Education/College Planning

College Savings is becoming increasingly more important as tuition, living expenses for students, and education expense have been increasing at a rate greater than the general level of inflation. Many of the education plans available today offer tax advantages such as tax deferred growth, tax exempt contributions, or qualified tax free withdrawals, which lessen the financial burden. Many education planning strategies become even more effective if you do your planning early.

There are a number of funding options available for your college investment plan.

529 Plans

529 is the savings plan. It's similar to an investment account, but the funds accumulate tax deferred. Withdrawals from state-sponsored 529 plans are free of federal income tax as long as they are used for qualified college expenses.2 Unlike the case with prepaid tuition plans, contributions can be used for all qualified higher-education expenses (tuition, fees, books, equipment and supplies, room and board), and the funds usually can be used at all accredited post-secondary schools in the United States. The risk with these plans is that investments may lose money, or may not perform well enough to cover college costs as anticipated.

In most cases, 529 savings plans place investment dollars in a mix of funds based on the age of the beneficiary, with account allocations becoming more conservative as the time for college draws closer. But recently, more states have contracted professional money managers — many well-known investment firms — to actively manage and market their plans, so a growing number of investors can customize their asset allocations. Some states enable account owners to qualify for a deduction on their state tax returns or receive a small match on the money invested. In 48 states, earnings are exempt from taxes.3 And there are even new consumer-friendly reward programs popping up that allow people who purchase certain products and services to receive rebate dollars that go into state-sponsored college savings accounts.

Funds contributed to a 529 plan are considered to be gifts to the beneficiary, so anyone — even non-relatives — can contribute up to $12,000 per year (in 2007) per beneficiary without incurring gift tax consequences. Contributions can be made in one lump sum or in monthly installments. And assets contributed to a 529 plan are not considered part of the account owner's estate, therefore avoiding estate taxes upon the owner's death.

Major Benefits

These savings plans generally allow people of any income level to contribute, and there are no age limits for the student. The account owner can maintain control of the account until funds are withdrawn — and, if desired, can even change the beneficiary as long as he or she is within the immediate family of the original beneficiary. A 529 plan is also extremely simple when it comes to tax reporting — the sponsoring state, not you, is responsible for all income tax record keeping. At the end of the year when the withdrawal is made for college, you will receive Form 1099 from the state, and there is only one figure to enter on it: the amount of income to report on the student's tax return.

Benefits for Grandparents

The 529 plan is a great way for grandparents to shelter inheritance money from estate taxes and contribute substantial amounts to a student's college fund. At the same time, they also control the assets and can retain the power to control withdrawals from the account. By accelerating use of the annual gift tax exclusion, a grandparent — as well as anyone, for that matter — could elect to use five years' worth of annual exclusions by making a single contribution of as much as $60,000 per beneficiary in 2007 (or a couple could contribute $120,000 in 2007), as long as no other contributions are made for that beneficiary for five years.4 If the account owner dies, the 529 plan balance is not considered part of his or her estate for tax purposes.

By comparing different plans, you can determine which might be available for your situation. You may find that 529 programs make saving for college easier than before.

Sources:

1. The College Board, 2006
2. As with other investments, there are generally fees and expenses associated with participation in a Section 529 savings plan. In addition, there are no guarantees regarding the performance of the underlying investments in Section 529 plans. The tax implications of a Section 529 savings plan should be discussed with your legal and/or tax advisors because they can vary significantly from state to state. Also note that most states offer their own Section 529 plans, which may provide advantages and benefits exclusively for their residents and taxpayers. The tax-free qualified withdrawal provision of these plans is due to expire after December 31, 2010 unless new legislation is enacted by congress.
3. SavingForCollege.com
4. If the donor makes the five-year election and dies during the five-year calendar period, part of the contribution could revert back to the donor's estate.

Coverdell Education Savings Accounts (ESAs) – (formerly Education IRAs)

Coverdell Education Savings Accounts (ESAs) are trusts or custodial accounts established to pay qualified educational expenses for designated beneficiaries. The earnings grow on a tax-free basis and distributions are tax-free if used to pay "qualified education expenses." A taxpayer's income determines eligibility for contributions to the plan.

Contributions

Taxpayers can set up ESAs, and make nondeductible contributions up to the annual contribution limit of $2,000 for each child under age 18 (and past 18 for special-needs beneficiaries). Earnings inside the ESA grow on a federal income tax-deferred basis, and the contributions are not subject to federal gift tax.

Contributions may be made by the time required to file the federal income tax return (e.g., April 15 of the following year).

Traditional and Roth IRA

Withdrawals from Traditional and Roth IRAs for qualifying education expenses are not subject to a penalty for early withdrawals. However, the withdrawal from the Traditional IRA may be subject to income tax.

Other Investments

US Savings Bonds

Interest on redeemed series EE and series I bonds may be excluded from income if the proceeds are used to pay qualified education expenses. However, some interest may be taxable if proceeds are in excess of the qualified educational expenses.

Tax Reductions and Credits

Student Loan Interest

Taxpayers may claim an above-the-line deduction for up to $2,500 in student loan interest paid during a designated tax year on qualified higher education loans. The deduction may be claimed in any year in which the taxpayer pays interest on the loan, even if the payments are made voluntarily, provided the taxpayer's modified adjusted gross income (MAGI) falls below designated limits. The 2005 MAGI phase-out ranges are between $50,000 and $65,000 for single filers and between $105,000 and $135,000 for joint filers. These ranges do not change for 2006.

Only the taxpayer who is legally obligated to make an interest payment on a qualified education loan may take a deduction. Helpful parents or employers that pay the interest do not enjoy the tax deduction that the student would have received if he/she had actually paid the interest.

Student loan interest payments made when the student is not required to make payment (i.e., during a deferment or prior to the student entering his repayment period) still may be deducted for income tax purposes.

The Hope Credit

Taxpayers may elect to claim a 2006 Hope credit for each eligible student up to 100% of the first $1,100 for payment of tuition and related expenses for attendance in a qualified higher education institution, and 50% for the next $1,100 in expenses. Therefore, taxpayers may claim a maximum 2006 Hope credit of up to $1,650. The Hope credit is phased out ratably for single filers with 2006 modified adjusted gross income (MAGI) of between $45,000 to $55,000 for single taxpayers, and $90,000 to $110,000 for joint return filers.

The credit may only be claimed for two tax years, and only to cover expenses for the first two years of post-secondary education. Students must be enrolled at least part-time (defined as taking at least half of the normal full-time course load of a student in that area of study).

The Lifetime Learning Credit

The Lifetime Learning credit may be claimed for up to 20% of the first $10,000 of qualified tuition and related expenses paid in 2006. Thus, the maximum credit for 2006 is $2,000. The Lifetime Learning credit is limited to these maximum amounts whether paid for the taxpayer, taxpayer's spouse or a dependent (whereas the maximum Hope credit may be claimed for each qualifying student). It is available for both undergraduate and graduate expenses, with no limit on the number of years it may be claimed.

© 2007 Emerald Publications