Graduation ceremonies abound this time of year. It is a reminder that college expenses are just around the corner.
18 years ago, parents might have begun saving for their child’s college costs with a Uniform Gift to Minors Act (UGMA) or a Uniform Transfer to Minors Act (UTMA). This is an account that is set up in the minor’s name. A parent may be the custodian on the account.
These were popular because the earnings were taxed at the child’s tax rate. Tax laws eventually changed and now the first $1,000 is tax exempt. The amount between $1,000 and $2,000 is taxed at the child’s rate. Amounts over $2,000 are taxed at the parent’s rate.
The amount you may accumulate in an UGMA is unlimited. However, the annual gift tax amount does apply which is currently at $14,000.
There aren’t any restrictions on how the money may be used. It can be used for travel costs to the college, off campus housing, clothing, medical insurance etc. Monies can also be used on behalf of the child prior to college such as private schooling and summer camps. However, basic needs of the child need to be paid by the parents or guardians.
Unlike some college savings programs, you can’t change the beneficiary on the account. The child, for whom you set the account up, is the one who needs to use ALL the assets. Ownership of the account is the student’s.
This has 2 drawbacks. If you apply for financial aid, the monies are counted as the child’s and 30% of the assets will be included in the family contribution. As the parent’s asset, only 10% of the assets is included.
The second drawback is the control of the assets transfers to the child at the age of majority, which may be 18 -21 depending on the state. At 18 years of age, a car can be much more appealing than a college education.
Fortunately, Congress has established other tax favored means of saving for college expenses.
We will explore those options in the next few weeks.
Educational Savings Accounts
Are college expenses looming on your horizon? Educational Savings Accounts are another option available to save for college costs.
This savings account is a nondeductible contribution limited to $2,000 per year, per child. The earnings on the contribution grows tax deferred and can be 100% tax free if used for qualified expenses. The $2,000 limit is from all sources, including grandparents.
Qualified college expenses include tuition and fees, books, supplies, equipment, and room and board if the student is attending at least half time. Educational Savings Accounts may also cover expenses for K-12.
Contributions may be made until the child reaches 18. And the monies must be used by the time the child/beneficiary reaches 30. However as the asset is the parents’, the beneficiary may be changed to another family member. This allows flexibility in planning for the child’s further education. Some children may choose other routes like military, or receive scholarships.
And since the asset is the parents, it is counted as such in the financial aid family contribution.
The money may only be withdrawn tax free if it is used for qualified expenses. If it is used for other purposes, the earnings are included in taxable income, and is subject to a 10% penalty. Be careful to not overfund.
A more commonly known college savings plan is the Qualified Tuition Program or 529 plans. What is less well known is there are 2 types of this plan under this program.
A lesser known program is the prepaid tuition plan. Prepaid tuition plans allow you to buy future tuition at today’s prices. With 6% inflation per year in college costs, locking in a price has some advantages. The drawback is, knowing which college your child will want to attend. Once you fund at a college, you are locked in – very few exceptions for refunds.
The more recognized 529 plans act similarly to the educational savings plan. The contributions are not deductible. But the earnings grow tax free. The monies are withdrawn tax free if they are used for qualified college expenses and ONLY for college expenses. If they are used for other purposes, the gains on the funds are included in taxable income and subject to a 10% penalty.
The amount you may fund is limited to the $14,000 annual gift tax exclusion. Unless you select the 5 year election, then your maximum is $70,000. The collective maximum you invest is determined by the program and may be as much as $300,000 per beneficiary.
Nearly every mutual fund family has a 529 program. However, your state may have a specific plan. For example, Idaho has the Ideal plan. If you contribute under this program, you may deduct up to $8,000 per year on your Idaho income tax return. You are restricted to the investment choices of the program.
The 529 plans maintain some flexibility. There is no age restriction of when you have to use the funds. Also, you can change the beneficiary on the plan to another family member.
One key to college planning is flexibility. Life brings changes and you need to be able to adapt your plans.
U.S. Savings Bonds for College
Double the money! Another college savings option with relatively low risk is the U. S. Savings Bonds. These types of bonds are usually purchased and redeemed at your bank. They are issued in denominations of $50 to $10,000. For example a $50 bond would cost you $25.
The typical bond issue is Series EE. The earnings are usually tax deferred for Federal and tax free for state. Some post 1989 EE bonds may be redeemed federally tax free if used for qualified higher education. To be federally tax free, the bond owner must be at least 24 years old before the bond’s issue date. Bonds purchased for grandchildren in the grandchild’s name usually won’t qualify for this exemption.
Parents have a restriction of income for the bonds to be tax free. If you are married filing jointly, your phase out range for tax exemption of savings bonds for education currently is from $113,950 to $143,950. As head of household, the range is $76,000 to $91,000.
However, giving a series EE bond to grandchildren may build a nice fund for the child. There is more flexibility in how the money can be spent – without penalty. And anybody can give a gift of a bond. Parents may encourage gifts of this kind to keep children from being over indulged with the latest, greatest toys.
The series EE bond has a 20 year cycle. It can be redeemed before the 20 year period. However, if you redeem within the first 5 years, you will have a penalty of 3 months interest – similar to a Certificate of Deposit. To determine the value of your Series EE bond you can go to the bond calculator at http://www.treasurydirect.gov.
Roth IRA for College
Roth IRA’s are another option that can be part of your game plan for college funding.
One of the challenges in planning for college is to know what your newborn’s talents will be, what college they should attend, or will they get scholarships or have great athletic talent. Add the fact, that if you over fund your 529 plan or educational savings account, you will have a 10% penalty to use the monies for non-qualified expenditures.
I know of an instance where the child attended college in England in order to absorb the monies accumulated in the 529 plan.
So how do you adequately fund without over funding? One means is to use a Roth IRA. You can withdraw principal contributions from a Roth, if it has been established for at least 5 years, without incurring income tax or a penalty. This is a means to save tax free and use it for college if necessary.
You can fund a Roth IRA up to $5,500 a year. There are income restrictions. Your contributions is phased out if you are married filing jointly and your Adjusted Gross Income is over $167,000. And you aren’t eligible if your income is over $181,000. If you are single, your adjusted gross income phase out range is between $105,000 and $120,000.
A word of caution is careful to not jeopardize your own retirement to fund your child’s college. Or you may decide to work a few years more to replenish the funds distributed from your retirement account.
Tax Credits and Other Options
College funding is often like a chess game. You have to move pieces around carefully. Tax laws are chess moves that can be played in the years the dependent is a student.
The American Opportunity Credit gives you a tax credit for college expenses. The first $2,000 of college expense is credited to your taxes – 40% is refundable, 60%reduces your taxes but is not refundable. 25% of the next $2,000 is eligible for credit. The total credit is $2,500 in one year. This credit can be used on first 4 years of undergraduate courses.
Lifetime Learning Credit may also be used to offset college expenses. This credit is non-refundable, but does reduce your tax bill. The credit is 20% of college expenses up to $10,000 or maximum of $2,000. This credit can be applied to both undergraduate and graduate work.
Both credits are applied to qualified college expenses defined as tuition and fees, books, supplies, and equipment. Room and board is not qualified expenses. These tax credits do have income limitations. But they can be used for taxpayer, spouse or dependents.
Another savings option available to some parents comes from their employer’s stock purchase program. Frequently, these programs allow employees to buy at a 10% – 15% discounted price. And you can payroll deduct giving you disciplined savings. This is another way to accumulate assets, leave it as an asset in your financial aid calculation with only 10% counting towards family contribution. It is also in your name, so if it isn’t needed for college, you can use it as you please. Several clients have had this option work well for them. One client set aside stock from a previous employer for his children. Both children received full ride scholarships. The clients now own a cabin. FLEXIBILITY!!!
Another option you can use similar to the Roth IRA is a traditional IRA. While this will come out as taxable income to the parent, it can be withdrawn free of the 10% early distribution penalty. A word of caution: The 1099R will be issued with reason listed as unknown. Higher education expenses are one of the penalty exemption reasons. Be sure you, or your tax preparer, are aware of this and complete the early distribution form correctly. Again, be careful to not jeopardize your own retirement in helping your child.
After all these many suggestions of HOW to save – WHAT investments do you use? To receive tax deductions on your state income tax return, you may have to use the state program. Regardless of which fund family you use, the investing philosophy is the same. It is similar to retirement planning. The younger the child is, the more aggressive you can be in your investing. The closer to college the child is the more principal preservation becomes your focus. In the 2008 melt down, I called my clients with children nearing college age to tell them to take a couple years tuition to cash. They did not have recovery time before tuition would be due. You want the funds to be there when the child is ready to start college. And you want to sleep peacefully.