Tax Law Changes Make Saving For College A Little Easier
by Jason McDonald
So what did you get from The Tax Relief Act of 2001? You probably haven’t noticed any extra weight in your wallet from the heralded act. In fact, one of the most exciting changes to come from the president’s final signature on the act may not provide an immediate windfall to burn a hole in your pocket either, but it may be a substantial opportunity for you to reduce your taxes in the future.
Now consider that with these changes it may be possible to pay for a full four years of college costs at a major university, whereas without the increased benefits from the changes you may have only been able to afford a two-year junior college for your child. This isn’t your run-of-the-mill, trickle-down effect tax incentive feature. It is an honest to goodness, across the board benefit to any person interested in saving money for future college costs. It’s a change that may lighten the load of the rising cost of education.
You may have heard of the Section 529 College Savings Plan1 of late. It has been a hot topic recently, and probably for good reason. The repeal of the estate tax was supposed to be a big boon, but it was quickly written off as an impractical solution to estate taxes. It was necessary to dig a little deeper into the tax relief act to find something worth shouting about. What was discovered about the changes to the 529 Plan could put a happy tune on the lips of those that take advantage of it.
The Tax Relief Act offers benefits for investors in 529 plans in the form of tax-deferred or Federal tax-free withdrawals. For example, the contribution limits to IRA’s and Roth IRA’s were raised, as well as for Education IRA’s. This allows people to save more money on a tax-deferred basis. Funds placed in 529 Plans are contributed after tax, but growth in 529 accounts and withdrawals for qualified use are not Federally taxed.
So why does the Section 529 Plan stand out in the circle of tax-favored programs? These plans have been dubbed by some as the Grandparents Plan, and that term may provide the clue to one of their biggest potentials.
There are many grandparents out there that saved and put their own kids through college and have seen the rewards of their sacrifices. The baby boom generation was highly educated and has profited from the opportunities education afforded them. Their parents, the Greatest Generation as they have been called, may be largely responsible for that success. The Greatest Generation are now grandparents, and most haven’t forgotten the lessons that helped them accumulate large estates- they save a lot of money. Since they are savers, they have money sitting around that at some point will be transferred to their families. One of their fears is that their estates will be heavily taxed and the money they have hung onto for so long will go to Uncle Sam.
Enter the 529 Plan. It has no income limits to qualify. It allows contributions up to $250,000 per student. It allows a lump sum deposit up to $100,000, and future deposits of $10,000 annually, matching the gifting laws. And flexible it is. It can be transferred among family members, with a relaxed definition of “family member” including first cousins. So if junior doesn’t go to college, the money goes to someone else in the family that does. And the custodian maintains control over the funds to make the decisions. This recipe smells extremely sweet to many grandparents who are facing estate-planning obstacles. Instead of blindly passing money on to future generations, grandparents can underscore the importance of education and help guide their posterity in the direction that made them successful in the first place.
Section 529 Plans were started a few years ago as a way for the government to encourage college savings. The plans are managed by each state individually, and initially had very few investment options. Recently they have grown to include a wide array of investment choices, including many guaranteed interest accounts, as well as brand-name investment managers. Participants can choose from any state’s plan, but your home state may provide benefits that other state’s plans do not. There is no requirement that the funds be used only for education in your particular state however. A plan started in Arizona can be used to pay for education expenses at a school in California for example.
A comparison with other college savings vehicles makes it clear that the 529 Plans can be a great method for grandparents, and also parents, to save for college. Look at the following information on the other college savings options.
The Education IRA was created in 1997 to allow people to save for college with tax-deferred growth on savings. But until 2002, the limit for contributions was a meager $500 per beneficiary, and that was further limited by income. If a couple made more than $160,000 they couldn’t contribute at all. In 2002 the limit for contributions was raised to $2,000 per year, and income for couples must now be less than $220,000 to contribute. You can change beneficiaries for these accounts as long as the new beneficiary is a member of the family.
The Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) provide a simple method of making a gift to a minor under the gift tax exclusion of $10,000 per year for each minor. The asset is placed in the name of an adult as “custodian”, but legal title vests in the minor. The custodian terminates, however, when the minor reaches her majority, which is 18 in most states. Also, income on the assets is taxable to the minor, whether distributed or accumulated. And children under 14 are normally taxed at their parents top tax rate on unearned income over $1,500.
I’m sure you realized quickly, as many have, that the 529 Plan has captured the high points of the Education IRA (Federal tax-free growth and use) and the UGMA/UTMA ($10,000 annual contributions with no income limits), and left the negatives behind. (Some negatives are: Income and contribution limits for the Education IRA, and loss of control at the beneficiary’s age 18 for the UGMA/UTMA).
If you want to put an emphasis on college education and are looking for a savings plan that provides extremely favorable incentives, you may not need to look any further than the Section 529 College Savings Plan.
. Your earnings grow and compound tax-deferred2.
. When the assets are withdrawn to pay for qualified higher education expenses, they are taken Federal income tax-free3.
. You control when withdrawals take place and you can change the beneficiary at any time within the family4.
. Anyone can start a plan since there are no income limits.
. They are a wide variety of investment strategies and options available from many states and many investment companies.
. You can start a plan with as little as $15 dollars with some plans, up to $250,000 per student.
. Contributions are treated as completed, present-interest gifts, which qualify for the $10,000 annual gift tax exclusion. A special election allows a $100,000 gift from a married couple to be treated as if it were made over a five-year period, free of gift tax.
. Withdrawals can be used for qualified higher education expenses including tuition, fees, books, supplies and room and board for students living either on or off-campus.
A professional financial advisor can most likely answer any questions that you may have about the Section 529 Plans. Manulife Financial, Putnam Investments and The American Funds are just a few managers that can help you find an advisor that will explain the plans. There are also many web sites that are dedicated to providing information on college savings, like collegesavings.org and savingforcollege.com. Your state is also a resource to provide details on their specific programs and who they have partnered with to mange the plans.
Whatever plan you choose to help pay for college costs and possibly assist in estate planning, it is wise to further investigate the benefits of the updated and much improved Section 529 Plan. Remember, the older generation probably does know best- saving for a rainy day or a big college bill by planning ahead is definitely the best option. And with the Grandparents Plan that generation can put their own advice to work for them.
1. There is no guarantee that any investment portfolio will achieve its investment goals. The value of you 529 college savings program account will fluctuate, as the value of the securities in which it invests fluctuate, so that your investment, when it is withdrawn, may be worth more of less than its original cost.
For more complete information on the 529 college savings program, including a description of fees, expenses and risks, see the Program Description. You may obtain a Program Description by contacting your investment representative.
2. The earnings from completely free of federal income tax. You may also make withdrawals at any time after two years. There is, of course, a 10% penalty on the earnings portion for unqualified distributions and you will be taxed as ordinary income on earnings.
3. Qualified expenses include tuition, fees, room and board, books and other supplies needed to attend an institution of higher education. A 10% federally mandated penalty or additional tax applies on any earnings you withdraw for non-qualified expenses.
4. Under a “sunset provision”, the tax exemption for earnings on qualified withdrawals is scheduled to expire on December 31, 2010, unless extended by Congress. As with all tax related decisions, consult with your tax advisor.
2001 Meridian Magazine. All Rights Reserved.
