College Admissions
College Home Admissions Paying for College Saving for College
Saving for School and College Costs
A Brief Word on Saving for Education Costs
This section offers detailed information on 529 college savings and 529 college prepaid plans, Coverdell Education Savings Accounts (ESAs) and other savings options, but there are some basic guidelines to follow with regard to saving for education costs that should be mentioned briefly.
First, if you have existing investments in taxable accounts that you are happy with, then by all means carry on.
Second, ESAs can be used to pay for some types of private school and college costs tax-free, but many of the best provisions in these accounts are set to expire on December 31st, 2010. If it were not for this pending legislative expiration ESAs would be an excellent choice for education savings for those families that have incomes that permit them to save in these accounts, but the bottom line is that the future for ESAs is unknown.
Third, 529 college savings and prepaid plans have come a long way with respect to lower fees, better investment options and, in some cases, enhanced state tax benefits. Due to these positive changes 529 plans in general are an excellent way to save for college, but taxable investments combined with the tax-saving tactics outlined in chapter five can be an excellent choice too.
Ultimately the type of account that you use to save for education in your name or your child's name should be made with the help of a financial advisor that can also assist you in selecting the underlying investment vehicle (mutual funds, stocks, bonds, etc.) as well.
Starting in 2009 the dilemma over what type of account to use for college savings and whose name to save under, yours or your child's, is less of an issue because for federal need-based aid purposes all reportable student-owned assets that are not in 529 plans or ESAs are the only assets assessed at more than 5.64%. Therefore, the difference in whose name to save for aid purposes is not an issue when saving in 529 and ESAs.
However, if you save in your child's name using savings accounts, checking accounts, stocks, bonds, and mutual funds, those assets will be assessed at a rate of 20%, and could have a much greater impact on need-based aid eligibility.
So the bottom line is that if you think you may qualify for need-based aid you will want to save in accounts that you own, or in a 529 account owned by your child. By doing so, the value of these savings will count against you for aid purposes at a maximum of 5.64%, but not 20%. This makes life much easier for you as a parent because no matter what type of account you save in it will be assessed at a maximum of 5.64% for need-based aid purposes. Therefore, the decision about what type of account to save in and what to invest in through that account is less of a concern for financial aid eligibility and you can focus on the business of investing for the best after-tax return that you can get (see chapter eight on options for educations savings).
The bottom line on saving for education is that you should save wherever and however you can get the best after-tax rate of return with the lowest impact on your child's financial aid eligibility, if aid eligibility is even a concern.
There are savings options that you should consider including 529 plans, Coverdell Education Savings Accounts (ESAs), Roth IRAs, brokerage accounts, custodial accounts and trusts.
Section 529 Qualified Tuition Plans
529 Plan Overview
A 529 plan is a program that is designed to help fund the costs of post-secondary education (college) and meets the requirements set forth in section 529 of the Internal Revenue Code (IRC) for Qualified Tuition Plans. Section 529 provides the legal language for 529 plans with regard to personal income taxes and estate, gift and generation-skipping taxes.
529 plans fall into two categories: state-sponsored or private. State-sponsored plans can only be established by a state, state agency or instrumentality. There are two types of state-sponsored plans: prepaid and savings. Private 529 plans are only offered by eligible institutions; e.g., colleges and universities, and must be the prepaid type of 529 plan only.
Who Can Participate in a 529 Plan?
There are few exceptions to who can participate in a 529 plan. US citizens can own a 529 account, be a contributor to a 529 account or be the beneficiary of a 529 account without any income restrictions. Moreover, participants can participate in 529 plans offered by states in which they are not residents. Beneficiaries are not required to reside in the state of the plan that offers the 529 plan for which they are a beneficiary.
Who Has Investment Control?
Participants and beneficiaries are not permitted to have direct investment control over their account. This responsibility falls on the sponsoring state, but the state offers participants a wide variety of investment choices and participants can make a change to their investment choice one time per calendar year. Most 529 plans also allow participants to make changes to their investment selection if they are changing the beneficiary. This can be done even if they have already made their annual change in their investment selection.
Federal Income Tax Rules on 529 Plans
Contributions to 529 plans must be made in cash and are not deductible for federal income tax purposes. Earnings in a 529 plan remain tax-free until they are distributed. Distributions will not be taxable as long as the amount of the distribution is less than or equal to the amount of qualified higher education expenses (QHEE) that the beneficiary incurs in that tax year. The QHEE and the distribution must occur in the same calendar tax year. The tax-free status of 529 plans was made permanent with the Pension Protection Act of 2006.
QHEE for purposes of 529 plans and ESAs are tuition, fees, books, computers, supplies and equipment required for enrollment or attendance on a full-time or part-time basis at an eligible educational institution. Room and board are also considered to be QHEE's, but the amount paid for room and board cannot exceed the allowance applicable to the room and board included in the cost of attendance as determined by the eligible institution for that time period. The room and board costs must be incurred during a period in which the beneficiary is enrolled or accepted for enrollment in a degree, certificate or other program that leads to a recognized educational credential. Studying abroad is acceptable if approved for credit by an eligible institution.
Eligible institutions are accredited post-secondary educational institutions offering credit towards a bachelor's degree, associate's degree, graduate or professional degrees. Some proprietary institutions and post-secondary vocational institutions also qualify as eligible institutions. Eligible institutions must be eligible to receive Title IV federal financial aid
Distributions from 529 savings plans that are made in excess of the QHEE that the beneficiary incurs in a calendar year are deemed to be non-qualified withdrawals. Non-qualified withdrawals are taxable and carry a 10% federal tax penalty. The penalty is waived in four circumstances: disability, the beneficiary receives a scholarship, the beneficiary's death or when tuition and related expenses were reduced by using the Hope Scholarship or Lifetime Learning Credit.
The federal tax on non-qualified distributions is computed by subtracting the basis portion of the distribution from the total amount of the distribution which leaves the earnings portion. Only the earnings portion of the distribution is taxed as ordinary income and assessed the additional 10% federal tax penalty if it applies.
The owner of the account determines who the "distributee" is, and the "distributee" receives a 1099-Q from the 529 plan administrator at the end of each year that provides information on gross distributions, earnings and basis. In the event of a non-qualified distribution, the distributee is responsible for paying the tax and penalty that are due.
Non-qualified distributions from prepaid 529 plans are calculated a little differently than non-qualified distributions from 529 savings plans. In a prepaid plan, the total value of the distribution is determined by the current value of the tuition credits the beneficiary uses during the year. The principal (basis) portion is based on the number of tuition credits used during the year as a percentage of the total number of credits that were originally purchased.
As if this is not confusing enough, the taxation of 529 plans is further complicated by the use of the Hope Scholarship and Lifetime Learning tax credits.
Since these tax credits are based on paying tuition and fees, and tuition and fees are considered as QHEE expenses, the potential existed to claim one of these tax credits and also "write off" the same tuition expense as part of a qualified withdrawal from a 529 plan or ESA in the same year. So in order to prevent "double dipping" the IRS limited the use of tuition and fee expenses if a taxpayer claims the Hope scholarship and makes a distribution from a 529 plan to pay tuition expenses in the same year. The amount of tuition and fees used to calculate the Hope Scholarship reduces the amount of tuition-related expenses that can be claimed as part of a QHEE for purposes of the tax exclusion on qualified distributions from a 529 plan or ESA.
This presents a problem for a family that qualifies for one of the tax credits and has all of their money saved for college in a 529 plan. If their total QHEE equal $12,000 and they pay it all from a 529 plan, they have to choose between not taking one of the credits and removing the tuition portion of the QHEE for the 529 distribution which would result in a non-qualified distribution since their distribution would exceed the total QHEE for the year.
If the family can find other assets to pay the amount of the QHEEs equal to the amount of tuition expenses used to calculate one of the two tax credits, then they can claim the tax credit and the full distribution will be qualified.
Gift and Estate Tax Rules of 529 Plans
Although the account owner of a 529 plan retains ownership of the account, the gift of assets into the account is treated as a completed gift to the beneficiary for gift and estate tax purposes. Due to the fact that the gift is treated as a gift of present interest, it qualifies for the $13,000 annual exclusion from gift taxes.
Therefore, a 529 account can be opened in the name of a beneficiary, have money contributed to it without gift tax and the money in the account is removed from the contributor's estate despite the fact that he or she retains ownership of the account.
Moreover, section 529 permits the contributor to treat his contribution on a pro-rata basis as if it occurred over five years. This means that the contributor can "front-load" up to $65,000 into a 529 account per beneficiary and spread the gift over five years to avoid gift taxes.
However, if the contributor dies prior to the completion of the five year period, the gift is pulled back into his estate on a pro-rata basis. For example, if a contributor only lives two of the five years after making a $65,000 contribution to an account, then three year's contributions or $39,000 would be pulled back into his estate.
Financial Aid Treatment of 529 Plans
under the Federal Methodology for EFC Calculation
As a result of the College Cost Reduction and Access Act passed in September of 2007, starting with the 2009-2010 academic year student-owned 529 accounts are treated the same as parent-owned 529 accounts.
If a parent is an account owner of a 529 plan, then the full value of the 529 account will be counted at a maximum rate of 5.64% of the full value. Depending on the value of the 529 account, it may not affect aid eligibility at all if the parents don't have other reportable assets that would count against them because parents have an asset protection allowance that "shields" a portion of their reportable assets from being assessed in the calculation of financial need. The Asset Protection Allowance is typically around $40,000 for married couples in their mid-forties. So, for example, if the 529 account's value is less than $40,000 and the parent has no other reportable assets, then the asset protection allowance will "shield" the value of the 529 account in the calculation of financial aid under the federal formula.
Conversely, if the 529 is valued at $200,000, then 5.64% of $160,000 or $9,024 would count against them.
Investment Choices in 529 Savings Plans
Mutual funds are the predominant investment vehicle for 529 savings plans. States that offer such plans outsource the administration and investment management of the plan to large mutual fund companies which offer the state a suite of investment options that the state then approves and offers to plan participants.
Typically there are five categories of investment options: age-based portfolios, static portfolios, individual mutual funds, CDs and a guaranteed option.
Age-based portfolios are a series of portfolios that are made up of stock, bond and money market mutual funds with each portfolio having different allocations among the three types of assets.
The concept behind age-based portfolios is to automatically and systematically adjust the risk of the portfolios as the beneficiary gets closer to age eighteen and college. The allocation among stocks and bonds gets more conservative the closer the child is to certain preset age groupings.
For example, the age group that has 15 to 18 years until college will have a higher percentage of the portfolio's assets in stocks than bonds and may not have any assets in money markets at all. Conversely, the portfolios for beneficiaries with 0 to 3 years to go until college will be largely invested in money markets with a small allocation to short term bonds.
This is a nice way to automate risk management and simplify investing for the participant. However, most age-based portfolios are limited in their sophistication and ultimately their performance, because they are based solely on the beneficiary's age.
Static portfolios are like age-based portfolios except that their allocations do not change based on the age of the beneficiary but remain static, set at one allocation. Typically there are four static portfolio offerings: aggressive, growth, moderate and conservative - each having different allocations that are based on risk, not the age of the beneficiary.
Individual mutual funds are a popular option here because it allows the participant to invest in individual mutual funds that they choose from a list the plan sponsor offers. This option allows participants to create their own allocation of individual funds instead of using pre-packaged age-based or static portfolios.
CDs are a good choice for those participants who choose to avoid the equity markets. Many states partner with in-state banks, credit unions and such to offer CDs as part of the state's 529 savings plan.
The guarantee option offered by some savings plans is a guarantee backed by the state offering the plan that your account will increase in value equal to the rate of inflation in tuition costs at one or more of the state's public universities.
Generally speaking, investment options for 529 plans have improved markedly in recent years.
Coverdell Education Savings Accounts (ESAs)
The Coverdell part of ESAs is a reference to the late senator Paul Coverdell who helped pass legislation that added some key features to these accounts. One feature that ESAs have that 529 plans do not is the ability to use CESA assets to fund K-12 private school costs. However, the tax permanency that 529s received via the Pension Protection Act of 2006 was not extended to ESAs and therefore, in 2011, will revert to their pre-2002 status and the K-12 private school provision will go away unless it is addressed by congress.
Likewise, if legislation is not passed prior to the sunset of the EGTRRA at the end of 2010, ESAs will revert to having maximum contributions per beneficiary of $500 per year, down from the existing $2,000 contribution level. Account owners will also lose the ability to take distributions from a CESA and claim either the Hope Scholarship or the Lifetime Learning credit. With 529 plans, participants will continue to be able to take distributions from their 529 and claim one of the tax credits as previously described.
ESAs From Now Until Sunset
In the meantime, ESAs may still be a good option for some families. In contrast to 529 plans, account owners of ESAs have complete control over the investment of the account and DO NOT have to choose from a selection of investment options provided by a program manager and/or a sponsoring state. This ability alone was enough for many astute investors to choose the CESA over a 529. The drawback of ESAs is the maximum contribution limit per beneficiary of $2,000 per year up to the beneficiary's age of 18.
This limit has always been a complaint of advisors and investors alike, because the contribution limit prevents investors from saving more substantial amounts. The ability to contribute to a CESA is phased-out for joint filers between $190,000 and $220,000 of modified adjusted gross income. There is no earned income requirement to contribute to a CESA, so students can even contribute to their own account. The maximum annual contribution of $2,000 is per beneficiary which means that contributions to a single beneficiary's account should be communicated among contributors in order to avoid making excess contributions.
Parents with children in K-12 private school know that the average cost of private school can be well over $16,000 per year per child. While $2,000 doesn't cover the entire cost in most cases, it still does help.
The K-12 provision of ESAs means that these accounts allow for tax-free accumulation of earnings and withdrawals for both QHEE and qualified elementary and secondary education expenses, or QESEE. QESEEs are: a) tuition, fees, tutoring, books, supplies and equipment that are incurred on the beneficiary's behalf in connection with enrollment or attendance at an elementary or secondary school, b) room and board, uniforms, transportation and other supplementary items that are required or offered by the school in connection with enrollment or attendance and c) computers, software, internet access and other technology and services so long as these items are used by the student and/or the student's family during any of the years the student is enrolled or in attendance at the school.
Remember that an ESA's tax exclusion is only good until December 31, 2010 when EGTRAAs provisions sunset. 529 plans received tax permanency and will continue to enjoy favored tax status.
Transferring ESA Assets
Account balances in ESAs can be transferred into a 529 plan account without tax or penalty as long as there is ample room for contributions in the 529 plan.
Roth IRA
A Roth IRA is a type of retirement account in which you make after tax contributions and earnings grow tax deferred. You can withdraw your contributions tax free at any time, but the earnings on your contributions cannot be withdrawn prior to age 59 ½ without incurring a 10 percent penalty. After age 59 ½ the earnings can also be withdrawn tax free for any reason.
Eligibility for married couples filing a joint tax return to make full contributions of $5,000 to Roth IRA's requires an AGI on joint tax returns of less than $166,000 ($101,000 for single taxpayers), and under $176,000 ($120,000 single) for partial contributions. Contributions are not permitted with a joint AGI in excess of $176,000 ($120,000 single).
The ability to make $5,000 annual contributions per year, per eligible taxpayer, creates the opportunity to make a total of $70,000 (14 x $5,000) in contributions over fourteen years before high school begins. During that time if the account earned an annual return of 8% it would be worth $121,000. You could withdraw your $70,000 in contributions tax free to pay for private school or college and leave the $51,000 of earnings in the account to continue to grow for retirement. If you choose to withdraw a portion of the earnings and the money is used to pay for QHEEs, the withdrawal would not be subject to the 10% excise tax as long as the withdrawal does not exceed the amount of QHEEs for the year in which the withdrawal is taken.
Using a Roth IRA for education funding purposes should only be considered if you have additional retirement savings and would not be jeopardizing your retirement security later in life.
Brokerage Accounts and UGMAs
Common brokerage accounts are most often titled in an individual's name or jointly between two people (husband and wife). In a brokerage account, the investor can buy and sell a variety of investments and all interest, dividends and realized capital gains are taxable to the account holder(s) in the year in which they are realized.
Custodial accounts are referred to by the tax acts that created them, the Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA). Most custodial accounts these days are UTMAs and permit donors, usually parents and grandparents, to make irrevocable gifts of assets to minor children for the purposes of health, education, maintenance and support. The account is overseen by a custodian, typically the parent or grandparent, who is responsible for the investment of the assets as well as distributions of funds and the payment of taxes (remember the kiddie tax).
A regular taxable custodial account turns into a brokerage account when its owner is no longer a minor.
Due to the fact that taxes must be paid each year on income earned from both brokerage and custodial accounts they are often deemed not to be as tax-efficient as a Roth IRA or ESA. While this is true, it is common for investors to "harvest" capital losses from investments that have lost money and us those losses to offset capital gains from investments that have made money. For example, if after one year of investing an investor sells one stock for a $3,000 loss and sells another stock for a $3,000 gain, the investor would have net long-term capital gains of $0, and $0 in capital gains taxes due, while liquidating some assets to pay independent school costs. Thus, for tax-efficient investing it is important to know what tax bracket you are in, what corresponding tax rate you pay on capital gains, and be able to "harvest" capital losses to offset capital gains.
Gifting appreciated assets from a parent's brokerage account to a child's custodial account, and then using the standard deduction, personal exemption and one of the education tax credits to minimize the tax on income from the account was discussed in detail in chapter five.
Unlike ESAs and Roth IRAs, contributions to brokerage and custodial accounts are not limited by income phase-out. The annual gift tax exclusion of $13,000 ($26,000 on a joint return) per year, per person is the only limitation placed on contributions to these accounts. So grandparents, as a couple, can make gifts of $26,000 per year to the custodial accounts of each of their grandchildren. In addition, the grandparents can make similar gifts to the parents. In contrast, anyone with a brokerage account can make any size contribution to that account, or to the account of their spouse, without having to deal with the gift tax exclusion.
Trusts and Other Options
Trusts
Some families have long-established trusts that were funded with gifts over a period of years or from a single windfall. These trusts can be prudently managed to provide funding for a long list of beneficiaries for independent school, college, and graduate school. Although they are not the most tax-efficient investment vehicles, they do afford a high degree of control over the trust's assets, the type of assets that can be contributed to the trust and the beneficiaries that can benefit from them.
There are two specific types of trusts that are commonly used to fund education costs, a section 2503(c) trust and a Health and Education Exclusion Trust (HEET).
Other Options
A full-blown discussion on trusts is beyond the scope of this book and would be best addressed by a tax or estate planning attorney.
This is also true of other advanced options such as 1035 exchanges, private equity, making children shareholders of closely held businesses and family limited partnerships, to name a few.