How to take advantage of tax-sheltered programs for educational savings
Would you turn down Uncle Sam's help in putting your kids through college? Would you pass on the chance to limit the tax bite on your estate? If you aren't taking advantage of tax-sheltered programs for educational savings, you may be missing out on some incredible opportunities like these.
In my last column I discussed the reasons behind the move toward tax-advantaged savings programs for retirement. In brief, the government wants individuals to take more responsibility for accumulating the money they'll need. That same rationale applies to tax-sheltered educational savings programs. Government-backed student loans usually cover only a fraction of school expenses (especially for private colleges and universities). With college tuition increasing by as much as 25 percent a year in some states, it's clear that families will have to save more.
Improved savings incentives
When my parents saved for my college education, they did it in the traditional fashion through a savings account at their local bank. No tax shelters were available to them. When I saved for my children's education, I was able to do so under the Uniform Gift to Minors Act (UGMA). This allowed me to open accounts in my children's names and have the interest or dividends taxed at their level. Not a big advantage, but I used it anyway. The income of a custodial account is taxed to the child. However, the so-called "kiddie tax" eliminates most of the benefit from shifting income to children under age 14.
In 1996, however, Congress passed section 529 of the IRS code, which permitted the states to set up tax-sheltered college savings programs. Those programs were enhanced in 2001 with the passage of the Economic Growth and Tax Reconciliation Act (EGTRA). So now we have plans that parents and grandparents -- or anyone else -- can use to put away sizable amounts of money for a child's education while gaining significant income tax and estate tax enhancements.
Beginning in 2002, the Education IRA -- now known as a Coverdell Education Savings Account -- was also improved and expanded to cover educational expenses from kindergarten through college. Both of these tax-advantaged educational savings programs make it easier and more financially attractive to put money aside.
529 plans complex, confusing
Choosing a 529 plan can be difficult because every state has a fairly large amount of leeway in structuring its plans. Although details may vary, there are two basic types of 529 programs: prepaid tuition and educational savings programs. All 50 states offer at least one type, and most have both.
The prepaid plans generally offer a guarantee of fully paid tuition and fees at a state college in return for certain specified payments (lump sum, yearly, or monthly). While payments may be deductible on state taxes, the prepaid plans do not offer the flexibility and the added tax benefits of educational savings programs.
The 529 educational savings programs, on the other hand, allow anyone -- parent, grandparent, aunt, uncle, or even someone unrelated -- to open an account for a beneficiary. These after-tax contributions grow tax-free, and money taken out for higher education costs is free of federal taxes (and usually state taxes as well).
On the plus side
Several unique features make the 529 savings program an attractive investment and estate-planning tool:
The donor -- not the beneficiary -- retains control of the money in the account, and can even change the beneficiary if necessary.
Suppose you open a 529 savings plan for a grandson who decides at age 18 that he's not going to attend college. He can't take the money that you've put aside and blow it on a hot sports car. You can either keep the money in the account and hope your grandson eventually goes to college, or change the beneficiary on the account.
Or maybe you have a 529 savings account for your daughter, who won an all-expenses-paid scholarship to the school of her choice. Since she doesn't need the money, you have the option of designating another child as the beneficiary of the account.
Keep in mind that the new beneficiary must be a family member of the original beneficiary. This definition is fairly loose, and can include siblings, parents, aunts, uncles, and even first cousins.
The contribution limits to a 529 savings plan are high, which makes it an excellent method of transferring wealth.
A donor can put up to $55,000 in each beneficiary's account in one year, although this will count as an accelerated five-year contribution (the maximum tax-free gift of $11,000 per year for five years). Two donors -- a grandmother and grandfather, for example -- can contribute up to $110,000. This money is no longer counted as part of your estate, even though you retain control of it.
If you are a parent or grandparent with significant net worth, the 529 education savings plan provides a great opportunity for you to pass your wealth on to the next generation.
529 savings accounts are considered parental, not children's, assets.
For the purposes of federal financial aid, schools consider 529 accounts as parental assets. This means that only 5.6 percent of the money in such an account is considered available for college expenses, as opposed to 35 percent of the money in an account in a child's name. That is, the calculation used to determine if you are eligible to obtain financial aid will include only 5.6 percent of the value of any assets in the parents' names, including the 529 plan.
529 plan contributions can be used for all higher education expenses. Generally, most any institution of higher education will meet the criteria for using the funds in the 529 account. If your child's plans include vocational school, graduate school, or even medical school, the money in the 529 plan can be used to cover tuition, room and board, books, fees, supplies, and equipment.
States offer choices
Every state's 529 education savings plan is different. Some have one investment manager and offer a single, basic portfolio. Others may have several different fund managers who offer as many as three different mutual fund choices.
Another choice to make is whether you want a static or an age-based-enrollment savings program. With static programs, you make your selection of a fund or funds for the 529 savings account and the mix does not change without your intervention. The age-based-enrollment plans, on the other hand, change the mix of investments as your child gets older, moving into more conservative choices as he or she nears college age.
The good news is that you're not limited to investing only in the 529 savings plan for your state. Most states open their enrollment to everyone. Remember, however, that you might receive a state tax deduction only if you live in the same state where the 529 plan is located. Deductions allowed by states vary widely from $2,500 to unlimited amounts.
When comparing plans from various states, make sure you have a good understanding about the real costs of the plan. Some states may charge an enrollment fee or annual program fees or fees for changing investments. As with any investment, you'll want to check out the fund manager's reputation as well as the management fees and expenses that you will be charged.
Even the best tax shelter has some drawbacks, however, and the 529 education savings plan is no exception. Here are some of the restrictions:
Despite these restrictions, the 529 plans still offer one of the best opportunities available today to save for college with the government's assistance.
Another savings opportunity
Until 2002, the Coverdell Education Savings Account (formerly the Education IRA) was of limited interest to most families saving for education because contributions were limited to $500 per year for each child. Two changes in the tax laws at that time, however, have made this a more attractive savings vehicle.
First, money in the account can now be used for financing educational expenses for children in grades K through 12. The contribution limits were raised as well, to $2,000 per year per child. Contributions to a Coverdell account are made on an after-tax basis and qualified distributions are tax-free.
This means that parents who want to send their children to private school can make contributions to a Coverdell account and withdraw it for tuition and related expenses.
Some limitations: unlike the 529 plans, Coverdell accounts are held in trust for minors. That means that when children reach the age of majority they can use the money in whatever way they wish (although they are subject to tax penalties if they use it for non-educational purposes). Funds in Coverdell savings programs must be used by age 30 (unlike funds in 529 plans, which are not subject to age restrictions). And Coverdell accounts are not available for jointly filing taxpayers earning over $220,000 or singles making over $110,000. Section 529 plans have no such limitations on income.
The 529 and the Coverdell education savings programs provide real tax benefits to anyone funding a child's education. But the variety of choices -- and the way that they work in conjunction with each other and with other education-related tax credits such as the Hope Scholarship (for students in the first two years of college, whereby taxpayers are eligible for a tax credit equal to 100 percent of the first $1,000 in tuition and fees and 50 percent of the second $1,000) and the Lifetime Learning Credits (a tax credit of 20 percent of the first $5,000 of tuition and fees through 2002 and the first $10,000 thereafter, for college juniors, seniors, graduate students, and working people who are pursuing learning to upgrade their job skills) -- can make choosing the right combination of savings a real challenge. For guidance, consult your investment adviser or financial planner.
Trevor C. Lewis Jr., CFP, can be reached via firstname.lastname@example.org.
This article originally appeared in the July 2003 issue of Physicians Practice.