In the wake of the federal tax law changes enacted by Congress last year (the Economic Growth and Tax Relief Reconciliation Act of 2001- EGTRRA), a great deal of attention has been focused on the benefits of the Section 529 plan as a tax-friendly method of saving for a college education. While there is no denying the very attractive tax benefits now available with 529 plans, there are also other options that might still be appropriate.
529 advantages
Section 529 of the Internal Revenue Code are innovative plans sponsored by individual states to encourage individual savings for higher education. Originally, growth was tax-deferred and any earnings were taxed at the student’s rate (usually lower than the parents’ rate) when funds were withdrawn for qualifying college expenses (tuition, fees, room and board, supplies and equipment). The biggest change for 2002 is that any earnings are withdrawn completely tax-free if applied to qualified higher education expenses. (Please note, unless Congress Acts, after 2010 the BGTRRA is scheduled to “sunset” and qualified distributions then will be considered taxable).
Also, the annual gift tax exclusion limit has been increased to $11,000 per year, and a one-time contribution of $55,000 can be made by an individual ($110,000 for a couple) to cover a five-year period without incurring any gift tax liability. This jump-starts the account by allowing more money to grow. 529 plans do have limitations you need to keep in mind. You have limited choices of how and where your contributions are invested; most states operate their 529 plan in cooperation with a professional money manager who selects the investments. Fortunately, you are not restricted to the plan in your state, so you have the option to shop other states’ plans to find the best investment options for you. Keep in mind, however, that some plans offer additional state tax breaks for their residents, so you’ll want to consider all of your options, including your own state’s plan.
Beyond 529
Along with 529 plans, there are several other significant changes in the new tax law that can greatly benefit your educational planning:
Coverdell Education Savings Account (CESA). The biggest changes to what was formerly known as the Education IRA are a large increase in the annual contribution limit and expanded qualified education costs. The annual contribution limit went from $500 to $2,000 (also subject to the “sunset” provision after 2010), dramatically increasing the amount of potential growth; a family that saves $2,000 per year from the time a child is bom will earn more than $54,000 (at 5%) by the time the child graduates from high school. Also, a Coverdell account is not restricted to college expenses. Withdraws now can be used for qualified expenses incurred at elementary and secondary schools, and qualified expenses now include transportation costs, computers, Internet access and tutoring in addition to tuition, room and board. Coverdell ESA investments are self-directed, so you can choose the investment strategy that best fits your personal financial goals and risk tolerance. Another benefit of the new law is that you now can invest in both a 529 plan and a Coverdell ESA in the same year and take distributions from both programs in the same year as long as you coordinate the expenses.
On the downside, the maximum annual contribution is phased out for married couples filing a joint return who have modified adjustable gross income between $160,000 and $220,000 ($95,000-$110,000 for single filers).
Tax credits. Many individuals can take advantage of two federal tax credits for tuition costs. The Hope Scholarship Credit and the Lifetime Learning Credit amount to free money from, the IRS, since they are a dollar-for-dollar reduction in the income tax you owe. The Hope Credit offers a tax credit of up to $1,500 a year per child for tuition paid during the first two years of post-secondary education 100% of the first $1,000 and 50% of the next $1,000 each year.
The Lifetime Learning Credit gets you a 20% credit on the first $5,000 of qualified educational expenses (tuition and fees). Starting in 2003, the ceiling bumps up to $10,000. You should note, however, that you cannot claim both a Hope Credit and a Lifetime Learning Credit in the same year, and your adjusted gross income must be below $51,000 (single) $102,000 (married filing jointly).
Series EE savings bonds. These savings bonds allow interest to be partially or completely excluded from federal income tax when the taxpayer pays for qualified higher education expenses (of the taxpayer, or spouse or his or her dependents) at an eligible educational institution in me year the bonds are redeemed.
Deductible expenses
Another nice benefit of the new tax law is a special deduction for educational expenses. In 2002 and 2003, you can deduct up to $3,000 a year in educational expenses if your adjustable income does not exceed $65,000 (single) or $130,000 (married filling jointly). In 2004 and 2005, the maximum deduction is increased to $4,000 and a more limited deduction of $2,000 is available for tax payers with adjusted gross incomes between $65,000 and $80,000 (single) and between $130,000 and $160,000 (roamed filing jointly), but there are additional limitations; you can’t take a deduction in the same year as a Hope or Lifetime Learning Credit and any tax free portion of a distribution from a Coverdell ESA in the same taxable year will reduce the expenses eligible for the deduction.
Other education-related options
In addition to the above benefits arising from last year’s tax law changes, there are other programs and benefits that can help secure your child’s educational future:
UGMA/UTMA accounts. These accounts offer another option for accumulating funds for your future education goals. Property transferred (either by gift or bequest) under your state’s Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) statue generally will be managed by a custodian until the child reaches the age of majority (usually 18 or 21). A custodianship is created by a gift (or bequest) to a minor in which you specify that an adult will serve as custodian for the minor. The custodian then has the obligation to hold and use the property for the benefit of the minor (including, but nor limited to, educational expenses). You can make gifts of up to $11,000 per year per child without incurring any gift tax liability. If the child is over the age of 14, income generated by the UTMA/UGMA property will be taxed at the child’s lower income tax bracket.
You should be aware that once the child reaches the specified age, he or she is entitled to unlimited access to the account balance. This may defeat the purpose of establishing the account if the child chooses to use the money for purposes other than education expenses. Additionally, gifts to UTMA/UGMA accounts are irrevocable and the assets will no longer be available to you (as the donor) to meet other financial goals, including education expenses for another child. In addition UTMA/UGMA may adversely affect eligibility for financial aid.
Prepaid tuition plans. These plans allow a family to “buy” a future college education at today’s prices- States offering these plans, also known as Prepaid 529 plans, guarantee that they will grow to at least match college tuition inflation. Because prepaid education plans are usually limited to in-state public colleges and universities, they are best suited to families who know their children will go to a public college within their state.
Roth IRA. The Roth IRA is primarily a retirement vehicle, however, often overlooked is the fact that you can withdraw contributions at any time without having any income or penalty taxes. Withdrawal of earnings will not be subject to 10% penalty tax if used for higher education expenses.
Professional financial advice. Because of all the options now available for educational financing, the professional advice a financial advisor can offer is invaluable for most families. A financial advisor can look at your entire financial situation and provide comprehensive financial advice on a college saving strategy that’s right for you. And as your situation changes and college gets closer for your children, a financial advisor can review your plan to make sure you remain on track to meet your goals. Now may be a good time to develop a relationship with a knowledgeable financial advisor who can answer your college-planningquestions and help you select a strategy that fits with your family’s overall financial objectives.
Maurice Moreau is a financial advisor with American Express Financial Advisors in Jay. For more information call (207) 897-5117 or email maurice.r-moreau@aexp.com.
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