount of educational assistance received, an employee must take into account
the fair market value of all educational assistance paid or provided directly by an employer, as
well as all the reimbursements received from employers for educational assistance. Any amount
expended for education that is (or would be) deductible by the employee as an employee busi-
ness expense is not subject to the $5,250 limitation on educational assistance benefits and is not
counted in determining whether other educational benefits received during the year exceed the
$5,250 limitation.16
An employee cannot avoid exceeding the $5,250 limit in the present tax year by electing to
forgo reimbursements of educational assistance expenses until a subsequent year, because an
employee is considered to be in constructive receipt of the reimbursement in the year he incurred
the expense. An employer must also report to an employee who separated from the employer’s
service during the taxable year the value of educational assistance benefits received by the em-
ployee during the year.17
Educational Assistance
For purposes of the exclusion, educational assistance means the payment by an employer of ex-
penses incurred by or on behalf of an employee for education. These expenses include, but are
not limited to, tuition, fees and similar payments, books, supplies, and equipment. Educational
assistance also includes the employer’s provision of education directly to an employee (including
books, supplies, and equipment).18 The term “education” generally means any form of instruc-
tion or training that improves or develops an individual’s capability, whether or not job related or
part of a degree program. Education paid for or provided under a qualified program may be fur-
nished directly by the employer, either alone or in conjunction with other employers, or through
a third party such as an educational institution.19 Payments for graduate level courses beginning
after December 31, 2001, are also included in the definition of educational assistance.20
Expenses specifically excluded from the definition of educational assistance include tools or
supplies (other than textbooks) that the employee may retain after completion of a course of
instruction, and meals, lodging, or transportation. In addition, educational assistance does not
include payments for, or provision of, benefits related to any education involving sports, games,
or hobbies unless the instruction or course involves the business of the employer or is required
as part of a degree program.21
OBSERVATION: The phrase “sports, games, or hobbies” does not include education
that instructs employees on how to maintain and improve their health, so long as the edu-
cation does not involve the use of athletic facilities or equipment and is not recreational
in nature.22
16
H.R. Rep. 1049, 98th Cong., 2d Sess. 6 (1984).
17
H.R. Rep. 1049, 98th Cong., 2d Sess. 6-7 (1984).
18
19
Reg. Section 1.127-2(c)(4).
20
See Pub. L. 107-16, Economic Growth and Tax Relief Reconciliation Act of 2001, Section 411(b).
21
Code Section 127(c)(1); Reg. Section 1.127-2(c)(3).
22
Reg. Section 1.127-2(c)(3)(iii).
COMPLIANCE TIP: An employee who receives payments under a qualified educa-

tional assistance program must be prepared to provide documentation to his employer
showing that any payments or reimbursements made under the program constitute edu-
cational assistance within the meaning of these rules.23
Non-Discrimination Requirements
A qualified educational assistance program must benefit employees who qualify under a clas-
sification set up by the employer and found by the IRS not to be discriminatory in favor of em-
ployees who are highly compensated employees (within the meaning of Code Section 414(q))
or in favor of their spouses or dependents who are themselves employees. For these purposes,
employees who are covered by a collective bargaining agreement may be disregarded provided
there is evidence that educational assistance benefits were the subject of good faith collective
bargaining.24
OBSERVATION: For purposes of the exclusion, an employee is a highly compensated
employee if he (1) was a 5 percent owner at any time during the current or preceding
year; or (2) had compensation from the employer for the preceding year in excess of
$80,000, adjusted for inflation (for 2004, the amount is $90,000).25 However, the em-
ployer can elect to limit employees treated as highly compensated employees under (2)
to those who are in the group consisting of the top 20 percent of employees when ranked
on the basis of compensation paid during the year (the top-paid group).26 A former em-
ployee counts as a highly compensated employee if he qualified as a highly compensated
employee when he separated from service or at any time after attaining age 55.27
The classification of employees to be considered benefited consists of employees who are actu-
ally eligible for educational assistance under the program, taking into account the eligibility
requirements set forth in the written plan, the eligibility requirements reflected in the types of
educational assistance available under the program, and any other conditions that may affect the
availability of benefits under the program. Thus, for example, if an employer’s plan provides that
all employees are eligible for educational assistance, yet limits that assistance to courses of study
leading to post-graduate degrees in fields relating to the employer’s business, then only those
employees able to pursue such a course of study are considered actually eligible for educational
assistance under the program. Whether any classification of employees discriminates in favor of
highly compensated employees is generally be determined by applying the same standards as are
applied to qualified pension, profit-sharing, and stock bonus plans.28
An educational assistance program is not considered discriminatory merely because it (1) is
utilized to a greater degree by one class of employees or (2) because reimbursement under
the program is dependent on successfully completing a course, attaining a particular grade, or
23
Reg. Section 1.127-2(i).
24
Code Section 127(b)(2); Reg. Section 1.127-2(e)(1).
25
Code Sections 127(B)(2), 414(q). For the 2004 inflation-adjusted amount, see Notice 2003-73, 2003-2 C.B.
1017.
26
27
28
Reg. Section 1.127-2(e)(1). See Kleinrock’s Analysis and Explanation, Section 122.10, for a discussion of the
non-discrimination requirements for qualified plans.
Educational Assistance Programs 89
satisfying a reasonable condition subsequent (such as remaining an employee for a year after
completion of the course).29
In addition, an educational assistance program is not a qualified program for any program year
in which more than 5 percent of the amounts paid or incurred by the employer for educational
assistance benefits during the year are provided to the employer’s limitation class. For this pur-
pose, the program year must be specified in the written plan as either the calendar year or the
taxable year of the employer.30 In the case of a corporate employer, the limitation class consists
of those employees (and their spouses and dependents) who, on any day of the program year,
own more than 5 percent of the total number of shares of the outstanding stock of the employer.31
In the case of a non-corporate employer, the limitation class consists of those employees (and
their spouses and dependents) who, on any day of the program year, own more than 5 percent of
the capital or profits interest in the employer.32
Reporting Requirements
An employer that maintains an educational assistance program for its employees must file any
annual report that includes the following information:
(1) The number of employees it has;
(2) The number of its employees that are eligible to participate in the plan;
(3) The number of employees that do participate;
(4) The total cost of the plan for the year; and
(5) Its name, address, and taxpayer identification number, and the type of business in
which it is engaged.33
COMPLIANCE TIP: This report is filed on Form 5500, Annual Return Report of Em-
ployee Benefit Plan, which is filed with the Employee Benefits Security Administration.
The Code also requires an employer to report the number of highly compensated employees it
has, the number of highly compensated employees who are eligible to participant in its plan, and
the number of highly compensated employees that do in fact participate in plan.34 However, the
IRS has suspended this requirement until it provides further guidance.35
29
Code Section 127(c)(5); Reg. Section 1.127-2(e)(2).
30
Code Section 127(b)(3); Reg. Section 1.127-2(f).
31
Reg. Section 1.127-2(f)(2). For these purposes, the term shareholder includes an individual who is a shareholder
as determined by the attribution rules under Code Section 1563(d) and Code Section 1563(e), without regard to
Code Section 1563(e)(3)(C). Reg. Section 1.127-2(h)(4).
32
Reg. Section 1.127-2(f)(2). The regulations prescribed under Code Section 414(c) are applicable in determining
an individual’s interest in the capital or profits of an unincorporated trade or business.
33
Code Section 6039D.
34
Code Section 6039D.
35
Notice 90-24, 1990-1 C.B. 335.
Student Loan Interest Deduction

Generally
Up to $2,500 per year of interest paid on a qualified education loan can be claimed as an above-
the-line deduction.1 The $2,500 maximum deduction amount is not indexed for inflation. There
is no limitation on the number of months during which interest paid on a qualified loan is deduct-
ible. Furthermore, the student loan interest deduction is available even though payments are not
required, such as where payments are voluntarily made during a period of loan forbearance.
COMPLIANCE TIP: The student loan interest deduction is claimed on Line 25 of the
2003 Form 1040, U.S. Individual Income Tax Return.
The deduction for student loan interest is, however, phased out for taxpayers with modified AGI
of $50,000 to $65,000 ($100,000 to $130,000 for joint returns), indexed for inflation after 2002.2
Under the phase-out rules for 2004, the deduction is reduced by an amount that bears the same
ratio to $2,500 as the excess of the taxpayer’s modified AGI over $50,000 ($100,000 for joint
filers) bears to $15,000 ($30,000 for joint filers).3
EXAMPLE: In 2004, Judy paid $2,600 interest on a qualified student loan. She files
a joint return with Bill. Their modified AGI is $110,000. The most they can deduct is
$2,500. However, they must reduce this amount by $833, calculated as follows:
$110,000 – $100,000
$2,500 × = $833
$30,000
Therefore, Judy and Bill’s deductible student loan interest for 2004 is $1,667.
For purposes of the deduction, modified AGI is determined without taking into account the
deduction for qualified tuition and related expenses (see Deduction for Qualified Higher Educa-
tion Expenses, p. 53); the exclusion for foreign earned income and housing cost amounts; the
exclusion for income from sources within Guam, American Samoa, or the Northern Mariana
Islands; or the exclusion for income from sources within Puerto Rico. However, for purposes of
the deduction, modified AGI is determined after applying the rules relating to the:
(1) Taxation of certain social security benefits;
(2) Exclusion of income from U.S. savings bonds used to pay higher education tuition
and fees (see Exclusion for Bond Interest Income, p. 67);
(3) Exclusion of amounts paid or expenses incurred by the employer for qualified adop-
tion expenses;
(4) Deduction for amounts contributed to individual retirement accounts (IRAs); and
(5) Limit on passive activity losses and credits.4
1
Code Section 221.
2
Code Section 221(b)(2), (f).
3
Rev. Proc. 2003-85, 2003-2 C.B. 1184.
4
Code Section 221(b)(2)(C).
OBSERVATION: Calculating modified AGI without taking into account the listed
deductions and exclusions, increases the taxpayer’s modified AGI and, therefore, the
chances of having the student loan interest deduction phased-out. On the other hand,
allowing modified AGI to be computed after the application of certain other deductions
and exclusions decreases both the taxpayer’s modified AGI and the chances of having the
student loan interest deduction limited.
If a taxpayer is married at the close of the taxable year, the deduction is allowed only if the tax-
payer and his spouse file a joint return for the taxable year.5 In addition, no deduction is allowed
to an individual for the taxable year if a dependency exemption with respect to the individual is
allowed to another taxpayer.6
EXAMPLE: Bonnie, a student, pays $750 of interest on qualified education loans dur-
ing 2004. Only Bonnie is legally obligated to make the payments. Bonnie’s parents claim
her as a dependent and take a dependency deduction for Bonnie in computing their 2004
federal income tax. Neither Bonnie nor her parents may deduct the $750 of interest paid
in 2004.
PRACTICE TIP: If Bonnie’s parents are not allowed to claim Bonnie as a dependent,
then Bonnie is entitled to the interest deduction.7 In any event, she will be able to claim
the interest deduction in later years when she no longer qualifies as a dependent on her
parents’ return.
Furthermore, no student loan interest deduction is allowed for any amount that is also deductible
under another provision of the Code.8 For example, if the student loan interest paid is actually
interest on a home equity loan and is deductible as an itemized deduction on Schedule A of
Form 1040, U.S. Individual Income Tax Return, the interest does not qualify for the student loan
interest deduction.
Loan origination fees, other than those paid for property or services provided by the lender, and
capitalized interest on qualified education loans are also deductible. Capitalized interest means
any accrued and unpaid interest on a qualified education loan that is capitalized by the lender
(in accordance with the terms of the loan) and added to the loan’s outstanding principal balance.
Loan origination fees and capitalized interest are deemed to be paid by the taxpayer when the
loan’s principal is repaid. Accordingly, a taxpayer can deduct the portion of a stated principal
payment that is treated as the payment of any loan origination fees or capitalized interest on the
loan. For this purpose, a payment (regardless of its label) is treated first as a payment of inter-
est to the extent that interest has accrued and remains unpaid as of the date the payment is due,
second as a payment of any loan origination fees or capitalized interest (until such amounts have
been reduced to zero), and third as a payment of principal.9
5
Code Section 221(e)(2). Marital status is determined under Code Section 7703. See Kleinrock’s Analysis and
Explanation, Section 2.2, for a discussion of marital status.
6
7
See Reg. Section 1.221-1(b)(2).
8
9
Reg. Section 1.221-1(f).
Student Loan Interest Deduction 93
EXAMPLE: Interest on Harvey’s qualified education loan accrues while Harvey is in

college, but Harvey is not required to make any payments on the loan until six months
after he graduates. At that time, all accrued but unpaid interest is capitalized and added
to the outstanding principal amount of the loan. Thereafter, Harvey is required to make
monthly payments of interest and principal on the loan. Harvey may claim a student loan
interest deduction for any principal payments that are treated as capitalized interest pay-
ments.
COMPLIANCE TIP: Effective for student loans made on or after September 1, 2004,
lenders are required to report loan origination fees and capitalized interest. However, the
IRS has stated that it will not impose penalties on lenders that fail to do so for returns
required to be filed in 2005 relating to the 2004 tax year if certain requirements are met.
See Reporting, below. A borrower that receives a 1098-E or other information statement
that does not include payments of loan origination fees can use any reasonable allocation
method to allocate the fees over the term of the loan.10
CAUTION: The IRS warns that a method that results in a double deduction of a portion
of the fees would not be reasonable.
Qualified Loans
Only interest paid on a “qualified loan” can be deducted under Code Section 221. For purposes
of the deduction, a qualified education loan is any indebtedness incurred by the taxpayer solely
to pay for the qualified higher education expenses of the taxpayer, the taxpayer’s spouse, or any
dependent of the taxpayer.11 See Qualified Expenses, p. 95, for a discussion of the expenses that
can be paid for with a qualified loan. Thus, the deduction may be claimed only by a taxpayer
who is legally obligated to pay interest on the indebtedness.12 If a third party who is not legally
obligated to make a payment of interest on the loan makes a payment on behalf of the taxpayer
who is legally obligated to make the payment, the taxpayer is treated as receiving the payment
from the third party and, in turn, paying the interest, and, thus, is entitled to the deduction.13
For a loan to qualify as an education loan, the qualified higher education expenses must be in-
curred within a reasonable period of time before or after the indebtedness is incurred.14 What
constitutes a reasonable period of time is determined based on all the relevant facts and circum-
stances. Expenses are treated as paid or incurred within a reasonable period of time before or
after the taxpayer incurs the indebtedness if either the expenses are paid with the proceeds of
education loans that are part of a federal postsecondary education loan program or the expenses
relate to a particular academic period and the loan proceeds used to pay the expenses are dis-
bursed within a period that begins 90 days prior to the start of that academic period and ends 90
days after the end of that academic period.15
10
Notice 2004-63, 2004-41 I.R.B. 597.
11
12
13
14
Reg. Section 1.221-1(e)(3)(i)(C).
15
Reg. Section 1.221-1(e)(3)(ii).
EXAMPLE: Henry signs a promissory note for a loan on August 15, 2004, to pay for
qualified higher education expenses for the Fall 2004 and Spring 2005 semesters. On
August 20, 2004, loan proceeds are disbursed by the lender to Henry’s college and cred-
ited to his account to pay qualified higher education expenses for the Fall 2004 semester,
which begins on August 26, 2004. On January 25, 2005, additional loan proceeds are
disbursed by the lender to Harry’s college and credited to Harry’s account to pay quali-
fied higher education expenses for the Spring 2005 semester, which began on January
20, 2005. Henry’s qualified higher education expenses for the two semesters are paid
within a reasonable period of time, as the first loan disbursement was made within 90
days prior to the start of the Fall 2004 semester and the second loan disbursement was
made during the Spring 2005 semester.
A qualified education loan includes indebtedness used to refinance indebtedness that qualifies as
a qualified education loan.16 Furthermore, a loan does not have to be issued or guaranteed under
a federal post-secondary education loan program to be a qualified education loan.17
A qualified education loan does not include any indebtedness owed to a person who is related to
the taxpayer.18 A loan made under any qualified employer plan or under any contract purchased
under a qualified employer plan also is not a qualified education loan.19 In addition, revolving
lines of credit (e.g., credit card debt) generally are not qualified education loans, unless the bor-
rower uses the line of credit solely to pay qualified higher education expenses.20 Finally, because
the debt must be incurred solely to pay qualified higher education expenses, mixed-use loans are
not qualified education loans. If any of the proceeds are used for expenses that are not qualified
as higher education expenses, none of the interest is deductible as interest paid on a qualified
education loan.21
EXAMPLE: John signs a promissory note for a loan secured by John’s personal resi-
dence. Part of the loan proceeds will be used to pay for certain improvements to John’s
residence and part of the loan proceeds will be used to pay qualified higher education
expenses of John’s spouse. Because the loan is not incurred by John solely to pay quali-
fied higher education expenses, the loan is not a qualified education loan.
The rule that the taxpayer must be legally obligated to pay interest on the indebtedness to be
entitled to claim the deduction requires that she be primarily responsible for payment of the loan.
Therefore, the student – rather than the parent – should take out the loan. Many student loans
carry a subsidized interest rate. Furthermore, the adjusted gross income limitations on claiming
16
17
Reg. Section 1.221-1(e)(3)(iv).
18
Code Section 221(d)(1). Whether a person is related to the taxpayer is determined pursuant to Code Sections
267(b) and 707(b). See Kleinrock’s Analysis and Explanation, Sections 404.7 and 506.5, for a discussion of the
Code Section 707(b) rules relating to transactions between a partner and a partnership and the related persons listed
in Code Section 267(b), respectively.
19
Reg. Section 1.221-1(e)(3)(iii).
20
See Preamble to REG-116826-97, 64 Fed. Reg. 3257 (Jan. 21, 1999).
21
Reg. Section 1.221-1(e)(4), Example 6.
the deduction precludes many parents from taking a deduction in any event. Parents who want to
claim the interest deduction may be better advised to take out a home equity loan that will enable
them to claim an itemized interest deduction.
Qualified Expenses
Only interest on loans used solely to pay for qualified higher education expenses is deductible.
For purposes of the deduction, qualified higher education expenses is equal to the student’s “cost
of attendance” at an eligible educational institution. Thus, the deduction is generally available
for interest on loans used to pay for tuition, fees, room and board, books, supplies, transporta-
tion, and miscellaneous personal expenses of a student attending on at least a half-time basis.
However, in determining a student’s qualified higher education costs, the student’s cost of at-
tendance is reduced by any:
(1) Scholarship excludable from gross income;
(2) Veterans’ or member of the armed forces’ educational assistance allowance;
(3) Employer-provided educational assistance excluded from gross income;
(4) Interest from U.S. Savings Bonds excluded from gross income;
(5) Distribution from a Coverdell ESA excluded from gross income;
(6) Distribution from a 529 plan excluded from gross income; or
(7) Other educational assistance excludable from gross income (other than a gift, be-
quest, devise, or inheritance).22
The expenses must also be paid or incurred within a reasonable period before or after the indebt-
edness is incurred, and must be attributable to a period when the student is at least a half-time
student.23
OBSERVATION: It is not clear whether interest on loans used in part to pay for a per-
sonal computer are deductible. Current Code Section 221(d)(2) states that “the term
‘qualified higher education expense’ means the cost of attendance (as defined in section
472 of the Higher Education Act of 1965, 20 U.S.C. 1087ll, as in effect on the day be-
fore the date of the enactment of this Act) . . .” This provision, however, was originally
enacted in 1997 by Pub. L. 105-34 as Code Section 221(e)(2), but in 2001 EGTRRA “re-
designated” Code Section 221(e)(2) as Code Section 221(d)(2). If the reference to “this
Act” in current Code Section 221(d)(2) refers to EGTRRA, then loans used in part to pay
for a personal computer would appear to be deductible because the definition of cost of
attendance in 20 U.S.C. 1087ll was amended in 1998 to include “a reasonable allowance
for the documented rental or purchase of a personal computer” (see Pub. L. 105-244,
Sec. 471(1)). However, if the reference to “this Act” in current Code Section 221(d)(2)
refers to the act originally enacting the provision (i.e., Pub. L. 105-34), then loans used
in part to pay for a personal computer probably are not deductible because the 20 U.S.C.
1087ll definition of cost of attendance in effect on the day before the enactment of Pub.
L. 105-34 was silent with regard to personal computers.
22
Code Section 221(d)(2); Reg. Section 1.221-1(e)(2)(ii).
23
For purposes of the deduction, an “eligible educational institution” is any college, university, vo-
cational school, or other post-secondary educational institution that is described in Section 481
of the Higher Education Act of 1965 (20 U.S.C. 1088) and, therefore, eligible to participate in
the student aid programs administered by the Department of Education. This definition includes
virtually all accredited public, nonprofit, and proprietary post-secondary institutions (including
many foreign institutions). In addition, institutions conducting internship or residency programs
leading to a degree or certificate awarded by an institution of higher education, a hospital, or
a health care facility offering post-graduate training are considered to be eligible educational
institutions.24 The deductibility of interest on a qualified education loan is not affected by the
institution’s subsequent change of status. Thus, interest on a qualified education loan may con-
tinue to be deducted even if the education institution ceases to be a qualified institution after the
end of the academic period for which the loan was incurred.25
Reporting
Any person in a trade or business or any governmental agency that receives $600 or more in
qualified education loan interest from a borrower during a calendar year must provide an infor-
mation report on such interest to the IRS and the borrower, using Form 1098-E, Student Loan
Interest Statement. In general, Form 1098-E must include the name, address, and taxpayer infor-
mation number of the borrower and the aggregate amount of interest received for the year.26 A
written statement must be provided to the payor of the interest that includes the name, address,
and phone number of the contact person making the report and the amount of interest reported.27
With the payor’s consent, the statement may be provided electronically.28
CAUTION: For qualified education loans made before September 1, 2004, a lender is
not required to report payments of loan origination fees and capitalized interest (or to
include these amounts in determining whether the $600 threshold is exceeded).29 Instead,
the lender must include in its statement furnished to the payor the information that the
payor may be able to deduct additional amounts, such as certain loan origination fees
and capitalized interest, that are not reported on the statement.30 Under the regulations,
a lender is required to report those items for loans made on or after that date.31 However,
the IRS has stated that it will not assert penalties on a lender for failure to report pay-
ments attributable to loan origination fees and capitalized interest received in calendar
year 2004 on a qualified education loan made on or after September 1, 2004, as long
as the lender reports the amount of interest received in 2004, other than the loan origi-
nation fees and capitalized interest, and furnishes a statement to the borrower that the
reported amount does not include payments attributable to either loan origination fees or
capitalized interest and that the borrower may be able to deduct amounts in addition to
24
Code Section 221(d)(2). See also Notice 97-60, 1997-2 C.B. 310.
25
Reg. Section 1.221-1(e)(4), Example 5.
26
Reg. Section 1.6050S-3(a), (c)(2).
27
Code Section 6050S(d).
28
Reg. Section 1.6050S-2(a).
29
Reg. Section 1.6050S-3(e)(1).
30
Reg. Section 1.6050S-3(d)(1)(iii)(B).
31
the amount reported. A borrower who receives an information statement indicating that
it does not include payments of loan origination fees may use any reasonable method to
allocate the loan origination fees over the term of the loan for purposes of the deduc-
tion.32
If a loan is not subsidized, guaranteed, financed, or is not otherwise treated as a student loan
under a program of the federal, state, or local government or an eligible educational institution,
the lender must request a certification from the borrower that the loan will be used solely to pay
for qualified higher education expenses. The lender may use Form W-9S, Request for Student’s
or Borrower’s Social Security Number and Certification, to obtain the certification. A lender
may establish an electronic system for borrowers to submit Forms W-9S electronically, develop
a separate form to obtain the certification, or incorporate the certification into other forms cus-
tomarily used by the lender, such as loan applications, provided the certification is clearly set
forth. If the certification is not received, the loan is not a qualified education loan.33
PRACTICE TIP: Taxpayers that are eligible for the education loan interest deduction
who take out a home equity loan should certify the loan as an education loan under the
procedures described above. If the interest paid in any year exceeds the taxpayers al-
lowable education loan deduction, the balance can still be deducted on Schedule A of
Form 1040, U.S. Individual Income Tax Return, as an itemized home equity loan interest
deduction.
32
Notice 2004-63, 2004-41 I.R.B. 597.
33
Financial Aid
According to the U.S. Department of Education (Department), over $67 billion in federal finan-
cial aid will be awarded to millions of students and families for the 2004-2005 school year. Most
federal aid is need based and consists of grants, work-study programs, and loans.
The process of obtaining financial aid starts when the student submits a completed Free Applica-
tion for Federal Student Aid (FAFSA) to the Department. Students can apply for the 2004-2005
school year after January 1, 2004, and must reapply for financial aid every year.
After the student’s FAFSA is processed, he will be sent a Student Aid Report (SAR). The SAR
outlines the information provided on the FAFSA and reports the student’s Expected Family Con-
tribution (EFC), which is used in determining the student’s eligibility for federal student aid. See
Expected Family Contribution, p. 101. The results will also be sent to the schools listed on the
FAFSA (i.e., the schools that the student is considering attending).
Once a college has the necessary information from the SAR, it determines the student’s financial
need and packages the student’s aid. Colleges arrive at different estimates of EFC depending
on which assets they choose to count. Furthermore, the components of the package depend on
a variety of factors, such as the college’s resources and the student’s merit. For example, they
might offer a top candidate all grants (which do not have to be repaid), while a package for a less
favored candidate might be made up mostly of loans.
Financial Need
Unlike scholarship programs that may award funds based on academic merit or based on the
student’s field of study, financial aid awards are generally based on the family’s need for as-
sistance. A student must have financial need to receive all federal financial aid funds except for
unsubsidized Stafford and PLUS loans under the Direct Loan and Federal Family Education
Loan (FFEL) programs. See Stafford Loans, p. 107, and PLUS Loans, p. 109.
A dependent student’s financial need is defined as the difference between her “cost of atten-
dance” (COA) at a particular educational institution and her “expected family contribution”
(EFC).1 If the EFC is less than the cost of attendance (i.e., if the student’s family cannot be ex-
pected to contribute the full costs faced), the student has financial need.
Cost of Attendance
The COA is an estimate of a student’s education expenses for the period of enrollment. The total
federal financial aid a student can receive cannot exceed the student’s cost. Generally, a depen-
dent student’s COA is the sum of:
(1) The tuition and fees normally assessed for a student carrying the same academic
workload. This includes costs of rental or purchase of equipment, materials, or sup-
plies required of all students in the same course of study;
1
20 U.S.C. Section 1087kk.
(2) An allowance for books, supplies, transportation, and miscellaneous personal

expenses. A reasonable allowance (as determined by the school) for the documented
rental or purchase of a personal computer can be included as part of this allowance.
(3) An allowance for room and board. For students without dependents living at home
with their parents, this will be an allowance that the student determines. For students
living on campus, the allowance is the standard amount normally assessed most resi-
dents. For students living off campus but not with their parents, the allowance must
be based on reasonable expenses for room and board.
(4) For a student with dependents, an allowance for costs expected to be incurred for
dependent care. This covers care during periods that include, but that are not lim-
ited to, class time, study time, field work, internships, and commuting time for the
student. The amount of the allowance is based on the number and age of the depen-
dents and cannot exceed the reasonable cost in the community for the kind of care
provided.
(5) For study-abroad programs approved for credit by the student’s home institution,
reasonable costs associated with such study.
(6) For a disabled student, an allowance for expenses related to the student’s disability.
These expenses include special services, personal assistance, transportation, equip-
ment, and supplies. Expenses provided by a government agency are not included.
(7) For students engage in a work experience through a cooperative education program,
an allowance for reasonable costs associated with such employment.
(8) Fees required to obtain student loans based either on the exact loan fees charged to
the student or an average of fees the college charges borrowers.
There are a number of exceptions to the normal COA allowances. For instance, only the costs
for tuition and fees and allowances for books and supplies, transportation, and dependent care
expenses can be included as part of the COA for students who are enrolled less than half-time.
In addition, the COA is limited to tuition and fees and required books or supplies for students
participating in correspondence study programs. Finally, college financial aid administrators
have the authority to use their professional judgment to adjust a student’s COA on a case-by-case
basis to allow for special circumstances.2
A student’s COA can also be reduced by other aid the student receives (known as “resources”
or “estimated financial assistance”). When a student receives additional aid (e.g., a scholarship
provided by an entity other than the school or amounts received under an employer-sponsored
educational assistance program), the basic calculation of COA does not change. See Scholar-
ships and Fellowships, p. 73; Educational Assistance Programs, p. 85. The only issue is whether
the arrangement between the school and the students results in a tuition and fee charge to the
student. If the student is charged for the tuition and fees, even if the charge is eventually paid by
someone besides the student (e.g., a scholarship agency or other source of aid), then that tuition
and fee amount is included in the COA. The tuition and fees payment would then be counted as
a resource or estimated financial assistance. However, if the student is never charged for tuition
and fees, then the COA does not include the tuition and fees component.
2
20 U.S.C. Section 1087ll.
Financial Aid 101
Expected Family Contribution

The EFC measures the family’s financial strength on the basis of the family’s income and assets.
The EFC formula also takes into account the family’s expenses relative to the number of persons
in the household and how many of them will be attending college during the award year. The
EFC for a dependent student is calculated using the information for a student and a student’s
parents provided on the FAFSA. The EFC is the sum of the parents’ contribution (from income
and assets), the student’s contribution from income, and the student’s contribution from assets.3
CAUTION: The formula for calculating EFC described below is for dependent students
only (for the 2003-2004 award year). Separate formulas exist for independent students
without dependents other than a spouse and independent students with dependents other
than a spouse. Information concerning the EFC calculation for independent students is
provided in Volume 1 of the Department’s Student Financial Aid Handbook, which is
available on-line at www.ifap.ed.gov.
Parents’ Contribution. There are three basic steps in calculating the parents’ contribution. First,
the parents’ available income is determined. Then, the parents’ contribution from assets is calcu-
lated. Finally, the parents’ contribution is calculated using the available income, the contribution
from assets, and the number of children the parents have in college.
Generally, the parents’ available income equals their taxable and untaxed income minus certain
allowances. First, however, their income is reduced by the amount of any Hope scholarship or
lifetime learning credit (see Hope Scholarship and Lifetime Learning Credits, p. 35); child sup-
port paid because of divorce or separation; taxable earnings from federal work-study or other
need-based work programs; or student grant, scholarship, fellowship, and assistantship aid (in-
cluding AmeriCorps awards) included in their gross income. The resulting figure is then further
reduced by the following allowances:
(1) U.S. Income Tax Paid. Non-filers do not receive this allowance. If this is a negative
amount, it is set to zero.
(2) State and Other Tax Allowance. This allowance is a percentage of the parents’ total
income and approximates the average amount paid in state and other taxes. The per-
centage varies according to the state and the parents’ total income. If the allowance
is a negative amount, it’s set to zero. See State and Other Taxes Allowance (Parents
Only) for 2003-2004 Award Year, p. 135.
(3) Father’s and Mother’s Social Security Tax Allowance. The father and mother’s
Social Security taxes are calculated separately by applying the appropriate tax rates
to the father’s income earned from work and the mother’s income earned from work
in 2002. See Social Security Tax Allowance for 2004-2005 Award Year, p. 133. The
total allowance for Social Security taxes is never less than zero.
(4) Income Protection Allowance. This allowance accounts for the basic living expenses
of a family. The allowance varies according to the number in the parents’ household
and the number in college in the award year. See Income Protection Allowance for
2004-2005 Award Year, p. 133.
3
20 U.S.C. Section 1087oo.
(5) Employment Expense Allowance. This allowance recognizes the extra expenses for
families with two working parents and one-parent families, such as housekeeping
services, transportation, clothing and upkeep, and meals away from home. Where
there are two working parents, the allowance is 35 percent of the father’s income
earned from work or the mother’s income earned from work, whichever is smaller,
but may not exceed $3,000 (for the 2003-2004 award year). For one-parent families,
the allowance is 35 percent of the parent’s income earned from work, also not to ex-
ceed $3,000 (for the 2003-2004 award year). If a student’s parents are married and
only one parent reports an income earned from work, the allowance is zero.
PRACTICE TIP: Parents can reduce the income that is included in the EFC calculation
by postponing bonuses until after financial aid base year, temporarily reducing their sal-
ary if they own a business, or selling stock that has decreased in value to incur a capital
loss. Parents should avoid selling appreciated stock between the student’s senior year
in high school and junior year in college. Otherwise, the capital gains incurred will be
included in the parents’ income for financial aid base years and, therefore, reduce the
student’s ability to obtain financial aid.
To determine the parents’ contribution from assets, the parents’ “net worth” and “discretionary
net worth” must first be calculated. The parents’ net worth is determined by adding the assets
reported on the FAFSA (if net worth is $1,000,000 or more, then $999,999 is entered on the
FAFSA). The net worth of a business or a farm is adjusted to protect a portion of their net worth.
See Business/Farm Net Worth Adjustment for 2004-2005 Award Year, p. 133. The parents’ discre-
tionary net worth is calculated by subtracting the education savings and asset protection allow-
ance from their net worth. See Education Savings and Asset Protection Allowance for 2004-2005
Award Year, p. 134. The discretionary net worth (which can be less than zero) is multiplied by
the conversion rate of 12 percent to obtain the parents’ contribution from assets (cannot be less
than zero), which represents the portion of the value of the parents’ assets that are considered to
be available to pay for the student’s post-secondary education.
OBSERVATION: “Assets” include, among other things, cash, savings accounts, check-
ing accounts, real estate (but not the primary residence), trust funds, money market
funds, mutual funds, certificates of deposit, stock and stock options, bonds, other se-
curities, Coverdell ESAs, 529 savings plans (but not prepaid tuition plans), installment
and land sale contracts (including mortgages held), and commodities. In addition to the
primary residence and prepaid tuition plans, “assets” does not include the value of life
insurance and retirement plans (pension funds, annuities, IRAs, Keogh plans, etc.).
The parent’s available income and contribution from assets are then added to determine the
parents’ adjusted available income (AAI). The parents’ AAI can be a negative number. The total
parents’ contribution from AAI (i.e., the total amount parents are expected to contribute toward
all their family’s post-secondary education costs) is 22 to 47 percent of their AAI. See Parents’
Contribution From AAI for 2004-2005 Award Year, p. 135.
OBSERVATION: Given the 12 percent conversion rate used to obtain the parents’ con-
tribution from assets and the 22 to 47 percent rate used to calculate the parents’ total con-
tribution from AAI, the parents’ assets are assessed at a maximum rate of 5.64 percent.
For example, if a student’s parents have $100,000 in assets above any education savings
Financial Aid 103
and asset protection allowance, no more than $5,640 of those assets can be included in
the parents’ total contribution from AAI (($100,000 × 12%) × 47% = $5,640).
The parent’s contribution for the individual student is calculated by dividing the total parents’
contribution from AAI by the number of children in college during the award year.
PRACTICE TIP: Since certain expensive consumer items are not included as assets
for purposes of determining the parents’ contribution, parents who are considering the
purchase of automobiles, boats, furniture, and other “big ticket” items should consider
making these purchases before the financial aid base year. This will reduce the parents’
liquid assets for purposes of calculating the student’s EFC.
Student’s Contribution from Income. To determine the student’s contribution from income, the
student’s available income (AI) is first calculated by subtracting certain allowances from the
student’s total income. The student’s AI is then assessed at a rate of 50 percent to obtain the
student’s contribution from income. If the student’s contribution from income is less than zero,
it is set to zero.
PRACTICE TIP: Since the student’s income is assessed at a higher rate (50%) than his
parents’ income (22% to 47%), the student’s income should be spent first (preferably all
in the first year of college) to avoid having more income assessed at the higher rate in
subsequent years.
As with the parents’ income information, the student’s total income is calculated using informa-
tion from the student’s FAFSA. The student’s total income is generally the sum of the student’s
taxable and untaxed income. If the student files a tax return, his AGI is the amount of taxable
income used in the calculation. If the student does not a file a return, the student’s reported in-
come earned from work is used. Total income may be a negative number.
OBSERVATION: The student’s available income is reduced by the amount of any Hope
scholarship or lifetime learning credit claimed on his return (see Hope Scholarship and
Lifetime Learning Credits, p. 39) and does not include child support paid because of
divorce or separation; taxable earnings from federal work-study or other need-based
work programs; or student grant, scholarship, fellowship, and assistantship aid (includ-
ing AmeriCorps awards) included in his gross income.
The allowances are calculated by adding the following:
(1) U.S. Income Tax Paid. Non-taxfilers don’t receive this allowance. If this is a negative
amount, it is set to zero.
(2) State and Other Tax Allowance. This allowance is a percentage of the student’s total
income and approximates the average amount paid in state and other taxes. The per-
centage varies according to the state and the parents’ total income. If the allowance
is a negative amount, it is set to zero. See State and Other Taxes Allowance (Student
Only) for 2004-2005 Award Year, p. 136.
(3) Social Security Tax Allowance. The student’s Social Security taxes are calculated
separately by applying the appropriate tax rates to the student’s income earned from
work in 2002. See Social Security Tax Allowance for 2004-2005 Award Year, p. 133.
The total allowance for Social Security taxes is never less than zero.
(4) Income Protection Allowance. The income protection allowance for a dependent
student for the 2003-2004 award year is $2,380.
(5) Parent’s Negative AAI. To recognize that a student’s income may be needed to help
support the family, the EFC calculation allows a parent’s negative adjusted available
income (AAI) to reduce a dependent student’s contribution from income. Because
the student’s contribution from income cannot be negative, this will not affect the
student’s contribution from assets.
Student’s Contribution from Assets. The student’s assets are treated the same way as the parents’
assets with three differences – there is no adjustment to the net worth of a business or farm, there
is no education savings and asset protection allowance, and net worth is assessed at the rate of
35%.
PRACTICE TIP: Since the student’s assets are assessed at a higher rate (35%) than his
parents’ assets (maximum rate of 5.64%), the student’s assets should be used first (pref-
erably all in the first year of college) to avoid having more assets assessed at the higher
rate in subsequent years.
The student’s net worth is calculated by adding assets reported on the FAFSA (negative amounts
are converted to zero for this calculation). Then, the student’s net worth is multiplied by the con-
version rate of 35 percent to obtain the student’s contribution from assets, which represents the
portion of the value of student’s assets that may be considered to be available to help pay for the
student’s post-secondary education.
PRACTICE TIP: If a student is planning to buy a car or other expensive item with his
own money, he should consider purchasing the item before the financial aid base year. It
will reduce the student’s liquid assets for purposes of determining his EFC.
In addition to the standard EFC formula, special calculations of the EFC are permitted in certain
circumstances.4 The first special calculation, known as the “simplified formula,” is basically the
same as the regular formula, except that asset information is not considered in the calculation.
A dependent student qualifies for the simplified calculation if (1) neither the student nor his par-
ents were required to file a Form 1040, U.S. Individual Income Tax Return, and (2) the parents’
AGI or income earned from work was less than $50,000.
Under the second special calculation, known as an “automatic zero EFC,” a dependent student
is automatically assign a zero EFC if (1) neither the parents nor the student was required to
file a Form 1040, and (2) the parents’ combined AGI or combined income earned from work is
$13,000 or less.
PRACTICE TIP: A family member who was not required to file a Form 1040 may have
filed one solely to claim a Hope or lifetime learning credit. This, however, does not dis-
qualify the applicant for purposes of the simplified formula or the automatic zero EFC.
4
20 U.S.C. Section 1087ss.
Financial Aid 105
Effect of Education Tax Incentives on EFC

Certain education tax incentives may increase the income or assets of parents and students for
purposes calculating a student’s EFC. To the extent that it does, it lowers the amount of the stu-
dent’s financial aid eligibility. If the incentive increases the student’s income, 50 percent of the
increase is included in the computation. However, if it raises the parents’ income, the additional
income is assessed at a rate ranging from 22 percent to 47 percent – the higher the parents’ in-
come, the higher the rate. If the incentive increases the student’s assets, the additional assets are
assessed at a 35 percent rate. However, if the parents’ assets are increased, the added assets are
assessed at a maximum rate of 5.64 percent.
PRACTICE TIP: Since the assessment rates for both income and assets are lower for
parents than for students, it is often better to have income and assets held in the parents’
name, rather than in the student’s name (at least for financial aid purposes).
The use of 529 savings plans can have various effects on financial aid, depending on who owns
the account and how the account is funded. See Qualified Tuition Programs (529 Plans), p. 19.
EXAMPLE: Mary and Joe have $50,000 in a 529 savings plan, additional assets worth
another $120,000 (after accounting for all applicable allowances), and no “available in-
come” when their only child, Sue, applies for financial aid for the 2003-2004 award year.
Mary and Joe opened the 529 savings plan account in their names, so they are considered
the owners of the account. Sue has no assets in her name. Since Mary and Joe’s total dis-
cretionary net worth is $170,000 and they have no available income, their contribution
for purposes of determining Sue’s EFC is $5,062. Sue’s contribution from assets is zero.
However, had the 529 plan been funded with assets held by a Uniform Gift to Minors’
Act account, Sue would have been considered the owner of the 529 savings plan account.
In that case, Mary and Joe’s contribution would have been only $3,240 (a $1,822 reduc-
tion), but Sue’s contribution from assets would be $17,500 ($50,000 × 35%). This results
in a net gain in EFC of $15,678 because the 529 savings plan would be assessed at higher
rate in this case if Sue owned it. An increase in EFC means a decrease in Sue’s ability to
obtain financial aid.
If an account established through a 529 savings plan is owned by a third party (e.g., a grandpar-
ent), the account will not be treated as an asset of the student or his parents and, therefore, will
not increase the student’s EFC. Likewise, prepaid tuition plans are not treated as an asset of either
the parent or the student. However, tuition credits generated by a prepaid tuition plan reduce the
student’s cost of attendance and, therefore, her financial need. Furthermore, since both taxable
and non-taxable income are considered in determining a student’s contribution from income, the
earnings portion of withdrawals from a 529 plan are chargeable to the student’s income and as-
sessed at a 50 percent rate for calculating the student’s contribution from income. The additional
income will reduce the student’s ability to receive financial aid in the following year.
Coverdell ESAs are treated as an asset of the student and, therefore, are assessed at the 35
percent rate for purposes of determining the student’s contribution from assets. See Coverdell
Education Savings Accounts, p. 5. Like withdrawals from a 529 plan, the earnings portion of
withdrawals from a Coverdell ESA are attributable to the student’s income in the following year
(assessed at 50 percent rate).
For purposes of determining the student’s EFC, either the parents’ or the student’s income is
reduced by the amount allowed by as a Hope scholarship credit or lifetime learning credit. See
Hope Scholarship and Lifetime Learning Credits, p. 35. Normally, the parents will claim an
education credit (if available), but the parents can elect not to claim a student as a dependent so
that the student can claim an education credit. This can increase the student’s ability to obtain fi-
nancial aid by decreasing the student’s expected family contribution. For example, if the parent’s
AAI for the 2003-2004 award year is $20,000 with a $1,500 Hope credit, allowing the student
to take the credit would increase the parent’s contribution by $510 ($4,926 – $4,416). This is
because the parent’s contribution is increased by 22 to 47 percent of the credit when the credit is
allocated to the student. However, since the student’s contribution from income is decreased by
50 percent of the allowable credit, permitting the student to take the $1,500 Hope credit would
lower the student’s contribution by $750 ($1,500 × 50%). Thus, the overall effect of allowing the
student to take the Hope credit is a $240 decrease in EFC ($750 – $510).
If U.S. Savings Bonds are used to pay for education expenses in order to claim the exclusion for
bond interest income, the effect on financial aid depends on who owns the bonds. See Exclusion
for Bond Interest Income, p. 67. If parents own the bonds, the bonds are assessed at the parent’s
asset rate. However, if the student owns bonds, they are assessed at the student’s asset rate. Since
the exclusion for bond interest only applies when a person 24 years of age or older purchases
the bonds, interest eligible for the exclusion will be paid on bonds owned by the parents in most
cases. Where the parents own the bonds, the interest paid upon redemption will be assessed the
at the 22 to 47 percent rate for purposes of determining the parents’ contribution in the follow-
ing year. If the bonds are owned by the student, the paid interest will be assessed the at the 50
percent rate for purposes of determining the student’s contribution from income in the following
year.
The amount of any scholarship or fellowship that is included in a student’s AGI is subtracted
from his income for purposes of calculating the student’s contribution from income. See Schol-
arships and Fellowships, p. 73. This will, of course, increase his eligibility for financial aid.
However, the student’s COA is reduced by the amount of any scholarship provided by an entity
other than the school. See Cost of Attendance, p. 99.
Any payment from a qualified tuition reduction program that is excluded from an employee’s in-
come increases the parent’s contribution from income if the payment is used for the educational
expenses of the employee’s dependent child. See Qualified Tuition Reduction Programs, p. 81.
Thus, the child’s EFC is increased by an amount equal to 22 to 47 percent of the payment.
Types of Federal Financial Aid

Pell Grants
The federal Pell Grant program provides grants to students who have financial need and meet the
other requirements for assistance. Grants, as opposed to loans, do not have to be repaid. Because
Pell Grants are federal entitlements, students receive the full amount for which they are eligible.
The maximum Pell Grant per student for the 2001-2002 award year is $3,750 and they were only
awarded to students with an EFC of $3,550 or less for that year.
OBSERVATION: As with most other federal subsidized programs, if a student receives
a scholarship or other aid that, in combination with the Pell Grant, causes the student’s
Financial Aid 107
financial aid package to exceed her financial need, then a college cannot award additional
need based federal aid.
Pell Grants are given only to undergraduate students or students enrolled in a post-baccalaure-
ate teacher certification or licensure program. Students incarcerated in a federal or state penal
institution are not eligible for Pell Grants.
Supplemental Educational Opportunity Grants (SEOGs)

SEOGs of up to $4,000 are available for exceptionally needy undergraduate students (i.e., stu-
dents with the lowest EFCs). As a grant, SEOGs do not need to be repaid. Each college receives
an amount from the federal government for allocation to its students as SEOGs. Students who
receive Pell Grants are given priority in receiving SEOG funds.
Work-Study Programs
Work-study programs are available to both undergraduate and graduate students. The are often
tied to community service and pay the minimum wage or more, depending on the type and skill
required for the work. Work-study awards are also limited to the student’s financial need. Work-
study jobs can be on-campus or off-campus jobs. Students working on campus usually work for
their school, while students working off campus usually work for a private non-profit organiza-
tion or a public agency. For students attending a proprietary school, there may be further restric-
tions on the jobs that can be assigned. In addition, the number of hours a student can work is
limited under federal work-study programs.
Perkins Loans
Perkins Loans are low-interest (5 percent) loans available to both undergraduate and graduate
students with financial need. Students can borrow up to $4,000 for each year of undergraduate
study (with the total amount of such outstanding debt not to exceed $20,000) and $6,000 for
each year of graduate or professional study (with the sum of undergraduate and graduate debt
totaling no more than $40,000).
Students have nine months after they graduate, leave school, or drop below half-time status be-
fore they must begin repayment (graduates on active duty with the military have longer than nine
months). Students are allowed up to 10 years to repay a Perkins Loan; however, Perkins Loans
can be deferred or cancelled under certain circumstances.
Stafford Loans
Stafford Loans may be made either through the Direct Loan Program or through the FFEL Pro-
gram. Generally, schools participate in the Direct Loan Program or the FFEL Program, but not
both. Direct and FFEL Stafford Loans have identical eligibility requirement and loan limits. The
major difference between the two programs is the source of the loan funds. Under the Direct
Loan Program, the U.S. government loans students the funds. Under the FFEL Program, loans
are made by a private lender (a bank, credit union, etc.). Loan repayment options also differ
somewhat. The interest rate on Stafford Loans is variable and could change each year, but it will
never exceed 8.25 percent.5
5
As of July 1, 2002, the interest rate for Stafford loans is 4.06 percent (3.46 percent for students who are in
school, within the six-month grace period, or in deferment).
Direct and FFEL Stafford Loans are either subsidized or unsubsidized. A subsidized loan is
awarded on the basis of financial need. Students receiving subsidized loans are not charged in-
terest before they begin repayment or during authorized periods of deferment. An unsubsidized
loan is not awarded on the basis of need and students are charged interest from the time the loan
is disbursed until it is paid in full.
A dependent undergraduate student can borrow annually up to:
* $2,625 if she is a first-year student enrolled in a program of study that is at least a full
academic year;
* $3,500 if she has completed her first year of study and the remainder of her program is
at least a full academic year; and
* $5,500 if she has completed two years of study and the remainder of her program is at
least a full academic year.
An independent undergraduate student or a dependent student whose parents are unable to get a
PLUS Loan (see Plus Loans, p. 109), can borrow annually up to:
* $6,625 if she is a first-year student enrolled in a program of study that is at least a full
academic year (only $2,625 of this amount may be in subsidized loans);
* $7,500 if she has completed her first year of study and the remainder of her program
is at least a full academic year (only $3,500 of this amount may be in subsidized loans);
and
* $10,500 if she has completed two years of study and the remainder of her program is at
least a full academic year (only $5,500 of this amount may be in subsidized loans).
Generally, graduate students can borrow up to $18,500 each academic year (only $8,500 of this
amount may be in subsidized Stafford Loans).
The total debt a student can have outstanding from all Stafford Loans combined is:
* $23,000 as a dependent undergraduate student;
* $46,000 as an independent undergraduate student (only $23,000 of this amount may
be in subsidized loans); and
* $138,500 as a graduate or professional student (only $65,500 of this amount may be
in subsidized loans).
A student has six months after he graduates, leaves school, or drops below half-time status be-
fore he must begin repayment of a Stafford Loan. During the grace period on a subsidized loan,
a student does not have to pay any principal, and no interest will be charged. During the grace
period on an unsubsidized loan, a student does not have to pay any principal, but interest will be
charged. Stafford Loans can also be deferred or discharged under certain circumstances.
Financial Aid 109
Parent Loans for Undergraduate Students (PLUS Loans)

PLUS Loans allow parents to borrow to pay the education expenses of each child who is a de-
pendent undergraduate student enrolled at least half time. PLUS Loans are available through
both the Direct Loan and FFEL programs. Most of the benefits to parent borrowers are identical
in the two programs. To be eligible to receive a PLUS Loan, parents must pass a credit check. If
they do not pass the credit check, they might still be able to receive a loan if someone who is able
to pass the credit check endorses the loan and promises to repay it if the parents fail to do so.
OBSERVATION: A dependent student whose parents are unable to obtain a PLUS loan
because they do not have good credit and independent students can still obtain unsubsi-
dized Stafford Loans. See Stafford Loans, p. 107.
The yearly limit on a PLUS Loan is equal to the student’s COA minus any other financial aid
the student receives. For example, if a student’s COA is $6,000 and he receives $4,000 in other
financial aid, his parents could borrow up to $2,000 The interest rate on PLUS Loans is variable
and could change each year, but it will never exceed 9 percent.6
Generally, repayment of a PLUS Loan must begin within 60 days after the final loan disburse-
ment for the period of enrollment for which the money is borrowed. There is no grace period
for these loans. Interest begins to accumulate at the time the first disbursement is made and the
parents must begin repaying both principal and interest while the student is in school. Parents
are allowed up to 10 years to repay a PLUS Loan; however, they can be deferred or cancelled
under certain circumstances.
PRACTICE TIP: Up to $2,500 per year of interest paid on Perkins Loans, Stafford
Loans, and PLUS Loans can be deducted by certain taxpayers.7 See Student Loan Inter-
est Deduction, p. 91.
Leveraging Education Assistance Partnership (LEAP) Programs

Under the federal LEAP program, the Department provides states with funds to establish grant
programs assisting students who demonstrate substantial financial need. The states must match
the federal funds they receive. The maximum amount that a student may receive is $5,000 per
academic year. Most states limit LEAP awards to undergraduates attending on at least a half-
time basis.
OBSERVATION: Since LEAP programs vary from state to state, questions about a par-
ticular state’s LEAP program should be directed to that state’s higher education agency
administering the program. See State Higher Education Agencies, p. 137, for a state-by-
state list.
The Special Leveraging Educational Assistance Partnership (SLEAP) program is an additional
component of the LEAP program. It enables states that participate in the LEAP program to
increase the number of awards they grant and/or increase the individual awards to more than
$5,000. The states may also use SLEAP funds to increase work-study awards and award schol-
arships to eligible students for merit and academic achievement who desire to enter careers in
6
As of July 1, 2002, the interest rate for PLUS loans is 4.86 percent
7
Code Section 221.
information technology, mathematics, computer science, engineering, teaching, or other fields

determined by the state to be critical to the state’s workforce needs.
Robert C. Byrd Honors Scholarship Program

Under the Robert C. Byrd Honors Scholarship Program, the Department makes available,
through grants to states, scholarships to exceptionally able students in order to recognize and
promote student excellence and achievement. Students can receive up to $1,500 for one year of
study. Awards can be renewed for up to three additional years, provided the funds are appropri-
ated and the student remains eligible.
COMPLIANCE TIP: To apply for a Byrd Scholarship, a student must follow the appli-
cation procedures established by the State Education Agency (SEA) in the state in which
she is a legal residence. See Byrd Scholarship State Education Agency Contact List, p.
143, for a list of the various state agency contacts.
The student may attend any domestic institution of higher education or post-secondary voca-
tional institute. A student who is attending a college outside of her state of residency must apply
for a Byrd Scholarship through the SEA of her state of residency. This includes a student attend-
ing a U.S. Department of Defense overseas school or an out-of-state boarding school. Part-time
enrollment is allowed after the first years.
Planning and Practice

Determining Appropriate Contribution Amounts for 529-
Plan Accounts
The rules governing 529 savings plans provide parents (and others) with a tax-friendly tool to
help them save for a child’s future college costs. See Qualified Tuition Programs (529 Plans),
p. 19. However, before parents begin saving for college, they should have a general idea of how
much college will cost when the child graduates from high school. Once they know how much
the child will need, they can then determine how much they should contribute to a 529-plan ac-
count on a monthly or yearly basis to cover some or all of the expected future costs.
OBSERVATION: Since contributions to a Coverdell ESA are capped at $2,000 per year
for a single beneficiary, use of a Coverdell ESA as the primary savings vehicle may not
be the best choice for parents wanting to save significantly more than $100,000 for their
child’s college education. However, Coverdell ESAs offer parents more control over the
investment options and can be used for elementary and secondary education expenses.
See Coverdell Education Savings Accounts, p. 5. For those parents who expect to save
less than $2,000 per year for the educational costs of their child, the process for deter-
mining annual or monthly contribution amounts described below applies to Coverdell
ESA contributions as well as to 529 savings plan contributions.
As a first step in estimating the costs of a child’s college education, the parents should define
“college costs.” For some parents, the term only includes tuition, while some parents think it
also includes mandatory fees. Other parents think college costs include tuition, fees, books,
room and board, clothing, spending money, and transportation expenses. It does not matter if
the parents define the term broadly or narrowly. However, it is important that they determine up
front what it is they are saving for.
The next step is to determine what portion of the expected college costs will be paid from other
sources (i.e., other than from the 529-plan funds). For example, some parents expect the child
to work and provide some of the necessary funds. Depending on the parents’ projected future
income, the students expected financial aid eligibility should also be considered. See Financial
Aid, p. 99. The parents’ projected income will also determine if the Hope scholarship credit,
lifetime learning credit, and/or tuition deduction can be used to offset the expected college costs
and, therefore, reduce the total amount that needs to be saved. See Hope Scholarship and Life-
time Learning Credits, p. 35; Deduction for Qualified Higher Education Expenses, p. 53. For
older children, the possibility of receiving a tax-exempt scholarship should be examined too.
See Scholarships and Fellowships, p. 73. Any contributions the child’s grandparents are able
to make towards the child’s educational expenses, currently available funds, and expected cash
payments for educational expenses should be factored into the equation as well.
The parents should then focus on the “type” of college they want their child to attend. In other
words, the parents must determine if they are going to save enough for the child to attend an Ivy
League school, a public in-state college, and out-of-state public college, a junior college, etc.
While every parent wants their child to attend a top-notch institution, realistic expectations are
important at this stage because, of course, the cost of tuition, fees, room, and board at Harvard,
Yale, Stanford, and other top schools are considerably higher than at most other schools.
Finally, the parents need to determine the number of years they have to save for the college costs
they intend to pay. Parents often fall into one of two categories: (1) those with a new-born child
who want to start saving immediately, and (2) those with a child just entering high school who
suddenly realize that there is not much time left to save. Although a child generally starts college
when she is 18 years old, the parents must remember that they have an additional four years to
save for the total costs of a traditional four-year college (i.e., they can continue to save for the
last year while the child is attending college). Obviously, the parents who start saving for their
child’s educational expenses shortly after the child is born are in a better position because they
can maximize the benefits of compounding and realize a greater overall return on their invest-
ment.
Examples
Bob and Mary want to save enough money to pay for all of their son Jack’s college-related ex-
penses (i.e., tuition, fees, books, room and board, transportation costs, and personal expenses) at
a top-flight private college. Currently, this would cost $35,000 for one academic year.
Since Bob and Mary have a combined adjusted gross income of $250,000 (which is expected to
grow in subsequent years), they realize that Jack probably will not qualify for financial aid and
that they will not be able to claim the Hope scholarship credit, lifetime learning credit, or tuition
deduction when Jack is in college. Furthermore, Bob and Mary are not counting on Jack receiv-
ing a scholarship. So that Jack can concentrate on his studies in high school and college, they
also do not want Jack to have to work to save money for his own higher education expenses.
Example 1 - Saving for Infant’s Future College Costs

Bob and Mary begin saving for Jack’s college costs when Jack is born. Assuming an average
annual increase in college costs over the next 22 years of 5.5 percent and a 7.5 percent return on
their investments over the same time period, Bob and Mary determine that they will need to save
$398,409 to pay for all of Jack’s college costs. Bob and Mary open an account under their state’s
529 savings plan. To reach their goal of saving enough to pay for all of Jack’s college costs, Bob
and Mary must contribute either a lump-sum amount of $97,092 to the 529-plan account, make
annual contributions of $8,507 until Jack is a senior in college, or make monthly contributions
of $733 until Jack is a senior in college.
Current College Cost $35,000

Future Total Cost – 18 Years $398,409
Assumed College Inflation Rate 5.5%
Assumed Investment Rate 7.5%
First Year’s Cost $91,751
Last Year’s Cost $107,738
Lump Sum Payment Required $97,092
Annual Payment Required $8,507
Monthly Payment Required $733
Planning and Practice 113
If Bob and Mary choose to make annual contributions to the 529-plan account, their investment
portfolio would be as follows:
College Fund Annual School Ending

Year Balance Payment Payments Balance
1 15,000 7,193 0 22,193
2 23,857 7,193 0 31,049
3 33,378 7,193 0 40,571
4 43,613 7,193 0 50,806
5 54,616 7,193 0 61,809
6 66,445 7,193 0 73,637
7 79,160 7,193 0 86,352
8 925,829 7,193 0 100,021
9 107,523 7,193 0 114,716
10 123,319 7,193 0 130,512
11 140,300 7,193 0 147,493
12 158,555 7,193 0 165,747
13 178,178 7,193 0 185,371
14 199,273 7,193 0 206,466
15 221,951 7,193 0 229,143
16 246,329 7,193 0 253,522
17 272,536 7,193 0 279,728
18 300,708 7,193 0 307,900
19 330,993 7,193 91,751 246,434
20 364,917 7,193 96,798 175,312
21 188,460 7,193 102,122 93,531
22 100,646 7,193 107,738 0
Example 2 - Saving for Teenager’s Future College Costs

Bob and Mary do not begin saving for Jack’s college costs until Jack begins high school. Assum-
ing an average annual increase in college costs over the next 22 years of 5.5 percent and a 4.5
percent return on their investments over the same time period, Bob and Mary determine that they
will need to save $188,276 to pay for all of Jack’s college costs. Bob and Mary open an account
under their state’s 529 savings plan. However, Bob and Mary decide not to use the $15,000 in
stock for Jack’s education expenses. To reach their goal of saving enough to pay for all of Jack’s
college costs, Bob and Mary must contribute either a lump-sum amount of $147,537 to the 529-
plan account, make annual contributions of $21,405 until Jack is a senior in college, or make
monthly contributions of $1,821 until Jack is a senior in college.
Current Cost $35,000

Future Total Cost – 4 Years $188,276
Assumed College Inflation Rate 5.5%
Assumed Investment Rate 4.5%
First Year’s Cost $43,359
Last Year’s Cost $50,914
Lump Sum Payment Required $147,537
Annual Payment Required $21,405
Monthly Payment Required $1,821
If Bob and Mary choose to make annual contributions to the 529-plan account, their investment
portfolio would be as follows:

1 0 21,405 0 21,405
2 22,368 21,405 0 43,773
3 45,743 21,405 0 67,148
4 70,169 21,405 0 91,574
5 95,695 21,405 43,359 73,741
6 77,059 21,405 45,744 52,720
7 55,093 21,405 48,259 28,238
8 29,509 21,405 50,914 0
Example 3 - Required Savings for Less Expensive Schools

If Bob and Mary determine that they cannot afford to send Jack to a top-flight private college or,
in the alternative, cannot afford to pay for all of Jack’s college costs at such an institution, they
can adjust their goals and plan to save a lesser amount. Assuming that college costs will increase
at an average annual rate of 5.5 percent over the next 22 years, if Bob and Mary start saving for
Jack’s college costs when Jack is born, they will need to save $170,747 to pay for all of Jack’s
college costs at a four-year college with annual costs of $15,000 in today’s dollars; or $284,578
for a four-year college with annual costs of $25,000 in today’s dollars.
Current College Cost $15,000 $25,000

Future Total Cost – 18 Years $170,747 $284,578
Assumed College Inflation Rate 5.5% 5.5%
Assumed Investment Rate 7.5% 7.5%
First Year’s Cost $39,322 $65,537
Last Year’s Cost $46,174 $76,956
Lump Sum Payment Required $41,611 $69,351
Annual Payment Required $3,646 $6,076
Monthly Payment Required $314 $524
Assuming an average annual return on investments of 7.5 percent, Bob and Mary’s investment
portfolio would be as follows if they planned to send Jack to a college costing $15,000 in today’s
dollars:
Year College Fund Annual School Ending
Balance Payment Payments Balance
1 0 3,646 0 3,646
2 3,919 3,646 0 7,565
3 8,132 3,646 0 11,778
4 12,661 3,646 0 16,307
5 17,530 3,646 0 21,176
6 22,764 3,646 0 26,410
7 28,391 3,646 0 32,036
8 34,439 3,646 0 38,085
9 40,941 3,646 0 44,587
10 47,931 3,646 0 51,577
11 55,445 3,646 0 59,091
12 63,523 3,646 0 67,168
13 72,206 3,646 0 75,852
14 81,541 3,646 0 85,186
15 91,575 3,646 0 95,221
16 102,363 3,646 0 106,008
17 113,959 3,646 0 117,605
18 126,425 3,646 0 130,071
19 139,826 3,646 39,322 104,150
20 111,961 3,646 41,485 74,122
21 79,681 3,646 43,766 39,561
22 42,528 3,646 46,174 0
dollars:

1 0 6,076 0 6,076
2 6,532 6,076 0 12,608
3 13,554 6,076 0 19,630
4 21,102 6,076 0 27,179
5 29,217 6,076 0 35,293
6 37,940 6,076 0 44,016
7 47,318 6,076 0 53,394
8 57,398 6,076 0 63,475
9 68,235 6,076 0 74,312
10 79,885 6,076 0 85,961
11 92,408 6,076 0 98,485
12 105,871 6,076 0 111,947
13 120,343 6,076 0 126,419
14 135,901 6,076 0 141,977
15 152,625 6,076 0 158,702
16 170,604 6,076 0 176,681
17 189,932 6,076 0 196,008
18 210,708 6,076 0 216,785
19 233,044 6,076 65,537 173,583
20 186,602 6,076 69,141 123,537
21 132,802 6,076 72,944 65,935
22 70,880 6,076 76,956 0
Assuming the same average annual rate increase for college costs over the next eight years, if
Bob and Mary start saving for Jack’s college costs when Jack begins high school, they will need
to save $80,732 to pay for all of Jack’s college costs at a four-year college with annual costs of
$15,000 in today’s dollars; or $134,554 for a four-year college with annual costs of $25,000 in
today’s dollars. Although the total amount of money needed is less than that required if Bob
and Mary started saving when Jack is born, the required annual contributions are considerable
higher (see below). This is because the value of compounding is largely lost and, therefore, the
return on investments is reduced.
Current Cost $15,000 $25,000

Future Total Cost – 4 Years $80,732 $134,554
Assumed College Inflation Rate 5.5% 5.5%
Assumed Investment Rate 4.5% 4.5%
First Year’s Cost $18,589 $30,982
Last Year’s Cost $21,835 $36,391
Lump Sum Payment Required $63,263 $105,439
Annual Payment Required $9,178 $15,297
Monthly Payment Required $781 $1,301
dollars:

1 0 9,178 0 9,178
2 9,591 9,178 0 18,770
3 19,614 9,178 0 28,793
4 30,088 9,178 0 39,267
5 41,034 9,178 18,589 31,622
6 33,045 9,178 19,614 22,610
7 23,627 9,178 20,684 12,111
8 12,656 9,178 21,835 0
dollars:
1 0 15,297 0 15,297
2 15,986 15,297 0 31,283
3 32,690 15,297 0 47,988
4 50,147 15,297 0 65,444
5 68,389 15,297 30,982 52,704
6 55,076 15,297 32,689 37,683
7 39,379 15,297 34,491 20,186
8 21,094 15,297 36,391 0
Use of Education Tax Incentives During the College Years

– A Comprehensive Example
In September 2004, Connie attends State University as a full-time freshman. Connie’s parents,
Jack and Gloria, have a combined AGI of $90,000 for 2004. Their income is not expected to
increase over the next four years.
Connie’s tuition and related expenses (including fees, books, supplies, and equipment required
for enrollment) will cost $10,000 for each of the next four years. In addition, room and board is
expected to cost an additional $12,000 each year. Therefore, Connie’s total annual cost to attend
State University for four years will be $22,000 per year (for a total of $88,000).
In 2000, Jack and Gloria opened a Coverdell ESA for Connie. The Coverdell ESA has $2,400 in
it when Connie starts college (no additional contributions are made after that time).
In addition, Connie’s grandmother established an account under the 529 savings plan sponsored
by Connie’s state of residence in 2001. Although Connie is the current beneficiary of the ac-
count, Connie’s grandmother wants the funds to be used for the educational expenses of Con-
nie’s younger siblings as well. When Connie begins college, the 529-plan account has a balance
of $50,000 (no additional contributions are made after that time).
Furthermore, on the basis of her Free Application for Federal Student Aid (FAFSA) form, State
University offered Connie a state-subsidized grant of $3,000 per year for four years (she did not
qualify for a Pell grant). The aid package also included a federally subsidized Stafford Loan that
allows her to draw down the maximum amount authorized under the federal guidelines in each
of the four years that she is in attendance.
Based on the information above, Connie and her parents devise the following strategy to pay for
Connie’s education expenses:
Year 1 Year 2 Year 3 Year 4
Grant $3,000 $3,000 $3,000 $3,000

Stafford Loan $2,625 $3,500 $5,500 $5,500
529 Plan $5,000 $5,000 $5,000 $5,000
Coverdell ESA $1,200 $1,200 – –
Bank Loan (Parents) $6,000 $6,000 $6,000 $6,000
Out-of-Pocket $4,175 $3,300 $2,500 $2,500
$22,000 $22,000 $22,000 $22,000
Years 1 and 2: The grants awarded to Connie by State University do not have to be repaid. In
addition, they are not included in Connie’s taxable income.
The maximum amount that can be borrowed under a Stafford Loan in the first two years of col-
lege are $2,625 and $3,500, respectively. The federal government pays the interest on the loan
(not to exceed 8.25%) both during the time that Connie is in college and during any authorized
deferment period. See Stafford Loans, p. 107. Like the grants, there are no immediate tax con-
sequences stemming from Connie’s use of the Stafford Loans.
Since more of Connie’s educational expenses can be paid with Stafford Loan funds in years 3
and 4 (see below), Jack and Gloria withdraw all of the Coverdell ESA funds in years 1 and 2
– $1,200 in each year. In addition, $5,000 is withdrawn from the 529-plan account established
by Connie’s grandmother in each of the first two years. Connie is not liable for income tax on the
combined $6,200 in distributions from the Coverdell ESA and the 529 plan since the distribu-
tions are used to pay for qualified expenses and do not exceed those expenses when combined.1
See Coverdell Education Savings Accounts – Distributions, p. 12; Qualified Tuition Programs
(529 Plans) – Income Tax Treatment of Distributions and Rollovers, p. 23. In addition, since the
Coverdell ESA and 529 plan distributions can be used to pay for room and board, the distribu-
tions should be allocated to those expenses first.
OBSERVATION: Although Connie is not subject to income tax on the Coverdell ESA
and 529 plan distributions, the earnings portion of the distributions are chargeable to
Connie’s income in the following year for purposes of determining her eligibility to
receive financial aid. In determining Connie’s “expected family contribution” (EFC) in
those subsequent years, the distributions will be assessed at a 50 percent rate and will
reduce her ability to receive aid in that year. However, based on the facts in this example,
it will have little or no adverse consequences. Furthermore, since the 529-plan account
is owned by Connie’s grandmother, the account itself is not counted in any year when
determining Connie’s EFC. See Financial Aid – Expected Family Contribution, p. 101.
The interest paid on the bank loans each year qualifies for an above-the-line interest deduction
on Jack and Gloria’s income tax return since the loan is used to pay for qualified education
expenses. The interest will be well below the $2,500 maximum that can be deducted in any
one year. In addition, since Jack and Gloria’s AGI is below $100,000, the deduction will not be
reduced by the phaseout provisions. Since the student loan interest deduction can be taken with
respect to loans used to pay for room and board (while many of the other tax incentives cannot),
the loan amounts should be applied towards Connie’s room and board first – along with the dis-
tributions from the Coverdell ESA and the 529 plan.
Jack and Gloria can also claim either the Hope scholarship credit, the lifetime learning credit,
or the above-the-line tuition deduction for a portion of the amount they pay for Connie’s col-
lege expenses (i.e., the bank loan and out-of-pocket amounts). See Hope Scholarship and Life-
time Learning Credits, p. 35; Deduction for Qualified Higher Education Expenses, p. 53. Even
though Jack and Gloria pay between $8,500 and $10,175 per year for Connie’s education costs,
only $7,000 of this amount can be used to calculate the education credits and tuition deduction,
since each of these tax benefits can be applied only to Connie’s tuition and related expenses
($10,000 per year), reduced by the amount of Connie’s grant ($3,000). Thus, after comparing the
tax benefits of each option, Jack and Gloria should claim the Hope credit in both 2004 and 2005.
Although they are eligible for a full $4,000 tuition deduction in 2004 and 2005, the deduction
1
This, of course, means that Connie avoids the additional 10 percent tax levied on any portion of a Coverdell
ESA or 529 plan distribution that is taxable.
will not reduce their tax liability as much as the Hope credit. Assuming that they fall in the 25
percent tax bracket for those years, a $4,000 deduction will decrease their total tax liability by
only $1,000 ($4,000 × 25%). As for the lifetime learning credit, considering the $2,000 maxi-
mum allowable credit ($10,000 × 20%), application of the phaseout rules, and the reduction in
qualified expenses due to the grant,2 use of the lifetime learning credit in 2004 would reduce
Jack and Gloria’s tax liability by only $1,050 (see below).
2004 Hope Scholarship Credit Amount
$90,000 – $85,000 = $5,000
$5,000 × $20,000 = 25%
25% × $1,500 = $375
$1,500 – $375 = $1,125
2004 Lifetime Learning Credit Amount

$90,000 – $85,000 = $5,000
$5,000 × $20,000 = 25%
25% × $1,400 = $350
$1,400 – $350 = $1,050
Years 3 and 4: Again, the grants awarded to Connie do not have to be repaid and they are not
included in Connie’s taxable income.
The maximum amount that can be borrowed under a Stafford Loan in the third and fourth years
of college is $5,500 (in each year). Again, there are no immediate tax consequences stemming
from Connie’s use of these loans.
The $5,000 distributions from the 529-plan account in Connie’s third and fourth years of college
are not taxable because the distributions are used to pay for, and do not exceed, Connie’s quali-
fied expenses.
All the interest paid by Jack and Gloria on the bank loans continue to qualify for the student loan
interest deduction since the loan is used to pay for qualified education expenses, the interest will
be below the $2,500 maximum, and their AGI is below the phaseout range for joint filers.
The Hope credit is not available in Connie’s last two years of college, nor is the above-the-line
deduction for tuition and related expenses3 for the amount they pay for Connie’s college ex-
penses. Jack and Gloria should claim the lifetime learning credit in 2006 and 2007. Claiming the
lifetime learning credit in those years would lower Jack and Gloria’s total tax liability by $1,050
(assuming no inflation adjustment for the phase-out ranges).
Post-Graduation: After Connie graduates, she can claim an above-the-line deduction for the
interest that will become due on the Stafford Loans since the loans were taken out in her name.
In addition, Jack and Gloria can continue to claim the same deduction for interest that they pay
on the bank loan.
2
Since only $7,000 in qualified expenses is available for purposes of claiming the lifetime learning credit, Jack
and Gloria’s maximum credit amount for 2004 is $1,400 ($7,000 × 20%).
3
The tuition deduction is available only through 2005 unless it is extended. Code Section 222(e).
Client Letter – Saving for College Expenses

Dear [client’s name]:
The cost of a college education is skyrocketing. The average bill for tuition, room, and board
at a four-year public college or university is just over $10,000 per year. At a private college or
university, the average cost is over $25,000 per year. And these figures do not include the costs
of books, supplies, lab fees, computers, and all the other items college students need. Plus, tu-
ition and fees are rising at a rate significantly higher than the rate of inflation (7% over the past
15 years, compared to an inflation rate of under 3% for the same time period) – and this trend
is expected to continue for the foreseeable future. Fortunately, two tax-favored savings vehicles,
the Coverdell education savings accounts and Section 529 plans, provide significant advantages
to saving for college expenses. They are well worth a look if you are worried about the future
college costs of your child or grandchild.
As you are probably aware, Coverdell education savings accounts offer a way of saving for edu-
cation expenses on a tax-free basis. Contributions are not deductible, but the earnings on the ac-
count are not taxed as earned, and the distributions from the account are not taxed as long as they
are used to pay qualified expenses. The amount that can be contributed per individual per year is
$2,000, providing a chance to build up meaningful tax-free appreciation. (And remember, even
though the amount that can be contributed may be decreased because the contributor has too
much income, there is no limit on who can make contributions on behalf of any individual, so
in many cases, another relative can make the contributions.) Businesses may make contributions
without regard to the amount of their income. Expenses that can be paid for with distributions
from these accounts include expenses incurred for elementary and secondary school education
– including expenses incurred in purchasing computers, software, and even internet access.
Thus, if you are hesitant to start an account because it might diminish your child’s chances of
qualifying for financial aid for college, you may want to consider starting an account and then
depleting it to pay for expenses incurred during high school or even earlier.
Section 529 plans are another type of tax-favored savings account for education. These plans
are established and maintained either by states or agencies or instrumentalities of states, or by
eligible educational institutions, and may be of two types – prepaid tuition plans and education
savings accounts. Contributions to Section 529 plans are not deductible, but the earnings are
taxed neither as earned nor as distributed, as long as they are used for qualified expenses. Such a
plan may well be worth looking into, since contributions are not limited by the contributor’s in-
come and are only limited in amount by the expected expenses. Further, since contributions may
be made to both a Coverdell account and a Section 529 plan in one year on behalf of the same
beneficiary, you don’t have to choose between the two and can, if appropriate, establish both.
Other tax-favored provisions for college expenses include a deduction of up to $4,000 for tu-
ition, the deduction for interest on student loans, and the exclusion from income of employer-
provided educational assistance.
If you want to enhance your ability to save for higher-education expenses in a tax efficient man-
ner, I would be happy to meet with you to discuss your individual situation and the many options
available. If you have any questions or would like more information, please let me know.
Major Education Tax Incentives After EGTRRA

Benefit Tax Available Available Subject to in- Can it be claimed in
treatment for higher for elemen- come limita- the same year as other
education tary and tions? benefits?
expenses? secondary
education NOTE: Yes means
expenses? benefits can be claimed
in same year, but gener-
ally not for the same
expenses.
Deduction Deduction Yes; but No Yes Education credits — no
for higher not living Coverdell ESAs — yes
education expenses QTPs — yes
expenses Other benefits — yes
Hope Credit Yes; but No Yes Deduction — no

scholar- not living Learning credit — no*
ship credit expenses Coverdell ESA — yes
QTPs — yes
Other benefits — yes
Lifetime Credit Yes; but No Yes Deduction — no

learning not living Hope credit — no*
credit expenses Coverdell ESAs — yes
QTPs — yes
Other benefits — yes
Coverdell Contributions Yes; Yes; in- Yes (for Deduction — yes
education not deductible includ- cluding individual Education credits — yes
savings Distributions ing living living contribu- QTPs — contributions
accounts not taxed if expenses expenses tors); no for yes; distributions yes
(education used to pay beneficiaries Other benefits — yes
IRAs) qualified ex-
penses
Qualified Contributions Yes, No No Deduction — yes
tuition not deductible includ- Education credits — yes
programs Distributions ing living Coverdell ESAs — con-
not taxed if expenses tributions yes;
used to pay distributions yes
qualified ex- Other benefits — yes
penses
*Can be claimed for another qualifying individual on the same return.

2004 Annual Limits and Phaseout Ranges
MAXIMUM
ANNUAL
ITEM AMOUNT PHASEOUTS
$1,500 Per Joint Filers $85,000 – $105,000

Hope Scholarship Credit Student All Others $42,000 – $52,000
$2,000 Per Joint Filers $85,000 – $105,000

Lifetime Learning Credit Taxpayer All Others $42,000 – $52,000
Above-the-Line Higher Education Joint Filers $130,000 – $160,000

Expense Deduction $4,000 All Others $65,000 – $80,000
Above-the-Line Student Loan Joint Filers $100,000 – $130,000

Interest Deduction $2,500 All Others $50,000 – $65,000
U.S. Savings Bond Interest Qualified Joint Filers $89,750 – $119,750

Deduction Expenses All Others $59,850 – $74,850
Coverdell Education Savings Joint Filers $190,000 – $220,000

Account Contributions (Eligibility) $2,000 All Others $95,000 – $110,000
529 Plan Contributions (Eligibility) No Limit No Phaseout

Expenses Covered by Education Tax Incentives

STUDENT
LOAN
LIFETIME TUITION INTEREST SAVINGS
HOPE LEARNING 529 COVERDELL DEDUC- DEDUC- BONDEX-
EXPENSE CREDIT CREDIT PLANS ACCOUNTS TION TION CLUSION
Tuition & Fees ✔ ✔ ✔ ✔ ✔ ✔ ✔
Books,
Supplies, and ✔ ✔ ✔ ✔ ✔ ✔ ✔
Equipment*
Room &
Board ** ✔ ✔ ✔
Elementary &
Secondary Schools ✔
Graduate Schools
✔ ✔ ✔ ✔ ✔*** ✔
Non-Degree Courses
✔
Special Needs
Expenses ✔ ✔
* Fees for books, supplies, or equipment (including computers) used in a course of study are covered only if they
must be paid to an eligible educational institution for the enrollment or attendance of the student.
** Student must attend eligible institution on at least a half-time basis.
*** Cost of attendance at institutions conducting internship or residency programs leading to a degree or certificate
awarded by an institution of higher education, a hospital, or a health care facility offering post-graduate training
are also covered.
State 529 Plan Contact Information

CAUTION: A number of states, including Colorado, Kentucky, Ohio, Texas, and West
Virginia, have suspended enrollment in their prepaid tuition programs because of a com-
bination of rising costs and plummeting investments. In states where programs have
been suspended, individuals with money already invested in prepaid plans are being
allowed to keep the funds in the program or are being offered other investment options.
Individuals contemplating participation in such a program should check with the state
agency involved to explore the continuing viability of the program.
(PP) = Prepaid Tuition Plan; (S) = Savings Plan
STATE PLAN(S) TELEPHONE WEBSITE

(PP) Prepaid Affordable College Tuition 800-252-7228
Program
AL www.treasury.state.al.us
(S) Alabama HigherEducation 529 Plan 866-529-2228
www.uacollegesavings.com
(S) University of Alaska College Savings Plan 800-478-0003
www.manulifecollegesavings.com
AK (S) Manulife College Savings Plan 866-222-7498
www.troweprice.com/
(S) T. Rowe Price College Savings Plan 866-521-1894 collegesavings
(S) Arizona Family College Savings Program 800-888-2723 arizona.collegesavings.com
(CSB)
AZ (S) Arizona Family College Savings Program 888-667-3239 www.smrinvest.com/college
(SM&R)
(S) Waddell & Reed Invest Ed Plan 888-923-3355 www.wadddell.com
AR (S) GIFT College Investing Plan 877-615-4116 www.thegiftplan.com
CA (S) Golden State ScholarShare Trust 877-728-4338 www.scholarshare.com
(PP) Colorado Prepaid Tuition Fund 800-448-2424 www.collegeinvest.org

CO
(S) Scholars Choice College Savings Program 800-478-5651 www.scholars-choice.com
CT (S) Connecticut Higher Education Trust 888-799-2438 www.aboutchet.com

DC (S) D.C. College Savings Plan 800-368-2745 www.DCCollegeSavings.com
DE (S) Delaware College Investment Plan 800-544-1655 www.fidelity.com/delaware
(PP) Florida Prepaid College Program

FL 800-552-4723 www.floridaprepaidcollege.com
(S) Florida College Investment Plan
GA (S) Georgia Higher Education Savings Plan 877-424-4377 www.gacollegesavings.com
HI (S) TuitionEDGE 866-529-3343 www.tuitionedge.com
ID (S) IDeal Idaho College Savings Program 866-433-2533 www.idsaves.org
(PP) College Illinois! 877-877-3724 www.collegeillinois.com

IL
(S) Bright Start College Savings Plan 877-432-7444 www.brightstartsavings.com
IN (S) Indiana College Choice 529 Investment Plan 866-400-7526 www.collegechoiceplan.com
IA (S) College Savings Iowa 888-672-9116 www.collegesavingsiowa.com
(S) Learning Quest Education Savings Plan 800-579-2203 www.learningquest.com

KS
(S) Schwab 529 College Savings Plan 800-435-4000 www.schwab.com/529-
(PP) Kentucky Affordable Prepaid Tuition 888-919-5278 www.getKAPT.com

KY
(S) Kentucky Education Savings Plan Trust 877-598-7878 www.kentucktrust.org
LA (S) Louisiana START 800-259-5626 www.osfa.state.la.us/START.htm

ME (S) Maine NextGen College Investing Plan 877-463-9843 www.nextgenplan.com
(PP) Maryland Prepaid College Trust

MD 888-463-4723
www.collegesavingsmd.org
(S) Maryland College Investment Plan
(PP) U.Plan 800-449-6332 www.mefa.org
MA
(S) U.Fund College Investing Plan 800-544-2776 www.fidelity.com/ufund
(PP) Michigan Education Trust 800-638-4543 www.treasury.state.mi.us/MET

MI
(S) Michigan Education Savings Program 877-861-6377 www.misaves.com
MN (S) Minnesota College Savings Plan 877-338-4646 www.mnsaves.org

(PP) Mississippi Prepaid Affordable College
Tuition Program 800-987-4450 www.treasury.state.ms.us
MS
(S) Mississippi Affordable College Savings 800-486-3670 www.collegesavingsms.com
Program
(S) MO$T-Missouri Savings for Tuition
MO 888-414-6678 www.missourimost.org
Program
Montana.collegesavings.com
(S) Family Education Savings Program 800-888-2723
MT www.collegesavings.PacificLife.
(S) Pacific Funds 529 College Savings Plan 800-722-2333
com
(S) College Savings Plan of Nebraska 888-993-3746 www.PlanForCollegeNow.com
NE (S) AIM College Savings Plan 877-246-7526 www.aimfunds.com
(S) TD Waterhouse College Savings Plan 877-408-4644 www.tdwaterhouse.com

(PP) Nevada Prepaid Tuition Program 888-477-2667 Nevadatreasurer.com/prepaid
(S) America’s College Savings Plan 877-529-5295 www.americas529plan.com

NV
(S) American Skandia College Savings 800-752-6342 www.americanskandia.prudential.
Program com
(S) The Upromise College Fund 800-587-7305 www.Upromisecollegefund.com
(S) Unique College Investing Plan 800-544-1722 www.fidelity.com/unique
NH (S) Fidelity Advisor 529 Plan 800-522-7297 www.advisor.fidelity.com/529
(S) Franklin Templeton 529 College Savings Plan 800-223-2141 www.franklintempleton.com

NJ (S) Better Educational Savings Trust 877-465-2378 www.hesaa.org/students/njbes
(PP) The Education Plan’s Prepaid Tuition Program 800-499-7581 www.tepnm.com
(S) The Education Plan’s College Savings Program 877-337-5268 www.theeducationplan.com
NM (S) Scholar’s Edge 866-529-7283 www.scholarsedge529.com
(S) CollegeSense 529 Higher Education Savings Plan 866-529-7367 www.collegesense.com
(S) Arrive Education Savings Plan 877-277-4838 www.arrive529.com
NY (S) New York’s College Savings Program 877-697-2837 www.nysaves.com
(S) National College Savings Program 800-600-3453 www.cfnc.org/savings

NC
(S) Seligman CollegeHorizonsFund 800-600-3453 www.seligman529.com
ND (S) College SAVE 866-728-3529 www.collegesave4u.com
(S) Ohio CollegeAdvantage Savings Plan 800-233-6734 www.collegeadvantage.com

OH
(S) Putnam CollegeAdvantage Savings Plan 800-225-1581 www.putnaminvestments.com
OK (S) Oklahoma College Savings Plan 877-654-7284 www.ok4saving.org

OR (S) Oregon College SavingsPlan 866-772-8464 www.oregoncollegesavings.com
(PP) TAP 529 Guaranteed Savings Plan

PA 800-440-4000 www.patap.org
(S) TAP 529 Investment Plan
(S) CollegeBoundfund 800-251-0539
RI www.collegeboundfund.com
(S) JP Morgan Higher Education Plan 877-576-3529
(PP) South Carolina Tuition Prepayment Program 888-772-4723 www.scgrad.org
SC
(S) Future Scholar 529 College Savings Plan 888-244-5674 www.futurescholar.com
SD (S) College Access 529 866-529-7462 www.CollegeAccess529.com
(PP) Tennessee BEST Prepaid Tuition Plan www.treasury.state.tn.us/best

TN 888-486-2378
(S) Tennessee BEST Savings Plan www.tnbest.com
(PP) Texas Guaranteed Tuition Plan

800-445-4723 www.texastomorrowfunds.org
TX
(S) Tomorrow’s College Investment Plan
UT (S) Educational Savings Plan Trust 800-418-2551 www.uesp.org
VT (S) Vermont Higher Education Investment Plan 800-637-5860 www.vsac.org
(PP) Virginia Prepaid Education Program

888-567-0540 www.virginia529.com
VA (S) Virginia Education Savings Trust
800-421-4120 www.americanfunds.com
(S) CollegeAmerica
WA (PP) Guaranteed Education Tuition Program 877-438-8848 www.get.wa.gov
(PP) SMART529 – Prepaid Tuition Option

WV 866-574-3542
www.smart529.com
(S) SMART529 – College Savings Option
(S) EdVest 888-338-3789 www.edvest.com
WI
(S) Tomorrow’s Scholar 866-677-6933 www.tomorrowsscholar.com
WY (S) College Achievement Plan 877-529-2655 www.collegeachievementplan.com

States Offering Income Tax Deductions for Contributions

to Their 529 Plan(s)
STATE ANNUAL LIMITS TO STATE TAX DEDUCTION (IF ANY)
CO No limits
Limited to $2,000 per beneficiary. Maximum deduction for each beneficiary decreases by $400
GA for each $1,000 of federal AGI over $100,000 for a joint return or $50,000 for a separate or
single return.
ID Limited to $4,000 ($8,000 for joint filers)
No limits for contributions to savings plan (Bright Start College Savings Plan). No deduction
IL
available for contributions to prepaid tuition plan (College Illinois!).
IA Limited to $2,180 per beneficiary for 2002
KS Limited to $2,000 per beneficiary ($4,000 for joint filers)
Limited to $2,400 per account; however, any unused payments may be carried forward to
LA
subsequent tax years
Limited to $2,500 per account; however, any unused payments to prepaid tuition plan
(Maryland Prepaid College Trust) may be carried forward to any subsequent tax year and any
MD
unused payments to savings plan (Maryland College Investment Plan) may be carried forward
for 10 years
No limits to deduction for contributions to prepaid tuition plan (Michigan Education Trust).
MI Deduction for contributions to savings plan (Michigan Education Savings Program) limited to
$5,000 ($10,000 for joint filers)
No limits to deduction for contributions to prepaid tuition plan (Mississippi Prepaid Affordable
College Tuition Program).
MS
Deduction for contributions to savings plan (Mississippi Affordable College Savings Program)
limited to $10,000 ($20,000 for joint filers)
MO Limited to $8,000
MT Limited to $3,000 ($6,000 for joint filers)
NE Limited to $1,000 ($500 for married taxpayers filing separately)
NM No limits
Limited to $5,000 ($10,000 for joint filers). The deduction also applies to New York City
NY
income taxes.
Limited to $2,000; however, any unused payments may be carried forward to subsequent tax
OH
years
OK Limited to $2,500 per account
OR Limited to $2,000 ($1,000 for married taxpayers filing separately)
Limited to $500 ($1,000 for joint filers); however, any unused payments may be carried
RI
forward to subsequent tax years
SC No limits
Limited to $1,410 per beneficiary for 2002 ($2,820 for joint filers if each spouse opens an
UT
account)
Limited to $2,000 per account; however, any unused payments may be carried forward to
VA
subsequent tax years. Limit does not apply to contributors who are 70 years of age or older.
WV No limits
WI Limited to $3,000 per beneficiary
Sample Election Statement to Treat Contributions to a

529 Plan as Made Over a Five-Year Period
Code Section 529(c)(2)(B) Election

(Attachment to Form 709)
Name:
Address:
Taxpayer ID Number:
Pursuant to Code Section 529(c)(2)(B) and Prop. Reg. Section 1.529-5(b)(2), the do-
nor elects to treat the gift of $ paid to the qualified tuition program of the State of
as five equal gifts extending over the period from to
.
The contribution to the qualified state tuition program is for the benefit of
, whose social security number is - - and
who is my .
[relationship]
Signature of taxpayer or authorized representative Date

Sample Election to Recognize Current Income on Non-

Interest-Bearing Discount Bonds Under Code Section 454
Election to Recognize Current Income on

Non-Interest-Bearing Discount Bonds
Name:
Address:
Taxpayer ID Number:
Election for:
[year]
The undersigned taxpayer elects to recognize current income on non-interest-bearing discount

bonds pursuant to Code Section 454. The taxpayer owns [description of obligation] and there
has been an increase of $ in the redemption price of the obligation. The taxpayer elects
to treat the increase as income for the year , when the increase occurred.
Taxpayer agrees to have the election apply to all market discount bonds that are acquired on or
after the first day of the current tax year. He is using the ratable accrual [or constant interest rate]
to compute the annual market discount amount.
Taxpayer also agrees to report the cumulative increase in the redemption price of such bonds
from the acquisition date of such bonds in the return for the current year.

Sample Statement for Automatic Consent of Accounting

Method Change upon Redemption of Savings Bonds
Change in Method of Accounting Under

Section 6.01 of the Appendix of Rev. Proc. 2002-9
Name:
Address:
Taxpayer ID Number:
The undersigned taxpayer requests permission to report all interest on the Series E, EE, or I U.S.
savings bonds described below under the cash method of accounting. The taxpayer also agrees
to report interest on all such obligations acquired in the year of change and all such obligations
acquired in subsequent tax years when the interest is realized upon disposition, redemption, or
final maturity, whichever is earliest.
As to such obligations on which interest has heretofore been reported on the accrual basis, the
taxpayer agrees to report the remaining interest income when the interest is realized upon dispo-
sition, redemption, or final maturity, whichever is earliest.
The Series E, EE, or I U.S. savings bonds for which the change of accounting from the accrual
method to the cash method is requested include:
___________________________________________________________
[List Bonds]
___________________________________________________________
___________________________________________________________
___________________________________________________________

Financial Aid Tables for Dependent Students
Income Protection Allowance for 2004-2005 Award Year
Number in College
––––––––––––––––––––––––––––––––––––––––––––
Family size: 1 2 3 4 5
–––––––––––––––––––––––––––––––––––––––––––––––––––––––––––
2 13,700 11,350
3 17,060 14,730 12,380
4 21,070 18,720 16,390 14,050
5 24,860 22,510 20,180 17,840 15,510
6 29,070 26,730 24,400 22,060 19,730
–––––––––––––––––––––––––––––––––––––––––––––––––––––––––––
For each additional family member add $3,280.
For each additional college student subtract $2,330.
Business/Farm Net Worth Adjustment for 2004-2005 Award Year
If the net worth of a

business or farm is: Then the adjusted net worth is:
–––––––––––––––– –––––––––––––––––––––––––
Less than $1 $0
$1 to $100,000 $0 + 40% of NW
$100,001 to $295,000 $40,000 + 50% of NW over $100,000
$295,001 to $490,000 $137,500 + 60% of NW over $295,000
$490,001 or more $254,500 + 100% of NW over $490,000
Social Security Tax Allowance for 2004-2005 Award Year
Income Earned from Work Social Security Tax*

––––––––––––––––––––– ––––––––––––––––
$0 – $87,000 7.65% of income
$87,001 or greater $6,655.50 + 1.45% of amount over $87,000
* Calculate separately the Social Security Tax of the father, mother, and student.
Education Savings and Asset Protection Allowance for 2004-2005

Award Year (for parents of dependent students)
Number of Parents in
Student’s Household
Age of
Older Parent Two Parents One Parent
25 or less 0 0
26 2,500 1,200
27 5,000 2,300
28 7,400 3,500
29 9,900 4,700
30 12,400 5,900
31 14,900 7,000
32 17,400 8,200
33 19,800 9,400
34 22,300 10,600
35 24,800 11,700
36 27,300 12,900
37 29,800 14,100
38 32,200 15,300
39 34,700 16,400
40 37,200 17,600
41 38,100 18,100
42 39,100 18,400
43 40,100 18,900
44 41,100 19,200
45 42,100 19,700
46 43,200 20,100
47 44,200 20,500
48 45,300 21,000
49 46,500 21,500
50 47,900 22,000
51 49,100 22,600
52 50,300 23,100
53 51,800 23,700
54 53,100 24,200
55 54,700 24,800
56 56,000 25,400
57 57,700 26,100
58 59,400 26,700
59 61,200 27,500
60 63,000 28,100
61 65,200 28,900
62 67,100 29,800
63 69,000 30,600
64 71,300 31,400
65 and over 73,700 32,300
Parents’ Contribution from Adjusted Available Income (AAI) for

2004-2005 Award Year (for parents of dependent students)
Parents’ AAI Parents’ Contribution from AAI
Less than –$3,409 –$750
–$3,409 to $12,200 22% of AAI
$12,201 to $15,400 $2,684 + 25% of AAI over $12,200
$15,401 to $18,500 $3,484 + 29% of AAI over $15,400
$18,501 to $21,600 $4,383 + 34% of AAI over $18,500
$21,601 to $24,700 $5,437 + 40% of AAI over $21,600
$24,701 or more $6,677 + 47% of AAI over $24,700
State and Other Taxes Allowance (Parents of Dependent Students)

for 2004-2005 Award Year
Parents’ Total Income
less than $15,000

Parents’ State or Territory of Residence $15,000 or more
South Dakota , Tennessee, Wyoming 1% 0%
Alaska, Florida, Nevada, North Dakota, Louisiana,

Texas, Washington 2% 1%
Alabama, Arkansas, Mississippi,

New Mexico, West Virginia 3% 2%
Arizona, Colorado, Delaware, Hawaii, Illinois, Indiana,

Iowa, Kansas, Missouri, Nebraska, New Hampshire,
Oklahoma, Pennsylvania, South Carolina 4% 3%
Georgia, Idaho, Kentucky, Michigan, Montana,

North Carolina, Ohio, Utah, Vermont, Virginia 5% 4%
California, Connecticut, Maine, Massachusetts,

Minnesota, Rhode Island, Wisconsin 6% 5%
District of Columbia, Maryland, New Jersey, Oregon 7% 6%
New York 8% 7%
Other 3% 2%
State and Other Taxes Allowance (Dependent Students Only) for

2004-2005 Award Year
Student’s State or Territory of Residence Percentage
Alaska, Florida, South Dakota, Tennessee,

Texas, Washington, Wyoming 0%
Louisiana, Nevada, New Hampshire, North Dakota 1%
Alabama, Illinois, Mississippi, West Virginia 2%
Arizona, Arkansas, Colorado, Delaware, Georgia, Indiana,

Iowa, Kansas, Michigan, Missouri, Montana, Nebraska,
New Mexico, Oklahoma, Pennsylvania, South Carolina,
Vermont, Virginia 3%
Connecticut, Hawaii, Idaho, Kentucky, Maine, Massachusetts,

Minnesota, New Jersey, North Carolina, Ohio, Rhode Island,
Utah, Wisconsin 4%
California, Maryland, New York, Oregon 5%
District of Columbia 6%
Other 2%
State Higher Education Agencies
Alabama Commission on Higher Education Colorado Commission on Higher Education

P.O. Box 302000 Suite 1200
Montgomery, AL 36130-2000 1380 Lawrence Street
Denver, CO 80204
(334) 242-1998; (800) 843-8534
FAX: (334) 242-0268 (303) 866-2723
E-Mail: wblow@ache.state.al.us FAX: (303) 866-4266
URL: http://www.ache.state.al.us/ E-Mail: tim.foster@state.co.us
URL: http://www.state.co.us/cche_dir/hecche.html
Alaska Commission on Post-Secondary

Education Connecticut Department of Higher Education
3030 Vintage Boulevard 61 Woodland Street
Juneau, AK 99801-7100 Hartford, CT 06105-2326
(907) 465-2962; (800) 441-2962 (860) 947-1833; (800) 842-0229

FAX: (907) 465-5316 FAX: (860) 947-1310
E-Mail: customer_service@acpe.state.ak.us E-Mail: info@ctdhe.org
URL: http://www.state.ak.us/acpe/ URL: http://www.ctdhe.org/
Arizona Commission for Post-Secondary Delaware Higher Education Commission

Education Fifth Floor
Suite 550 Carvel State Office Building
2020 North Central Avenue 820 North French Street
Phoenix, AZ 85004-4503 Wilmington, DE 19801
(602) 258-2435 (302) 577-3240; (800) 292-7935

FAX: (602) 258-2483 FAX: (302) 577-6765
E-Mail: toni@www.acpe.asu.edu E-Mail: dhec@state.de.us
URL: http://www.acpe.asu.edu/ URL: http://www.doe.state.de.us/high-ed/
Arkansas Department of Higher Education District of Columbia Department of

114 East Capitol Human Services
Little Rock, AR 72201-3818 Office of Post-Secondary Education, Research, and
Assistance
(501) 371-2000 Suite 401
FAX: (501) 371-2003 2100 Martin Luther King, Jr. Avenue, SE
E-Mail: ronh@adhe.arknet.edu Washington, DC 20020
URL: http://www.arkansashighered.com/
(202) 698-2400
FAX: (202) 727-2739
California Student Aid Commission
P.O. Box 419027
Rancho Cordova, CA 95741-9027 Georgia Student Finance Authority
State Loans and Grants Division
(916) 526-7590; (888) 224-7268 Suite 200
FAX: (916) 526-8004 2082 East Exchange Place
E-Mail: custsvcs@csac.ca.gov Tucker, GA 30084
URL: http://www.csac.ca.gov/
Georgia Student Finance Authority – Cont’d Iowa College Student Aid Commission
(770) 724-9000; (800) 776-6878 Fourth Floor
FAX: (770) 724-9225 200 10th Street
E-Mail: info@mail.gsfc.state.ga.us Des Moines, IA 50309
URL: http://www.gsfc.org/Main/main.cfm
(515) 281-3501; (800) 383-4222
FAX: (515) 242-3388
Hawaii State Post-Secondary Education E-Mail: icsac@max.state.ia.us
Commission URL: http://www.state.ia.us/collegeaid/
Room 209
2444 Dole Street
Honolulu, HI 96822-2302 Kansas Board of Regents
Curtis State Office Building
(808) 956-8213 Suite 520
FAX: (808) 956-5156 1000 SW Jackson Street
E-Mail: hern@hawaii.edu Topeka, KS 66602-1368
URL: http://www.hern.hawaii.edu/hern/
(785) 296-3421
FAX: (785) 296-0983
Idaho State Board of Education URL: http://www.kansasregents.org/
P.O. Box 83720
Boise, ID 83720-0027
Kentucky Higher Education
(208) 334-2270 Assistance Authority
FAX: (208) 334-2632 1050 U.S. Highway 127 South
E-Mail: board@osbe.state.id.us Frankfort, KY 40601-4323
URL: http://www.sde.state.id.us/osbe/board.htm
(502) 696-7200; (800) 928-8926
FAX: (502) 696-7496
Illinois Student Assistance Commission E-Mail: webmaster@kheaa.com
1755 Lake Cook Road URL: http://www.kheaa.com/
Deerfield, IL 60015-5209
(847) 948-8500; (800) 899-4722 Louisiana Office of Student Financial Assistance

FAX: (847) 831-8549 P.O. Box 91202
E-Mail: cssupport@isac.org Baton Rouge, LA 70821-9202
URL: http://www.isac-online.org/gateway.html
(225) 922-1012; (800) 259-5626
FAX: (225) 922-0790
(Indiana) State Student Assistance Commission of E-Mail: custserv@osfa.state.la.us
Indiana URL: http://www.osfa.state.la.us/
Suite 500
150 West Market Street
Indianapolis, IN 46204-2811 Maine Education Assistance Division
Finance Authority of Maine (FAME)
(317) 232-2350; (888) 528-4719 5 Community Drive
FAX: (317) 232-3260 Augusta, ME 04332-0949
E-Mail: grants@ssaci.state.in.us
URL: http://www.in.gov/ssaci/ (207) 623-3263; (800) 228-3734
FAX: (207) 632-0095
E-Mail: info@famemaine.com
URL: http://www.famemaine.com/
Maryland Higher Education Commission (651) 642-0533; (800) 657-0866

Jeffrey Building FAX: (651) 642-0675
16 Francis Street E-Mail: info@heso.state.mn.us
Annapolis, MD 21401-1781 URL: http://www.mheso.state.mn.us/
(410) 260-4500; (800) 974-1024

FAX: (410) 974-5994
Maryland Higher Education Commission –Cont’d
E-Mail: ssamail@mhec.state.md.us
URL: http://www.mhec.state.md.us/ Mississippi Office of Student Financial Aid
3825 Ridgewood Road
Jackson, MS 39211-6453
Massachusetts Board of Higher Education (601) 432-6997; (800) 327-2980
Room 1401 FAX: (601) 432-6527
One Ashburton Place E-Mail: sfa@ihl.state.ms.us
Boston, MA 02108 URL: http://www.ihl.state.ms.us/
(617) 994-6950
FAX: (617) 727-6397 Missouri Department of Higher Education
E-Mail: bhe@bhe.mass.edu 3515 Amazonas Drive
URL: http://www.mass.edu/ Jefferson City, MO 65109-5717
– OR – (573) 751-2361; (800) 473-6757

FAX: (573) 751-6635
Massachusetts Higher Education Information E-Mail: admweb@mocbhe.gov
Center URL: http://www.cbhe.state.mo.us/
Boston Public Library
700 Boylston Street
Boston, MA 02116 Montana University System
2500 Broadway
(617) 536-0200; (877) 332-4348 P.O. Box 203101
FAX: (617) 536-4737 Helena, MT 59620-3103
E-Mail: iriarte@teri.org
URL: http://www.adinfo.org/ (406) 444-6570
FAX: (406) 444-1469
E-Mail: jscott@oche.montana.edu
Michigan Higher Education Assistance URL: http://www.montana.edu/wwwoche/
Authority
Office of Scholarships and Grants
P.O. Box 30462 Nebraska Coordinating Commission for
Lansing, MI 48909-7962 Post-Secondary Education
Suite 300
(517) 373-3394; (888) 447-2687 140 North Eighth Street
FAX: (517) 335-5984 P.O. Box 95005
E-Mail: oir@state.mi.us Lincoln, NE 68509-5005
URL: http://www.michigan.gov/mistudentaid/
(402) 471-2847
FAX: (402) 471-2886
Minnesota Higher Education Services Office E-Mail: dpowers@ccpe.state.ne.us
Suite 350 URL: http://www.ccpe.state.ne.us/PublicDoc/
1450 Energy Park Drive CCPE/Default.asp
Saint Paul, MN 55108-5227
New Hampshire Post-Secondary North Dakota University System

Education Commission North Dakota Student Financial Assistance Program
2 Industrial Park Drive Department 215
Concord, NH 03301-8512 600 East Boulevard Avenue
Bismarck, ND 58505-0230
(603) 271-2555
FAX: (603) 271-2696 (701) 328-4114
E-Mail: kdodge@nhsa.state.nh.us FAX: (701) 328-2961
URL: http://www.state.nh.us/postsecondary/ E-Mail: ndus.office@ndus.nodak.edu
URL: http://www.ndus.edu/
Ohio Board of Regents

(New Jersey) Higher Education Student State Grants and Scholarships Department
Assistance Authority P.O. Box 182452
P.O. Box 540 Columbus, OH 43218-2452
Building 4
Quakerbridge Plaza (614) 466-7420; (888) 833-1133
Trenton, NJ 08625-0540 FAX: (614) 752-5903
E-Mail: cshahid@regents.state.oh.us
(609) 588-3226; (800) 792-8670 URL: http://www.regents.state.oh.us/sgs/
FAX: (609) 588-7389
URL: http://www.hesaa.org/
Oklahoma State Regents for Higher Education
Suite 200
New Mexico Commission on Higher Education 655 Research Parkway
1068 Cerrillos Road Oklahoma City, OK 73104
Santa Fe, NM 87505
(405) 225-9100
(505) 827-7383; (800) 279-9777 FAX: (405) 225-9230
FAX: (505) 827-7392 E-Mail: tsimonton@osrhe.edu
E-Mail: highered@che.state.nm.us URL: http://www.okhighered.org/
URL: http://www.nmche.org/
Oregon Student Assistance Commission

New York State Higher Education Suite 100
Services Corporation 1500 Valley River Drive
99 Washington Avenue Eugene, OR 97401
Albany, NY 12255
(541) 687-7400; (800) 452-8807
(518) 473-1574; (888) 697-4372 FAX: (541) 687-7419
FAX: (518) 474-2839 E-Mail: public_information@mercury.osac.
E-Mail: webmail@hesc.com state.or.us
URL: http://www.hesc.com/ URL: http://www.osac.state.or.us/
– OR –
North Carolina State Education
Assistance Authority Oregon University System
P.O. Box 13663 P.O. Box 3175
Research Triangle Park, NC 27709-3663 Eugene, OR 97403-0175
(919) 549-8614; (800) 700-1775 (541) 346-5700

FAX: (919) 549-8481 FAX: (541) 346-5764
E-Mail: information@ncseaa.edu E-Mail: bob_bruce@ous.edu
URL: http://www.ncseaa.edu/ URL: http://www.ous.edu/
(Pennsylvania) Office of Post-Secondary Texas Higher Education Coordinating Board

and Higher Education P.O. Box 12788
Department of Education Austin, TX 78711
333 Market Street
Harrisburg, PA 17126 (512) 427-6101; (800) 242-3062
FAX: (512) 427-6127
(717) 787-5041 URL: http://www.thecb.state.tx.us/
E-Mail: mkrapsho@state.pa.us
URL: http://www.pdehighered.state.pa.us/higher/
site/default.asp Utah State Board of Regents
Three Triad Center
Rhode Island Higher Education 60 South 400 West
Assistance Authority Salt Lake City, UT 84101
560 Jefferson Boulevard (801) 321-7100
Warwick, RI 02886 FAX: (801) 321-7199
E-Mail: heyring@utahsbr.edu
(401) 736-1100; (800) 922-9855 URL: http://www.utahsbr.edu/
FAX: (401) 732-3541
URL: http://www.riheaa.org/
Vermont Student Assistance Corporation
– OR – Champlain Mill
1 Main Street, Third Floor
Rhode Island Office of Higher Education P.O. Box 2000
301 Promenade Street Winooski, VT 05404-2601
Providence, RI 02908-5748
(802) 655-9602; (800) 642-3177
(401) 222-6560 FAX: (802) 654-3765
FAX: (401) 222-6111 E-Mail: info@vsac.org
E-Mail: ribghe@etal.uri.edu URL: http://www.vsac.org/
URL: http://www.ribghe.org/riohe.htm
(Virginia) State Council of Higher

South Dakota Board of Regents Education for Virginia
Suite 200 James Monroe Building
306 East Capitol Avenue Ninth Floor
Pierre, SD 57501 101 North 14th Street
Richmond, VA 23219
(605) 773-3455
FAX: (605) 773-5320 (804) 225-2600
E-Mail: info@ris.sdbor.edu FAX: (804) 225-2604
URL: http://www.ris.sdbor.edu/ E-Mail: bradford@schev.edu
URL: http://www.schev.edu/
Tennessee Higher Education Commission Washington State Higher Education

Parkway Towers Coordinating Board
Suite 1900 P.O. Box 43430
404 James Robertson Parkway 917 Lakeridge Way
Nashville, TN 37243-0830 Olympia, WA 98504-3430
(615) 741-3605 (360) 753-7850

FAX: (615) 741-6230 FAX: (360) 753-7808
URL: http://www.state.tn.us/thec/ E-Mail: cleap@hecb.wa.gov
URL: http://www.hecb.wa.gov/
West Virginia Higher Education Policy (608) 267-2206

Commission FAX: (608) 267-2808
1018 Kanawha Boulevard, East E-Mail: heabmail@heab.state.wi.us
Charleston, WV 25301 URL: http://heab.state.wi.us/
(304) 558-2101 Wyoming Community College Commission

FAX: (304) 558-0259 Eighth Floor
E-Mail: healey@hepc.wvnet.edu 2020 Carey Avenue
URL: http://www.hepc.wvnet.edu/ Cheyenne, WY 82002
(307) 777-7763
FAX: (307) 777-6567
E-Mail: sbutler@commission.wcc.edu
Wisconsin Higher Educational Aids Board URL: http://commission.wcc.edu/
Room 902
131 West Wilson Street
Madison, WI 53707-7885
Byrd Scholarship Program State Education Agency

Contact List
STATE NAME AGENCY TELEPHONE
AL Frank Heatherly State Dept. of Education (334) 242-8059

AK Noemi Obie Alaska Dept. of Education (907) 465-8728
AZ Thom Wilson State Dept. of Education (602) 542-7469
AR Margaret Crank Arkansas Dept. of Education (501) 682-4396
CA Cathy Mistler CA Student Aid Commission (916) 526-7968
CO April Bermara State Dept. of Education (303) 866-6974
CT John Siegrist Connecticut Dept. of Higher Education (860) 947-1856
DE Maureen Laffey State Dept. of Public Instruction (302) 577-3240
DC Michon Peek DC Public Schools (202) 442-5110
FL Marsha Colston Florida Dept. of Education (850) 487-1080
GA Joe Searle State Dept. of Education (404) 657-0183
HI Dianna Helber Department of Education (808) 735-6222
ID Sally Tiel State Dept. of Education (208) 332-6949
IL Mike Lacopo Illinois Student Assistance Comm. (217) 782-0734
IN Yvonne Heflin Indiana Dept. of Education (317) 232-2350
IA Brenda Easter Iowa Student Aid Commission (515) 242-3344
KS Tamla Miller State Dept of Education (785) 296-4950
KY Donna Melton Kentucky Dept. of Education (502) 564-3421
LA Chris Meyers State Dept. of Education (225) 342-2098
ME Greg Gollihur Finance Authority of Maine (207) 623-3263
MD William Cappe State Dept. of Education (410) 767-0480
MA Jack Conlon State Dept. of Education (781) 388-6325
MI Diane Sprague Michigan Dept. of Higher Education (517) 373-2436
MN Richard Peterson State Dept. of Education (651) 582-8629
STATE NAME AGENCY TELEPHONE
MS Tony Webber State Dept of Education (601) 359-4305

MO Janet Goeller State Dept of Elementary & Secondary Ed. (573) 751-1191
MT Judy Birch State Office of Public Instruction (406) 444-5663
NE Marla Nice Nebraska Dept of Education (402) 471-3962
NV Phyllis Furloong State Department of Education (775) 687-9228
NH Marie Gage State Department of Education (603) 271-6051
NJ Susan Sliker State Department of Education (609) 984-6314
NM Gabriel Baca State Department of Education (505) 827-3970
NY Douglas Mercado Grants Administration (518) 474-5313
NC Michael Cash North Carolina Dept. of Education (919) 807-3369
ND Clarence Bina State Department of Education (701) 328-2098
OH Edwin Whitfield State Department of Education (614) 466-4910
OK Ramona Paul State Department of Education (405) 521-4311
OR Lynn Horine Oregon Department of Education (503) 378-5585
PA Marian Smitter Department of Education (717) 783-6583
RI Rick Richards Dept. of Elementary & Secondary Ed. (401) 222-3126
SC Ann Winstead State Department of Education (803) 734-8357
SD Roxie Thielen Dept. of Education & Cultural Affairs (605) 773-3134
TN Michael Roberts Tennessee Student Assistance Corp. (615) 741-1346
TX Jewel Fletcher TX Higher Ed. Coordination Board (512) 427-6331
UT Diana Deman Utah State Office of Education (801) 538-7741
VT Douglas Chippeta State Department of Education (802) 828-2141
VA Vernon Wildy State Department of Education (804) 225-2877
WA Gayle Pauley Office of Superint. of Public Instruction (360) 753-2858
WV Michelle Wicks Central Office-State Coll. & Univ. Sys. (304) 558-4618
WI Susan Grady State Dept of Public Instruction (608) 266-1771
WY D. Leeds Pickering State Department of Education (307) 777-6265

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Contents Search Print

Saving with Education

Copyright © 2005 by Kleinrock Publishing. All rights reserved.

Quick Answers ....................................................................................................................3

Coverdell Education Savings Accounts ............................................................................5

Qualiﬁed Tuition Programs (529 Plans) .........................................................................19

Hope Scholarship and Lifetime Learning Credits ........................................................35

Claiming a Credit for a Dependent ............................................................................46

Deduction for Qualiﬁed Higher Education Expenses ...................................................53

Business Deductions for Educational Expenses ............................................................59

Exclusion for Bond Interest Income ...............................................................................67

Scholarships and Fellowships ..........................................................................................73

Qualiﬁed Tuition Reduction Programs ..........................................................................81

Educational Assistance Programs ...................................................................................85

Student Loan Interest Deduction....................................................................................91

Planning and Practice ....................................................................................................111

Sample Election Statement to Treat Contributions to a 529 Plan as

Mixing and Matching the Education Tax Incentives

2 Saving with Education Tax Incentives

About This Handbook

4 Saving with Education Tax Incentives

Coverdell Education Savings

6 Saving with Education Tax Incentives

(1) The designated beneﬁciary must be an individual;

Coverdell Education Savings Accounts 7

✔ FINANCIAL AID CONSIDERATIONS

8 Saving with Education Tax Incentives

Limitations and Reductions

Coverdell Education Savings Accounts 9

$96,500 – $95,000 $1,500 1

10 Saving with Education Tax Incentives

Coverdell Education Savings Accounts 11

12 Saving with Education Tax Incentives

Coverdell Education Savings Accounts 13

Qualiﬁed Education Expenses

14 Saving with Education Tax Incentives

Qualiﬁed Higher Education Expenses

Coverdell Education Savings Accounts 15

16 Saving with Education Tax Incentives

Qualiﬁed Elementary and Secondary Education Expenses

Coverdell Education Savings Accounts 17

Rollover and Change of Beneﬁciary

18 Saving with Education Tax Incentives

Similarly, a change in a Coverdell ESA’s beneﬁciary will not be treated as a distribution to be

Qualiﬁed Tuition Programs (529

20 Saving with Education Tax Incentives

✔ FINANCIAL AID CONSIDERATIONS

Qualiﬁed Tuition Programs (529 Plans) 21

Qualiﬁed Higher Education Expenses

22 Saving with Education Tax Incentives

OBSERVATION: An “eligible educational institution” is any college, university, voca-

Qualiﬁed Tuition Programs (529 Plans) 23

Income Tax Treatment of Distributions and Rollovers

24 Saving with Education Tax Incentives

($5,000/$6,000). Consequently, since Diane’s distribution exceeds her qualiﬁed higher

Qualiﬁed Tuition Programs (529 Plans) 25

(6) Stepfather or stepmother;

26 Saving with Education Tax Incentives

Qualiﬁed Tuition Programs (529 Plans) 27

Estate and Gift Tax Treatment of Contributions

28 Saving with Education Tax Incentives

Qualiﬁed Tuition Programs (529 Plans) 29

30 Saving with Education Tax Incentives

529 Plan Requirements