Sunday, September 14, 1997

Tax law has some complicated perks for college savings

By Kathy Bergen / Chicago Tribune

When Congress cobbled together the 1997 tax law, it threw in a passel of presents for parents who want to save for their children's college educations.

But before anyone starts jumping up and down with glee and anticipation, a few words of caution: You can't have them all, some may not wear well and the operating instructions are bewildering -- even to the nation's tax experts.

"They have increased the options tremendously, and some options overlap," said Greg Jenner, national director of tax policy at Coopers & Lybrand in Washington. "But the options can be mutually exclusive, so you need to be very careful how you work through the maze. ...

"Under certain provisions, you can use the money to pay for room and board (as well as tuition), but in others you can't," he said, "which strikes me as somewhat nutty." As well, each program phases out benefits at a different income level.

This is not to say the tax breaks, which take effect next year, are devoid of appeal, but rather that selecting the right approach will be a complex process for the middle- and lower-income families that stand to benefit.

"The individuals this most affects are the ones who have the least ability to pay for the advice they need to be able to figure it out," noted Bryan Malis, manager in the financial counseling services group in the Chicago office of Deloitte & Touche.

Among the most tantalizing new programs are the Hope Scholarship and Lifetime Learning tax credits.

The Hope credit offers tax savings of up to $1,500 a year for the first two years of college. The Lifetime credit provides tax savings of up to $1,000 a year for subsequent years of education; in 2003, this credit will rise to $2,000.

For joint filers, the credits begin to phase out when adjusted gross income hits $80,000; for single filers, $40,000.

To Abby Johnson, a single mother of four young children, this sounds like a good deal, especially for the working poor.

"It's a long time coming," said Johnson, 37, who hopes to find the means to send her kids to college.

So far Johnson, who says she makes about $20,000 a year as a family support advocate at a Family Focus resource center in Evanston, Ill., has been unable to save for college, although she is acutely aware of the costs.

Johnson's brother, however, has opened savings accounts for her two oldest children, ages 5 and 3, with $100 in each.

During the last school year, tuition alone ranged from an average of nearly $13,000 a year at private universities to about $1,400 at community colleges, according to the College Board.

The degree to which the credits will prove helpful to Johnson and other Americans depends largely on whether colleges jack up tuition costs, experts say.

"We don't know how colleges will respond to this -- that is the wild card in the big picture," said Kalman A. Chany, New York-based author of an updated edition of "Paying for College Without Going Broke," due out this fall.

Taxpayers have other tax breaks to choose from, of course, among them a savings vehicle for education similar to an individual retirement account.

Taxpayers can put $500 per child into these so-called education IRAs, and while contributions are not deductible, earnings build tax-free and withdrawals are tax-free if used for education. Eligibility phases out at $150,000 for joint filers and $95,000 for single filers.

This option has caught the eye of Daniel and Debbie Witte, of Downers Grove, Ill., who are saving for the education of their two young daughters through mutual funds structured as gifts in trust.

To them, the education IRA looks like a good way to avoid the complex gift-tax forms required by the federal government.

"It seems like it would be simpler," said Daniel Witte, 30, pastor at Good Shepherd Lutheran Church in Downers Grove.

He and his wife, Debbie, who is also 30 and who teaches piano, have an annual income of about $44,000, which includes church-related benefits, so they would qualify for the credits as well.

But the two cannot be used simultaneously, at least not fully.

You can't take a tax-free withdrawal from an education IRA in the same year as you take a tax credit.

So, which is better?

For those who earn too much to qualify for a credit, the answer is obvious.

But for those with a choice, it's more difficult.

Opting for the tax credit has a lot of appeal, assuming the taxpayer still socks away $500 a year per child into a solid investment vehicle, according to Malis, of Deloitte & Touche.

The earnings in a taxable account, coupled with the tax-credit savings, will outstrip the tax savings on the education IRA account in many instances, particularly when there is a short time before your children go to college, he found.

Yet, he notes a plus for the education IRA: Parents of young children can start contributing next year, so even if tax law changes, that money is set aside.

"Who knows what tax credits will be available five, 10 or 15 years down the road. ... Sometimes the wisdom of taking advantage of what's available today makes a lot of sense," Malis said.

And other goodies are available, too. For the first time since 1986, taxpayers can deduct interest paid on college loans from their taxable income, which experts see as a slam-dunk good deal.

As well, withdrawals now can be made penalty-free from a traditional IRA or from the Roth IRAs created by the new tax law, if the money is used to pay for higher education.

But experts advise that tapping retirement funds to pay for education should be avoided if at all possible.

The real bang-for-the-buck with IRAs is the tax-free buildup until retirement, notes Jenner of Coopers & Lybrand. By pulling out money for college expenses, "you're losing the true value of an IRA," he said.

The tax package also expands state prepaid tuition plans, allowing taxpayers to prepay not only tuition but also other expenses such as room and board. The plans are offered by 22 states, including Michigan and Wisconsin, but not in Illinois.

The caveat here: You cannot contribute to a state tuition plan in the same year as you contribute to an education IRA, and experts see the IRAs or equity mutual funds as better investments.

The tuition plan's rate of return is basically the inflation of tuition costs at state schools, noted Malis -- historically about 7 percent a year. Stock mutual funds over the long term have gained about 10 percent, he said.

The questions raised by the tax law seem almost endless. For example, if you take a tax credit, or make a withdrawal from an education IRA, how will that affect your eligibility for other forms of financial aid?

Or, given that taking a tax credit limits the tax break you can get when cashing in a Series EE savings bond for education purposes, how should you coordinate use of the two?

From all the complexity, a joke has arisen, noted author Chany: "Who benefits most from the tax law? Three classes of people: accountants, financial planners and attorneys."