College tuition and fees are on the rise with the cost of tuition at a four-year public institution rising 9.6 percent over past year and the cost of most four-year private schools topping $36,000 per year on average. While few can argue against the value of a college degree (according to the U.S. Census Bureau, individuals with a bachelor’s degree earn more than $1 million more in their lifetime than those with just a high school degree), the costs are prohibitive.
If you plan to subsidize your child’s degree, a tax-free college plan can save you thousands. The two most popular college savings programs are 529 plans and Coverdell Education Savings Accounts. Whichever you choose, be sure to start when your child is young. The sooner you begin, the less money you will have to put away each year.
Saving with 529 Qualified Tuition Plans
Section 529 plans, also known as Qualified Tuition Programs, are the best choice for many families.
Every state now has a program allowing persons to prepay for future higher education, with tax relief. There are two basic plan types, with many variations:
1. The Prepaid Education Arrangement: You essentially buy future education at today’s costs, by buying education credits or certificates. This is the older type of program, and it tends to limit the student’s choice of schools within the state.
2. Education Savings Accounts: You contribute to an account earmarked for future higher education.
Tip: When approaching state programs, you must distinguish between what the federal tax law allows and what an individual state’s program may impose. You may open a Section 529 plan in any state. But when buying prepaid tuition credits (less popular than savings accounts), you often need to apply the credits to a specific college or group of colleges.
Unlike certain other tax-favored higher education programs, such as the Hope and Lifetime Learning Credits, federal tax law doesn’t limit the benefit only to tuition. Room, board, lab fees, books, and supplies can be purchased with funds from your 529 Savings Account. (Individual state programs could be narrower). The key parties to the program are the Designated Beneficiary, the student-to-be, and the Account Owner, who is entitled to choose and change the beneficiary and who is normally the principal contributor to the program.
There are no income limits on who may be an account owner. There’s only one designated beneficiary per account. Thus, a parent with three college-bound children might set up three accounts. (Some state programs don’t allow the same person to be both beneficiary and account owner.)
Give the gift of education
When graduations, birthdays and holidays roll around, a 529 contribution can be the perfect gift. Grandparents, for example, may contribute up to $13,000 each ($26,000 if married filing jointly) per year directly to a tax-advantaged 529 college savings plan without paying gift taxes. In addition, a 529 plan allows “accelerated gifting” of five years’ worth of contributions; that’s $65,000 per contributor or $130,000 if married at one time. To take advantage of the accelerated gifting, you would need to file a gift tax return IRS Form 709 for the year in which the gifted contribution to the 529 account is made. Our firm can prepare this tax return for you if you would like.
Tax Rules Relating to 529 College Savings Plans
Income Tax: Contributions made by the account owner or other contributor are not deductible for federal income tax purposes. Earnings on contributions grow tax-free while in the program.
Distributions from the fund are tax-free to the extent used for qualified higher education expenses. Qualified expenses include tuition, required fees, books, supplies, equipment, and special needs services. For someone who is at least a half-time student, room and board also qualify.
Tip: In 2009, the American Recovery and Reinvestment Act (ARRA) added expenses for computer technology/equipment or Internet access to the list of qualifying expenses. Software designed for sports, games, or hobbies does not qualify, unless it is predominantly educational in nature. In general, however, expenses for computer technology are not qualified expenses for the American Opportunity Credit, Hope Credit, Lifetime Learning Credit, or tuition and fees deduction.
Gift Tax: For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them – thus they qualify for the up-to-$13,000 annual gift tax exclusion. One contributing more than $13,000 may elect to treat the gift as made in equal installments over that year and the following 4 years, so that up to $65,000 can be given tax-free in the first year.
Estate Tax: Funds in the account at the designated beneficiary’s death are included in the beneficiary’s estate – an odd result, since those funds may not be available to pay the tax.
Funds in the account at the account owner’s death are not included in the owner’s estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $13,000. For example, if the account owner made the election for a gift of $65,000 in 2011, a part of that gift is included in the estate if he or she dies within 5 years.
Tip: A Section 529 program can be an especially attractive estate-planning move for grandparents. There are no income limits, and the account owner giving up to $65,000 avoids gift tax and estate tax by living 5 years after the gift, yet has the power to change the beneficiary.
State Tax: State tax rules are all over the map. Some reflect the federal rules, some quite different rules. For specifics of each state’s program, see http://www.collegesavings.org.
Saving with Coverdell Education Savings Accounts
The total contributions for the beneficiary of a Coverdell Education Savings Account (ESA) cannot be more than $2,000 in any year, no matter how many accounts have been established. (A beneficiary is someone who is under age 18 or is a special needs beneficiary.)
The beneficiary will not owe tax on the distributions if they are less than a beneficiary’s qualified education expenses at an eligible institution. This benefit applies to higher education expenses as well as to elementary and secondary education expenses.
Here are some things to remember about distributions from Coverdell accounts:
• Distributions are tax-free as long as they are used for qualified education expenses, such as tuition, books, and fees.
• There is no tax on distributions if they are for an eligible educational institution. This includes any public, private, or religious school that provides elementary or secondary education as determined under state law.
• The Hope and Lifetime Learning Credits can be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses are not used for both benefits.
• If the distribution exceeds education expenses, a portion will be taxable to the beneficiary and will be subject to an additional 10% tax. Exceptions to the additional 10% tax include the death or disability of the beneficiary or if the beneficiary receives a qualified scholarship.
Considering the wide differences among state plans, federal and state tax issues, and the dollar amounts at stake, please call us before getting started with any type of college savings plan. To learn more about the right College Savings Plan for you, contact Darren Wendroff at 703-436-1461 or firstname.lastname@example.org.