ABC's of Education Tax Benefits

Tax Code complexity has come up in a number of conversations this week, so that inspired the concept of a topic related to demystifying important yet unclear areas of the code.  This creates plenty of choices as, according to the IRS official count, the IRC  has 3.8 million words.  Tax credits for education caught my eye first. According to Saturday’s piece in the Wall Street Journal , IRS wordsmiths explain these benefits in an 84 page booklet.  I’ll try to stick with highlights.

The winner of all the tax benefits is the American Opportunity Tax Credit.  This covers up to $2,500 a year in qualified education expenses up to$2,500.  Anyone who goes to college more than half time is eligible (assuming you meet the AGI cutoffs < $90,000 for singles and < $180,000 for married filing jointly).  The best part about this credit is that up to 40% of it is refundable.  So if you don’t owe enough tax to get the credit as a reduction in taxes, Uncle Sam cuts you a check.  This benefit is set to expire in 2012 – so don’t budget for it past that year.  It’s been extended before, but you never know. Oops – one more exclusion – you can’t deduct education expenses the same year you get the credit.

 If graduate school or some other continuing education is what’s causing your tuition pain, then the Lifetime Learning Credit is your best shot.  While it’s available for undergraduate expenses, you can’t use it at the same time you get the AOTC, and it’s for a maximum of $2,000. The AGI cut offs are lower for this one (< $61,000 single, and <$122,000 for married filing jointly).  You also can’t take this credit if you’re taking a deduction.

Speaking of taking a tuition deduction -- you can do this if you are going to school for a line of work you’re already pursuing.  It’s up to $4,000 for AGI < $65,000 single, or < $130,000 married filing jointly.  This benefit expires after the 2011 tax year, so barring congressional action, this is the last year you can deduct tuition.  You will be able to continue deducting the interest on your student loans through 2012. 

If your employer is helping to pay your tuition, up to $5,250 can be excluded from your income, and there’s not AGI cap to worry about.  One other tax benefit that’s not subject to income thresholds is raiding your IRA for tuition help.  No early withdrawal penalties kick in, but you will have to pay tax on that money once it comes out. 

Finally a quick mention for tuition savings plans.  Coverdell Educational Savings Accounts allow you to put away $2,000 a year, and take out the proceeds to pay for education without paying taxes on any growth that occurs in the interim.  The proceeds must pay for education for someone under 30 years old, and there are AGI restrictions for these accounts.  529 plans are state specific, have no AGI limitations, and can be used to pay for anyone’s educational expenses.

State of Mind

Coming back from vacation to dismal jobs news inspired me to attempt putting together some economic analysis of my own.  I started with an article from Barron’s that ranked states from a financial health perspective.  I overlaid that with a presentation done by a member of my LinkedIn alumni group  that ranks various aspects of state tax policy in terms of friendliness to taxpayers.  I had this theory that fiscal health and physical health were similar in the “no pain no gain” area.  You eat nothing but doughnuts and watch TV then you look and feel like Homer Simpson.  You eat vegetables and chop your own salads, and then you still have plenty of energy to count your money.  Or something like that…  Anyway – it wasn’t true.

California scored on two of Aaron Skloff’s worst states for “….tax” lists, and they also got the worst spot on Barron’s shakiest credit list.  However, New Hampshire tilted toward the tax friendly side of the ledger, and it sits right next to tax-unfriendly New York on Barron’s shakiest list.  Actually as an accountant I should be the first to know that you need to look at both sides of the entry.  It’s not just how much you collect in taxes – it’s also how much you spend. 

Barron’s also brought in unemployment as a factor to consider – needless to say unemployment lowers tax receipts regardless of the rate.  However, taxing tough didn’t pay or hurt in terms of jobs.  The states with no income tax had an average unemployment rate of 8.1%.  The top 5 states in terms of income tax rates had an average unemployment rate of 8.2%.  One area with a little correlation was sales tax (a recent favorite topic of mine).   The states with no sales tax had an average unemployment rate of 7.5%, and the states with the 5 highest sales tax rates had average unemployment of 8.9%. 

Clearly I should stick with accounting, and not move into economics.  The experts in that field added two more points in the Barron’s article that are worth noting.  First is that federal budget cuts will have disproportionate impact in states with many federal contracts (AAA rated Virginia gets almost 30% of state GDP from Uncle Sam and Maryland isn’t far behind).  

Last and most importantly, there is no number that indicates the willingness to introduce structural change into state spending.   That is the essential ingredient in fiscal stability, and probably the most relevant component of how one would rate a muni bond.  Sigh.

Biggest Tax Blunder of 2010

So now that the 2009 Tax Season is finally over  (for those who don’t follow things like this, October 15^th is when the IRS extension period ends) the New York Times Freakonomics blog decided to ask the question --  "What is the biggest tax blunder of the year?"  (They actually asked it in a more open ended manner.  They apparently are focusing on the fact that 2010 still isn’t over, and we could get more potential blunders before 12/31.)  The big winner was:   not addressing tax issues that impact 2010.  Most specifically the AMT patch (or lack thereof), the elimination of the Federal estate tax and the expiration of research and development tax credits.  According to Tax Vox continued inaction on AMT means that 27 million taxpayers will fall into the Alternative Minimum Tax category in 2010.  That’s a 23 million taxpayer increase from 2009.  Perhaps not as important, but certainly worth noting is that also going away will be the option to take an itemized deduction for state and local sales tax  vs. income taxes paid to the same entities.  The addition to the standard deduction for state and local real property taxes also is gone in 2010.  The above the line deduction for qualified educational expenses and the $250 teachers get for purchasing supplies for their classrooms are also not continuing (at this point).  So the list is long, and it is one of those things that while each item isn’t make or break, arguably in aggregate it is the biggest blunder of the year.

Then again, there’s so much competition.  Presumably allowing the Bush tax cuts to expire without any fine tuning would count as a 2010 event, and easily gets classified as a blunder.  (Ironically there are many smart people who see this not as a blunder, but an accomplishment.)  Then there’s the horrid implementation of the home buyer tax credit and associated extensions.  Speaking from personal experience, no one (including the IRS) knew exactly how to implement getting this credit if you had anything outside of a plain vanilla sale.  Also, we know that enforcement of what few rules there were around getting the credit was poor (arguably abysmal). I’m specifically thinking of the prison inmates who got the credit. 

It is really unfortunate that there are so many candidates for this inauspicious designation of biggest tax blunder in 2010.  Perhaps a better way to think of 2010 is as the least-boring tax year on record.  I think it’s an ancient Chinese curse, “may you live in interesting times…”



Fall Tax Planning To-Do List

It is true that it’s hard to do tax planning this year with all the open issues.  Still there are some things you can do now that will make it that much easier to react when we are able to fill in the blanks on the unknowns. 

 So here are 5 tax topics to make some decisions about while we wait for Congress to make their decisions on taxes.

 1.  Year end is always a good time to benchmark your retirement plan savings.  Either max out on your tax deductible retirement contributions for the year or convert some of your qualified plans to Roth IRAs.  As mentioned in earlier posts – this is a prime year to convert to a Roth plan if you are so inclined.  In 2010 only you can pay the tax liability on conversions over two years rather than right away.  No penalties.  And payments don’t start until 2011.  If you can afford it, and believe tax rates and / or your income are heading up, this is a must do.

2.  If you’re planning any activities that will lead to big deductions this year, make sure you need them.  If tax rates are higher next year you will appreciate the deduction even more.  Your favorite charity may prefer to get a holiday gift donation, but they’ll still happily take the money in January.  At that point the reward for giving may be larger for doing the same amount of good.

3.  There are still some energy saving tax credits to be gained this year if you’re feeling flush.  (Even if our bank balance isn’t large,  the combination of tax benefits and lower utility bills may make it worth deferring another kind of purchase until the new year.)  You can find the eligible energy tax credit purchases at www.energysavers.gov. 

- One warning here.  Many of our clients confuse the energy saving appliance rebate with this energy tax credit.  They are NOT the same thing.  The credit is for a new furnace or window, not a new washing machine.

4.  Some key education savings vehicles are on the list of tax breaks due to expire at the end of 2010.  It doesn’t hurt to use any education tax breaks to the max while they are there for sure.  For example, The American Opportunity Education Credit of to $2,500 is based on maximum spending of $4,000.  If you haven’t hit that threshold yet you are allowed to include pre-paid tuition for next semester in the year that it’s paid.  Also, if there are books you know you’ll need next semester they also qualify. 

Beware -- If you pay these expenses from a 529 Plan Account they are NOT eligible for the credit.

Speaking of 529 Plans, if you have one and also have money in a Coverdell Education Savings Account, you may want to roll the Coverdell Funds into the 529 plan.  Coverdell Accounts are due to be much less attractive without new legislation after 2010.  The 529 Plans are not on the chopping block.  The transfer from one account to the other is tax free.

5.    In January the reimbursable expenses for Flex Spending Accounts, Health Savings Accounts, Archer Medical and other tax-protected health reimbursement accounts will change.  In 2011 you won’t be able to use money in those accounts to purchase over the counter medications.  (Your doctor can write you a prescription for a drug you could purchase OTC and you can buy it that way.)  Have no idea why this has been changed, but if you’re in a “use it or lose it” plan add non-prescription medications to your holiday shopping list. 



Tax Planning Thoughts

While you don’t have to make a final decision until the end of the year, it is worth taking some time now to think about converting your traditional IRA or other tax qualified retirement plan to a Roth IRA.  This decision process requires many assumptions.  My preference is using facts to make financial decisions, but sometimes that option just isn’t available.   

A quick summary on traditional qualified plans vs. Roth IRAs yields the following bottom line.   Are you better off deferring taxes until you are age 70 ½ or should you get it over with now, and then get tax-free distributions from your retirement savings?

• The IRA / qualified plan money is contributed on a pre-tax basis.  If it stays in the plan until after you are 59½ years old, you will pay taxes on withdrawal.  If you try to take the money out earlier, you pay the taxes plus a 10% penalty.  Once you reach age 70½ you have to start taking a specified portion in distributions, as the IRS is done waiting to get the taxes due on that money.  You age-out of being able to contribute to a traditional IRA once you have to take those mandatory distributions
• With a Roth IRA, the contributions are made after taxes.  Earnings may be withdrawn without tax or penalty if you meet the 59½ age threshold and the money has been in the account at least five years.  There are no mandatory distributions.  So while you don’t get the turbo charge of pre-tax contributions and then getting deferral on the growth, on the other hand, what is in the account is yours to keep.    The Roth IRA doesn’t have an age restriction for contributions, but there are income limits that cause many upper income people to be ineligible for this type of plan. 

This brings us to 2010 -- a year that is notable because the income limitations on converting qualified retirement plans to a Roth have been removed.   This means you can roll over money in other qualified pIans regardless of your income.  In addition, moving the IRA into a Roth will not trigger tax penalty even if you haven’t reached the age where the IRA can be accessed.  However, all taxes owed must be paid.  If you make the decision to do this before the end of 2010, you can elect to pay the taxes over two years -- waiting to make the payments in 2011 and 2012.

Here’s where the assumptions stuff comes into play.  Normally, using the time value of money approach to managing your finances, paying later is always better.  However, if the Bush tax cuts expire in 2011, you could pay more in taxes that year than you would have if you took the hit in 2010.  Another assumption to watch out for is the Medicare surtax on investment income.  This tax is scheduled to start in 2013, and if you are in a higher income bracket you won’t pay it on your Roth distributions, but you will on your traditional IRA. 

One offset to all the crystal ball gazing skills involved in the conversion decision is talking to a tax advisor.  While it’s still an assumption, I’m convinced a thorough review of all your specific considerations this year is an especially good investment.