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Education Planning

The increasing costs of higher education have made education planning an important aspect of personal financial planning. Frequently, education planning does not receive proper attention because the actual expenditure may not be incurred for many years and seems low on the priority list.

In general, there are four basic methods of paying for a child’s higher education:

1. The child pays for college by working his or her way through school

2. Scholarships, grants, or loans are obtained

3. The parents pay college expenses out of current income or assets

4. Special education funds are accumulated over time

Method one works and many successful persons have obtained a good college education while working to pay their way. But this method often limits the student’s choice of schools, an adversely affect grades, and often becomes too overwhelming a task. Relying on scholarships, grants, or loans is risky, as many middle-income families do not qualify, and there is no certainty that such programs will be available when needed. Method three also works for some clients; however, the clients often will not know if their current income and/or assets will be sufficient until it is too late. Another major drawback of this method is that it is costly when compared with strategies used to accumulate special education funds (method).

You will continue to benefit from taking long-term savings approach to funding your children’s education. The time value of money and remaining tax benefits of income shifting point toward continued use of direct gifts to children. The following are some of the income-shifting techniques commonly used:

n Gifts under the uniform gifts to minors act

n Gifts of appreciated stock to minors

n Minor’s trust

n Crummy trust

Avoiding income tax at the parents’ rate for children is one of the goals of income-shifting however, the possibilities are severely limited, if the child is under the age of 14, by the so called "kiddie tax", which operates to tax the unearned income of a child under 14 in excess of $1,600 annually (to increase to $1,700 in 2006) at the parent’s top rate. At age 14 and over the child can enjoy the benefits of the 15 percent federal rate up to a point that will not come into play if the income is solely at a level designed to meet college costs.

If the income from an investment will be taxed to a child under 14, consideration should be given to tax-exempt, tax-deferred, or growth-oriented investments that do not generate current income. Postponement of income until after the child attains age 14 can have measurable positive effects on the family’s tax savings.

Several tax-exempt or tax-deferred investments may be appropriate: EE Bonds; Municipal Bonds; Municipal Bond Funds; or Tax-Deferred Annuities. Growth-oriented investments for consideration include stocks, real estate, an interest in a closely held business, and other assets likely to appreciate. Selection of such assets should be made with a view toward converting the assets to cash or to income- producing assets at a time after the child is age 14, but before college expenses are incurred.

Savings Bonds may be a tax-free way to pay for a child’s college education. If EE savings bonds issued after 1989 are used for qualified higher education expenses in the year the bonds are redeemed, then a taxpayer may exclude the interest on the bonds from income. In accordance with the technical corrections in the Small Business Job Protection Act of 1996 however, for 2005, the exclusion phases out for married couples filing jointly if AGI is over $91,850 and is phased out when AGI reaches $121,850. To curtail income-shifting strategies, bonds bought in a child’s name are ineligible for the exclusion.

The Treasury Department began issuing inflation-indexed securities as of January 1, 1997. The interest rate, which is set at auction, remains fixed throughout the term of the treasury security. However, the principal amount of the security will be adjusted for inflation. At maturity the security will be redeemable for the inflation-adjusted principal. Semi-annual interest payments will be based on the inflation-adjusted principal.

Series EE Bonds are sold at one-half their face value. Interest on series EE Bonds is not paid until maturity, and the holder is not taxed until the bond is redeemed absent an election to be taxed annually. Bonds purchased on or after May 1,1995, no longer receive a guaranteed minimum interest rate. Instead, the rates earned change every six months based on market yields of actively traded treasuries.

College prepayment programs allow current payment of a flat, one-time fee (or periodic payments) at a discounted rate for the child’s future education in a particular school or university system. The theory is that the institution (or the state in the case of state-sponsored plans) can invest the funds and earn an amount equal to the child’s future tuition. On the other hand, the parent has locked in the future cost at today’s tuition rates. On a present value basis, the parent is generally getting a better return than can otherwise be expected after taxes.

The state-sponsored prepayment plans can take several forms, such as (1) certificates of deposit with interest rates tied to an index based on tuition rate increases; (2) tax-free bonds issued by states; (3) trusts established by states that receive lump-sum or periodic payments and, in return, provide funds to cover an undergraduate education. Prepayment plans established by private universities are designed to cover tuition at that particular university.

The younger the child, the greater the risk that the child will not attend the particular institution or a school within a particular university system. Further, prepayment is generally no guarantee that the child will meet the requirements for acceptance to the particular institution. If the child does not attend, most colleges will refund the prepayment, but any interest the funds have earned may be forfeited. Also, plans may not allow the prepayment to be transferred to another individual.

The program’s earnings are tax-deferred until distributions are made or the beneficiary receives an education under the program. If the beneficiary uses the program to pay for or furnish higher education, the value of the educational services are compared with the contributor’s cumulative contributions to the program and, if the value of education exceeds the contributions, the excess is included in the beneficiary’s gross income. If the contributor receives the funds back, the distributions are compared with the contributor’s cumulative contributions to the program and the excess of the distributions over the contributions is included in the contributor’s income. Gift tax is avoided if the funds are used solely for the beneficiary’s education. In any event, gift tax consequences are not determined until distributions are made or an education is received.

Coverdell Education Savings Account (Formerly called an "Education IRA")

A Coverdell Education Savings Account (ESA)  is a trust that is created exclusively for the purpose of paying certain education expenses of a named beneficiary.  Under pre-2001 Act law, the annual contributions to a Coverdell ESA could not exceed $500 per designated beneficiary.  The phase out - range for married taxpayers filing a joint return was $150,000 to $160,000 of modified AGI.  The Coverdell ESA balance must be distributed to the beneficiary within 30 days after he turns age 30, unless transferred to a family member's Coverdell ESA.  Additional contributions can't be made after the beneficiary turns age 18.  Distributions in excess of qualified educational expenses are taxable and generally are subject to a 10% additional tax unless one of several exceptions applies.

The 2001 Act will increase the annual Coverdell ESA contribution limit to $2,000 in years beginning after 2001.  The Act also increases the phase-out range for married taxpayers filing a joint return to $190,000 to $220,000 of modified AGI.

Allowable annual contributions to tax-exempt Coverdell ESAs aren't deductible, but distributions for an individual beneficiary's qualified education expenses are tax-free.  For tax years beginning after 2001, the definition of qualified education expenses will include the following:

Elementary (including kindergarten) and secondary public, private, or religious school tuition and expenses, including tutoring, room and board, uniforms, and extended - day program costs, and special needs services for a special needs beneficiary.

The purchase of computer technology or equipment (including software), and internet access and services, if they are to be used by the beneficiary and his family during any of the beneficiary's school years.

These additional changes also take effect for tax years beginning after 2001:

Coverdell ESA contributions for special-needs beneficiaries will be allowed after they attain age 18, and deemed distributions of education IRA balances won't occur when those beneficiaries reach age 30.

Corporations and other entities, including tax-exempts will be able to contribute to Coverdell ESAs, regardless of the entity's income.  These contributions will be allowed regardless of the income of the child's parents.

Taxpayers will be able to claim Hope and Lifetime learning credits for a student in a year when excluded distributions are made from a Coverdell ESA for that student, as long as credits aren't claimed for amounts paid with tax-free distributions.

The Illinois "Bright Start" college savings plan is being offered under provisions of Section 529 of the Internal Revenue code. Bright Start works by investing in mutual funds. Illinois has contracted with Salomon Smith Barney to manage the investment trust.

Illinois also has "College Illinois" which has been around for a few years. Prepaid tuition through the college Illinois plan is a less aggressive investment, a defined benefit plan that acts as a hedge against tuition inflation by allowing parents and grandparents to lock in current tuition rates for state schools.

Section 529 college savings plans offer contribution advantages over another option called Coverdell Education Savings Accounts with their low annual deposit limits of $2,000 (beginning after 2001).

Contributions of up to $11,000 a year and $235,000 over the life of the account are permitted in Bright Start.

Provisions for lump sum contributions as large as $55,000 without gift tax penalties are also included in the tax code, in case grandma and grandpa want some of their nest egg to go toward educating their grandchildren.

Generally for tax years beginning after 2001, the Act expands and liberalizes prepaid tuition programs as follows:

Private institutions may be sponsors.  The definition of a "Qualified Tuition Program" will include certain prepaid tuition programs established and maintained by eligible educational institutions (including private institutions) that satisfy the requirements under code section 529.

Exclusion for qualifying payouts.  Distributions will be excluded from gross income to the extent they are used to pay for qualified higher education expenses.  The exclusion will apply to post-2001 payouts from qualified state tuition programs, and to post-2003 payouts from qualified tuition programs established and maintained by entities other than a state.

Qualified higher education expenses will include special needs services for special needs beneficiaries.

For the exclusion for distributions from qualified tuition plans to pay for qualified higher educational expenses, including room and board, the maximum room and board allowance will be the actual amount charged by the educational institution for room and board.

During the same tax year, taxpayers will be able to claim a Hope or Lifetime Learning Credit and exclude amounts distributed from a qualified tuition program for the same student as long as the distribution isn't used for the same expenses as which a credit will be claimed.

The definition of a family member for purposes of beneficiary changes and rollovers will include first cousins of the original beneficiary.

After the Act's changes, Coverdell ESAs and Qualified Tuition Programs offer essentially the same income tax benefit, namely tax-free earnings if payouts are made for qualified educational purposes.  However, each offers a unique combination of benefits and limitations.  For example, a Coverdell ESA can be used for elementary and secondary school expenses or college costs, but annual contributions are limited to $2,000 per beneficiary and an individual's contributions are subject to AGI phase outs.  The qualified tuition program, on the other hand, doesn't restrict contributions, but must be used for higher education.  The best savings vehicle ultimately will depend on the needs of the donor and the beneficiary who will receive the education.

Unlike custodial mutual funds in his name that become his property at age 18, college savings plans like Bright Start remain in the mane of the adult who opened the account. The beneficiary may be changed to another family member, including adults who may want to pursue an advanced degree.

The account is also not included as part of the owner’s taxable estate.

However, withdrawals for nonqualified education expenses incur a federally mandated 10% penalty on top of the income being taxed at the owner’s higher rate.

Most Section 529 savings plans offered by other states are open to out-of-state residents. For example: Missouri saving for tuition program offers investing flexibility and low fees to residents and nonresidents alike. Fidelity Investments has its Delaware College Investment Plan and Unique College Investing Plan in New Hampshire.

Bright Start applications and other information are available at 877-43-BRIGHT or online at www.brightstartsavings.com.

Most of the techniques for funding education work best if implemented when the children are young. Some of the techniques, or variations of them, that can be effective when college is imminent are as follows:

n Gifts of appreciated stock to minors

n Interest in partnerships and S corporations

n Children on parents’ payroll

n Home equity loans

n Borrowing from retirement plan

n Student loans

n Grandparents

n Financial aid programs

Grandparents may make tuition payments on behalf of a minor grandchild, directly to the grandchild’s school, without incurring any gift tax liability. These payments may be made in addition to the $11,000 annual gift tax exclusion.

There have been two types of Government-guaranteed student loans: Those issued by private institutions and national direct student loans. Repayment of either type of loan does not commence until after graduation.

Certain family tax factors must be considered in connection with student borrowers. A parent may claim an exemption for a child who is a full-time student under age 24, even though the child has income in excess of the exemption amount, provided the parent pays more than half of the child’s support. A loan granted to the student for college costs is treated as support provided by the student and thus could cause loss of the dependency exemption by the parents. On the other hand, certain high-income parents would not qualify for the exemption and would prefer to have the child get it.

Federal student aid falls into one of three categories:

1. Grants. Financial aid that does not have to be repaid

2. Loans. Financial aid that must be repaid, with or without interest, depending on the program.

3. Work-study programs. Programs that let a student work and earn money to help pay for school.

The financial aid process consists of following five steps:

The student should apply to and be accepted by several colleges. Applying to several colleges will allow the student the opportunity to compare and negotiate the financial aid awards at several colleges.

The student should file the appropriate financial aid applications. Aid from a federal program is not guaranteed from year to year, so a student must reapply each year. The two basic financial aid application forms are:

Free application for federal student aid (FAFSA) the form is available at high school guidance offices or at college financial aid offices.

Financial aid profile (PROFILE)

The family should receive an acknowledgment report within four to six weeks after filing the FAFSA or PROFILE.

The family may be selected for verification of the information that was submitted on the FAFSA or PROFILE (30% of all FAFSAs are verified). Verification can vary from merely providing tax returns and household information to providing appraisals for the assets reported on the application forms.

The family might receive a college financial aid award. The aid award will state the amount and type of financial aid offered to the student.

In addition to the financial aid programs discussed above, the following programs or resources may be available to your child:

n State programs - Most, if not all, states have student financial aid programs administered through the state’s higher education assistance agency.

n Programs funded by companies and labor organizations

n ROTC programs

n Local and institutional programs

n Academic, performing arts, and athletic scholarships

n Programs funded by business organizations

Application for these other sources of financial aid is often made on the same FAFSA used for federal financial aid. However, the application requirements and deadlines may vary, so the financial aid administration of the college or university must be consulted.

National and community service. Americorps, a program administered through the Corporation for National Service since 1994, will provide $4,725 a year for up to two years of community service work; in one of four areas: education, human services, the environment, and public safety. The work requires at least 1700 hours of service per year and can be done before or after attending school. The funds can be used to either fund educational expenses or repay student loans. In addition, a living allowance of approximately $7,400 a year will be paid during the community service work and, if necessary, an allowance will be paid for health care and child care costs. For more information on this program, call (800) 942-2677 or write to: The Corporation For National Service, 1201 New York Avenue, NW, Washington, DC 20525.

The Taxpayer Relief Act of 1997 and the Economic Growth and Tax Relief Reconciliation Act of 2001 provides several provisions related to education:

n Parents can put $2000 (beginning after 2001) a year into a Coverdell Educational Savings account for any child who is under age 18. No taxes are due on the investment earnings, so long as the money is used for education expenses.

n To pay for college, you can also make penalty-free withdrawals from two other accounts- a regular IRA or one of the new Roth IRAs.

n Prepaid-tuition plans have been expanded, so that they can be used to pay not just for tuition but also for room and board.

n The 1997 tax law introduces two new tax credits, The Hope Scholarship and The Lifetime Learning Credit. The Hope Scholarship is worth a maximum $1,500 a year in tax savings for the first two years of college. The Lifetime Learning Credit, which can be used in subsequent years, could save you $1,000 a year in taxes through 2002, after which the credit is worth an annual maximum of $2,000.

n Taxpayers can deduct $2,500 in student-loan interest in 2005. 

Many of the above benefits are phased out for higher-income earners. For joint filers (after 2001), the ability to fund a Coverdell ESA phases out beginning at $190,000, the student loan deduction starts disappearing at $100,000 and The Hope and Lifetime Learning Credits phase out at $87,000.

In fact, many of the new provisions will create headaches for those hoping to get financial aid. For instance, if you take the Hope or Lifetime Credit, it will boost your available income, which has the potential to reduce your aid eligibility in future years.

The Roth IRA could come in handy for education by pulling out tax free your original contributions for education, while leaving the investment earnings to continue growing tax-free.

 

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