By: Frank Armstrong
By: Frank Armstrong, CFP, AIFA
The 2001 Tax Act dramatically changed the education funding landscape, making education funding far more affordable, and choices more attractive than under previous law.
Education funding is a daunting task for many middle class families. Education costs have grown at a multiple over inflation for more than two generations. The magnitude of the problem is large compared to middle class annual income or net worth. Yet, education is the most important single factor in any child’s success or failure, so most families are understandably concerned. The federal government has belatedly recognized the problem and responded with a bewildering number of programs designed to encourage family education savings.
The 2001 Tax Act dramatically changed the education funding landscape, making education funding far more affordable and choices more attractive than under previous law. We are now fortunate to have more very good available programs than most middle class families could ever afford to fund. These programs vary in significant features of design, flexibility, control over proceeds, control over investment policy, cost, tax benefits, and guarantees. So, the problem facing many families is which and how many programs make the most sense. This in turn depends on individual family situation and preferences.
This paper will establish a pecking order of pre-funding alternatives for middle-income families and discusses the important variables that families will want to consider.
Remember, starting early puts time on your side, while various tax incentives reduce the burden.
Coverdell Education Savings Account – Formerly known as the Education IRA. Previously, the Education IRA was so puny in comparison to the magnitude of the college funding problem that most people ignored it. Not any more. Beginning in 2002 contributions of $2000 per year per child accumulated tax free, and tax free if withdrawals do not exceed qualified expenses. If contributions started at birth and earned 9% per year, the account would grow to $90,036 per child at the end of year 18. Theses plans can be set up at any brokerage or mutual fund company. They provide for complete control over investments, at potentially the lowest cost. Another favorable change in the new tax law, there are no longer any restrictions on making contributions in the same year as a contribution to a Qualified State Tuition Program or Section 529 plan.
Roth IRA – Beginning in 2002, the Roth IRA contribution is $3000 per year or $6000 for a couple. Principal amounts withdrawn from a Roth IRA are not subject to tax. So, if a husband and wife contributed $6000 a year to their Roth IRAs and earned 9%, at the end of 18 years, the accounts would have grown to $270,110. They could withdraw $108,000 tax free. The remaining $162,110 could continue to grow tax free for use during retirement. Advantages: Low cost, total control over investment policy, total control over withdrawals and expenditures. One disadvantage: a withdrawal for education funding will reduce future retirement benefits from the Roth.
Qualified Tuition Programs – You may contribute up to $100,000 gift per child. The funds grow tax free, and will be tax free upon distribution if used for qualified expenses. These plans contain great estate tax benefits. There are no income limits. The donor retains control of the assets to insure that they are used for the intended purpose, but the gift removes the asset from the donor’s estate, and isn’t subject to the normal $10,000 gift limitation ($20,000 if the spouse consents to the gift). So, this is a great way for wealthy grandparents to assist their children by providing for their grandchildren’s education. Withdrawals to meet qualified expenses will be tax-free. If the child doesn’t use the funds for the educational purpose, the account can benefit another close relative without penalty. Funds withdrawn from Qualified Tuition Plans that are not used for qualified expenses are subject to ordinary income tax and a 10% penalty. If you have additional funds you would like to save for education after the Coverdell deposits, and/or you would rather not use up future retirement benefits to fund education, this is a great way to go.
These plans come in two flavors:
College Savings Programs – While there are now hundreds of savings plans, donors have almost no direct investment control. Instead, they must select a plan that has an acceptable investment policy and funds. In the real world, I don’t see this as a giant problem. However, these plans have higher administrative costs than a simple Coverdell or Roth IRA account because each custodian or sponsor charges a “wrap fee” in addition to the costs of the underlying investments. The proceeds may be used for qualifying expenses at any approved educational facility. Restrictions on transfer.
Gifting from Unallocated Account – Parents can save in their own brokerage account, and later gift shares to the child. Of course, if the child doesn’t use for education, the parents just keep their shares. So, the parents retain total control over the use of the proceeds. They also retain total investment control. Expenses should be low. But there is no tax deferral of realized gains or income during parents holding period. So, consider the use of a tax efficient total market index funds to reduce tax exposure during the accumulation period. After transfer to the child, the gifted shares would be taxed at the long term capital gains rate of beneficiary (as low as 10%).
UGMA/UTMA – Uniform Gifts to Minor Accounts or Uniform Trust for Minor Accounts offer a partial income shifting opportunity. But, amounts over a minimum annual amount are taxed at the patent’s rate until the child reaches age 14. Then the proceeds are taxed at child’s tax rate. However, the cost is a total loss of control over expenditures, because the child generally obtains full control of the account when he/she reaches age of majority. Children being what they are, occasionally the proceeds are dissipated frivolously. It’s hard to generate any enthusiasm for UGMA/UTMA accounts with so many better funding methods available.
Summary: Parents have more tax favored education savings opportunities than most could ever fund. The trick is to find a combination that meets your needs and start early. Otherwise, all the tax favored plans in creation won’t get little Jenny into Harvard.