Battling College Costs Part II

By: By: Frank Armstrong, CFP, AIF
College education costs are high enough to put fear into the hearts of most parents. But our children’s financial success or failure will most likely be directly linked to their academic qualifications; their education isn’t optional. As one of my favorite bumper stickers says: “If you think education is expensive, try ignorance.”
In a previous article, I covered the new Section 529 education funding plans. There are a number of viable alternatives that a family should consider as they plan their college funding strategy. All trade tax advantages for varying degrees of control over the account, but most should be helpful to almost any family.
Good planning will help lighten the funding load. Still, there are no magic bullets. Families must budget and save to make it happen, and as always, the earlier they start the easier the task.
The Uniform Gift to Minors Act (UGM), and the sister Uniform Transfer to Minors Act (UTMA)
There is little good to say about this option. Because minors can’t own property, states have allowed parents (and others) to set up accounts for them. On one hand, the gift is considered irrevocable, and subject to the normal $10,000 or $20,000 limitations for gifting. The donor may not take it back, and the account may only be used to benefit the child. The child could even sue if the proceeds were used for any other purpose. When the child reaches the age of majority in the state of residence, he or she is free to use the funds for any purpose, whether it has to do with education or not. This potential diversion of the hard-earned funds from their intended purpose happens just enough that almost every financial advisor knows of at least one such horror show among their clients.
There are some tax advantages, of course. The first $700 of unearned income (gains, interest, and dividends) escapes taxation. The next $700 is taxed at 15%, but amounts over $1400 in the account all accrue at the parent’s highest tax rate until the child turns 14. After age 14 the tax rate is the child’s.
Even though the gift is considered final, if the custodian dies, the proceeds are included in his or her estate.
Education IRA
The chief problem with Education IRA’s is that, with the annual $500 per child limit, you can’t put enough into them to make a meaningful difference. Still, all gains are tax deferred, and if used for higher education, withdrawals are tax-free. The parent or guardian maintains control of the account until the child reaches 30, which insures that the account is used for the intended purpose. The account must be used by the time the beneficiary turns 30, but it may be transferred to another family member. If not used for qualifying expenses, gains on withdrawals may be subject to a 10% penalty and ordinary income tax, unless rolled over within 60 days to another qualifying Education IRA for a qualifying family member. Members of the designated beneficiary’s family include the designated beneficiary’s children and their descendants, stepchildren and their descendants, siblings and their children, parents, grandparents, stepparents and spouses of such individuals.
You may not make a contribution to an Education IRA in the same year that you contribute to a state prepaid tuition plan or state education funding plan (Section 529 plan). However, the Education IRA contribution will not reduce any other IRA contributions that you may be entitled to.
Note that the $500 annual maximum contribution per beneficiary is gradually reduced for depositors with Modified Adjusted Gross Income (MAGI) between $95,000 and $110,000 (or between $150,000 and $160,000 for a married depositor filing jointly).
Other IRA’s
Contributions to a Roth IRA can be withdrawn free of penalty and taxes for education expenses. In eighteen years, a married couple each making maximum Roth contributions—$2,000 each per year—would have deposited $72,000. If they had been successful in earning 10% during that time, the total value would have grown to $182,396.69. After withdrawing the basis for a qualifying education expense, $110,396.69 remains to grow for retirement.
The Roth IRA can be a handy source of education funds, and allows the contributor to maintain total control of the funds, insuring that they are spent as desired.
Don’t forget that kids can also contribute up to $2000 a year to a Roth if they have earned income, and can take advantage of the same tax-free withdrawals. (Those of you who have businesses may be able to find employment for a deserving family member while doing a little creative income shifting.)
Withdrawals from a regular IRA would not be subject to penalty if used for education expenses, but would be subject to regular income tax. This makes regular IRA’s somewhat undesirable for college funding.
Account in Parent’s Name
Holding an account in a parent’s name insures total control of the funds, and if properly designed may still provide tax favored accumulation. Of course, the parent would be taxed on any dividends, interest, or gains in the account, so individual stocks or mutual funds chosen for low turnover and dividends make a lot of sense. The S&P 500 index, a total market index, or a foreign index fund would be likely candidates. When the child is ready for school, shares can be gifted to the child. When the child sells the appreciated shares they will be taxed at the child’s lower capital gains rate, which could be as low as 10%.
State Prepaid College Tuition Plan
Under previous legislation, states established Prepaid College Tuition Plans to cover tuition and perhaps room and board. Under a typical plan, a deposit equal in amount to current tuition was guaranteed to cover the cost of tuition when the child enrolled. If the child did not attend a qualifying school, a refund was available. However, gains and interest were forfeited. Many expenses were not covered by the plan, so that only about 30% of the total cost of college might be provided for. Not all schools participated in the plans.
Given the restrictions on use of funds, limited coverage of expenses, and the forfeiture of profits if not used at a qualifying state school, these older state plans have been eclipsed by newer more favorable funding methods.
Hope and Lifetime Credits
As part of the 1997 Taxpayer Relief Act, Congress included the Hope Scholarship Credit and the Lifetime Learning Credit. These programs provide for limited tax credits for qualifying educational expenses.
The Hope Scholarship Credit is limited to $1500 against tuition and fees during the first two years of college. Lifetime Credits are limited to 20% of the first $5000 ($1000) but may be used at any time. Only one family member can qualify for a lifetime credit no matter how many members are in college. Both credits are subject to income limitations ($100,000 Joint/$50,000 Single with the standard phase ins beginning at $80,000/$40,000).
The Right Plan
Any of the above alternatives will work. It may come down to personal choice. But here are a few considerations.
If estate and gifting tax considerations are important, the Section 529 plan (from the previous article) is hard to beat. It’s also a great way for grandparents and other family members to reduce their estate tax burden and still maintain control of how the money gets spent. All the other options (with the exception of UGMA accounts) offer attractive combinations of income tax advantages and control.
In the final analysis, the decision of what plan to use may be far less important than the decision to start investing early, and the discipline to actually get it done.

By | 2018-11-28T23:47:03+00:00 September 18th, 2012|Blog|

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