By: Frank Armstrong, CFP, AIFA
No matter what you think of the rest of the tax act, if you are faced with education expense, you should celebrate. Your task just got a whole lot easier. With education expenses rising at a rate better than twice the general inflation average, we all can use some help.
The Ultimate College and Education Savings Plan
Section 529 Plans remain the preferred program for serious education funding. With no income or net worth limits for contributors, beginning next year the new law allows tax-free withdrawals for qualified education expenses. Tax-free is soooo much nicer than tax deferred!
The account remains the property of the contributor, and is under their control. So, they can be sure that it will be used for its intended purpose. But, up to a $50,000 single or $100,000 joint contribution per beneficiary can be made without triggering a gift tax limitation. Furthermore, the contribution and all of its growth and earnings are excluded from the contributor’s estate assuming that the contributor lives for five years. What a great way for grandparents to help children and grandkids!
All 50 states now have programs, and with the managers aggressively competing for accounts, prices and features should continue to improve. Unlike Education IRA’s contributors have no discretion over the investments, but with so many programs available, there should be one for the most demanding investor.
Beginning next year, contributions for the Education IRA are increased to $2000 a year, and when withdrawn for qualified expenses are entirely tax-free. A family that made regular $2000 contributions beginning at birth could accumulate $72,758 tax-free by the childs 18th year at a very conservative 7% earnings. That’s a serious benefit compared to the prior law.
More families will be able to participate because the qualifying income limit has been raised to $190,000 (phasing out to $220,000) Adjusted Gross Income (AGI) for joint filers up from the previous $150,000 to $160,000. Single filers limit is raised to $95,000 phasing out to $110,000, up from the old law. Of course, if your income is too high, you can always gift the child $2000 and let them establish their own Education IRA!
You will be able to contribute to both an Education IRA and a qualified state tuition plan in the same year without penalty. Funds may be withdrawn without jeopardizing Hope and Lifetime Learning Credits. Contributions can be made anytime up to April 15 following the tax year rather than December 31 as under the previous act.
The definition of qualifying expenses has been liberalized to include most related education expenses. Should you withdraw more than allowed for qualifying expenses, you will have until the following May 31 to put it back without penalty.
Qualified Tuition Plans
Private colleges and institutions can now establish qualified tuition plans like state programs if they first obtain a ruling from the IRS. Provisions similar to the IRA liberalization allow recipients to claim either Hope or Lifetime Educational Credits.
Unlike Section 529 Plans or Education IRA’s, Qualified Tuition Plans allow you to purchase future tuition and other future education related expenses like room and board at a discount today, so benefits are not dependent on investment earnings in the meantime.
Education Expense Deductions
In 2002 and 2003, couples with an AGI of less than $130,000 ($65,000 single) will be able to deduct up to $3000 for qualified education expenses. Those amounts increase to $5000 in 2004 and 2005. This deduction is in lieu of the Hope or Lifetime Education Credit, but should be more valuable for taxpayers above the 15% bracket. Taxpayers should do the math and may choose which offers better benefits. After 2005, barring any further extension, the deduction disappears! Nobody said this wasn’t a strange law!
Student Loan Interest Deduction
If you are still paying off student loans, the law provides that taxpayers with AGI below $100,000/$50,000 (Joint/Single) can deduct up to $2500 of interest on qualified educational loans paid after 2001 (unless that taxpayer is also claimed as a dependent by another taxpayer). A phase out occurs on AGI to $130,000/$65,000. The 60-month limit has been eliminated.
The Bottom Line
Education isn’t optional today. It’s about time taxpayers and parents got some relief and assistance. This law is a great start, providing a number of improved tax favored options. And any contributions made today to an Education IRA, Section 529 Plan, or State Qualified Tuition Plan will receive tax-free treatment when distributed after this year.
Note: There’s an outside chance that the act’s “sunset” provisions might kick in after 2011. That would cause the taxation of distributions, or some part of them made during and after 2002 as they would be taxed today. Most observers believe that the distributions would be “grandfathered” to retain their tax free character, or that subsequent legislation will provide for permanent status to the education provisions. Even in the worst case where the distributions become taxable to the recipient, these programs retain strong tax-favored advantages.
But, the government is only providing incentives. Only you can make the decision to actually save the funds your children will need.
Of course, the earlier you start, the easier the task. For example, if your education goal is $100,000 in 18 years, then you need to contribute $2749 each year assuming a 7% net return. But, wait just five years, and you must contribute $4640 under the same assumptions. Wait 10 years and your annual cost to fund the goal jumps to $9109! So, put time and the new law on your side. Just do it!