The Hope Scholarship Credit: Giving Tuition Payers a Little Hope

One of the best tax incentives aimed at middle class parents of college students is the Hope Scholarship Credit. Under this plan, the government offers up to $1,500 per year as a tax credit to partially compensate parents (or other tuition payers)

for paying their dependent student's college tuition. Independent students can also qualify for the Hope Scholarship Credit for their own education.

Hope Scholarship Credits don't refer to scholarships in the usual way. Instead of receiving a check to pay for school, you or your parents receive these "awards" in the form of tax credits. In other words, you get to deduct a certain amount of your education costs from your annual income to get a break on your taxes. In short, you get a tax credit for being or supporting a scholar, not for winning a scholarship.

The Hope Scholarship Credit can only be claimed for the first two years of college attendance. After that, you can use other programs, such as Lifetime Learning Credits and Coverdell ESAs, to help with education expenses.

The amount you can claim under the Hope Scholarship Credit program is directly affected by your income. Congress has mandated that Hope Scholarship Credits be fully available below a pre-set income threshold but not available at all if your income is above another (higher) income threshold. Between these two income levels, a phaseout calculation gradually reduces the amount available for the credit.

In the 2003 tax year, for example, the amount of a Hope Scholarship Creditwas fully available if the taxpayers' modified adjusted gross income (usually shortened to MAGI) was $41,000 or less (or $83,000 or less, if filing jointly). Between $41,000 and $51,000 (or $83,000 and $103,000 for a joint return), credits were subjected to a phaseout that gradually eliminated any Hope Scholarship Credit benefit. Above the $51,000 MAGI level ($103,000 if filing jointly), these credits were completely phased out (eliminated). Limits change all the time, so check with the IRS to confirm this year's levels.

Who can claim the Hope Scholarship Credit?

If you "win" a Hope Scholarship Credit, you or your parents get a credit against taxes in the year paid. To receive this free money, however, you have to meet four criteria:

• You must have paid qualified tuition and related expenses of an "eligible institution of higher education." Claims can only be made for student tuition, and only for that portion that is not covered by other scholarships, grants, and federal loans.

• You must pay the tuition and related expenses for an eligible student. If your parents are footing the bills, they get the credit; if you pay the bills as an independent student, you can claim the benefit.

• The eligible student must be yourself, your spouse, or a dependent for which you claim an exemption on your tax return. If you're a dependent student, you can't claim this credit. If your grandparents pay for your college tuition and you aren't their legal dependent, they can't claim the tax credit.

• You have to complete IRS Form 8863 entitled, Education Credits (Hope and Lifetime Learning Credits) and attach it to IRS Form 1040 or IRS Form 1040A.

In case you were wondering, the IRS defines an eligible institution of higher education as "any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited, public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions."

Okay, what's the catch?

The IRS isn't out to get you, so you don't have to worry about obscure catches or loopholes that will prevent you from getting this credit. It really does want to help you. However, you do need to be aware of a few ways to disqualify yourself for Hope Scholarship Credit eligibility (and avoid them if you can help it):

• If your parents are married, they can't file their taxes separately if they want to claim the Hope Scholarship Credit. If you're an independent student and married, you must file jointly with your spouse to claim the Hope Credit. Divorced parents, on the other hand, can file separately.

• If you're a dependent student and listed as such on someone else's tax return, you can't file for a Hope Scholarship Credit. For this reason, parents file for the Hope Credit, not the dependent student.

• If your modified adjusted gross income (your MAGI) is $51,000 or more (or $103,000 or more, if you file jointly), your benefit is eliminated.

• If you (or your spouse) were classified as a nonresident alien for any part of the year for which you're filing and you did not elect to be treated as a resident for tax purposes, you can't file for a Hope Scholarship Credit. You must pay U.S. taxes to take advantage of the credit because the Hope Scholarship Credit is appliedagainst taxes payable. If you don't file your taxes here, you can't receive credit.

• If you claim the Lifetime Learning Credit for a student for a given year, you can't file for the Hope Credit for the same student.

Which college expenses aren't covered?

Some expenses aren't covered by the Hope Scholarship Credits. Although tuition and other required college fees (including lab fees, student government fees, and other fees levied by the school that must be paid to enroll) are covered by Hope Scholarship Credits (within the specified limits and limitations), some otherwise legitimate expenses aren't allowable.

For example, even though just about every college across the United States requires students to have separate health insurance coverage to attend school, these insurance expenses don't qualify under the Hope Scholarship Credit program.

Besides health insurance costs, other expenses specifically excluded from the Hope Scholarship Credits include the following:

• Medical expenses (including student health fees). The rationale behind this exclusion is that even if students weren't going to school, they would still pay for medical expenses in the normal course of life.

• Room and board. Although several federal loans programs include room and board as allowable expenses, the Hope Scholarship Credit does not.

• Transportation. Despite the fact that students might have to commute to college, Hope Scholarship Creditsdon't cover any travel expenses. Some students may find this exclusion particularly weird because they might have to stay home with their parents because college residence expenses are also not covered.

• Personal or family living expenses. These expenses are difficult to quantify and it's almost impossible to verify that students aren't "overpaying" their parents for room or board — so the government simply excludes the entire category.

How can I calculate my Hope Scholarship Credit?

You can calculate the base amount of the Hope Scholarship Credit by using this easy formula:

1. Take 100 percent of the first $1,000 of qualified tuition and related expenses paid by you or paid by your parents for you.

2. Add 50 percent of the next $1,000 of qualified tuition and related expenses your parents paid by you or paid by your parents for you.

This number is your maximum allowable Hope Scholarship Credit.

The maximum amount of Hope Scholarship Credit that could be claimed in 2003 was $1,500 per student, per year. The good news is that your parents (or you if you're an independent student) can claim the full $1,500 for each eligible student for whom they paid at least $2,000 in qualified tuition expenses. The bad news is that the credit may be reduced based on your parents' MAGI, or yours if you're an independent student. This reduced amount is called the allowable credit.

The IRS uses the following formula to calculate the allowable Hope Scholarship Credit:

Allowable Hope Scholarship Credit = Maximum Credit x (Phaseout limit – Payer's MAGI) / Phaseout Range

Here's a quick explanation:

• Maximum Credit is 100 percent of the first $1,000, and 50 percent of the next $1,000; tuition expenses over $2,000 are not recognized for this award.

• Phaseout Limit is the maximum MAGI that will qualify for the Hope Scholarship Credit. Currently, this amount is $51,000 for single parents of dependent students (the same for single independent students) and $103,000 for two-parent families (or married independent students).

• Phaseout Range is the dollar amount over which the Hope Scholarship Credit is phased out. For single payers, this amount is currently $10,000 (because full credit is given to a single payer whose MAGI is $41,000 or less, and no credit is given to a single payer whose MAGI is $51,000 or more). Married payers have double the MAGI allowance and thus have double the phaseout range: $20,000.

To understand how the phaseout works, here are college payment scenarios for two hypothetical families.

Example #1: Payers under the phaseout limit

Mark and Mary have a combined MAGI of $75,000, and they pay $2,000 in the fall semester sending their daughter Marisa to college. The amount of $2,000 represents qualified expenses above and beyond other scholarships, loans, grants, and other sources of free (or free-for-now) money that Marisa has been awarded for college.

Because Mark and Mary file their IRS Tax Form 1040 together, and their MAGI is under the phaseout limit of $83,000, they're eligible to apply the entire $1,500 Hope Scholarship Credit to their tax return. (Remember that while the first $1,000 is 100 percent eligible, only 50 percent of the second $1,000 is eligible for credit.)

Example #2: Payer near the upper range of the phaseout limit

Widowed Julie, on the other hand, has a MAGI of $50,000 this year. Julie incurs an expense of $3,500 for sending one of her two sons, Jack, to college at a nice school. Alas, the Hope Scholarship Credit program only takes notice of the first $2,000, and then only the second $1,000 at 50 percent. Thus her allowable Hope Scholarship Credit is calculated as follows:

Hope Scholarship Credit = $1,500 x ($51,000 - $50,000) / $10,000

Or $150

If Julie's MAGI was $1,000 more that year, her Hope Scholarship Credit would be completely zeroed out.