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TAX STRATEGIES AND PITFALLS OF PLANNING FOR COLLEGE
Depending on a family's situation, the various approaches to investing for future college expenses have tax benefits and risks that need to be analyzed.
Author: JOSEPH D. BEAMS and JOHN W. BRIGGS
The continuing increase in the cost of higher education has made early planning for college a necessity for many families. According to a recent CNN Money article, college costs have risen 130% in 20 years, far surpassing the growth in household incomes over that period. 1 The College Board reports that for the 2011-2012 academic year, the average total costs, including room and board, to attend a public university for in-state students rose 5.4% from the prior year, to $21,477. 2 For private colleges, the average total annual costs are $42,224, a 4.3% increase from last year. To encourage young people to attend college, the government provides several tax incentives for pursuing higher education. Many of these incentives pertain to the college savings process. If parents allocate a portion of current income to college savings, the earnings on those savings can accumulate tax-free, or with a reduced tax rate.
Many factors should be considered in deciding on an educational savings strategy. Tax professionals are in an ideal situation to help clients plan for these future expenses because they know the clients' financial situation. This additional service can be offered in combination with yearly tax planning. This article compares the advantages and disadvantages of the major choices available for college savings and their tax implications. Additionally, it addresses specific questions and warns of potential pitfalls of the various plans that parents need to consider.
Transferring educational assets to dependents (UGMA Accounts)
A Uniform Gift to Minors Act (UGMA) account is an easy way to transfer assets to children to lower the taxes on the earnings from the assets. A UGMA account is a “custodial account” and not a formal trust. It can be established at banks or brokerages. Custodial accounts are the original college savings vehicle, existing before newer plans were established.
Custodial accounts can be advantageous if either of the following apply:
- (1) There is significant uncertainty about whether the child or other family member will go to college. Since there are no restrictions on the use of account assets, failure of the child to attend college does not create penalties. The money can be used for education, housing, cars, or other living expenses, but it must be used for the child's benefit.
- (2) Parents want the ability to choose specific investment assets. In a UGMA custodial account, a portfolio of individual stocks and bonds can be purchased, so it is not limited to specific investment funds.
Unlike other types of savings plans, custodial account earnings are not necessarily tax-free, but instead are taxed at lower rates. If assets are transferred to a UGMA account, the income on the assets is considered income of the minor even though the parents still control how the money is invested. A dependent child receives a $950 standard deduction. Therefore, the first $950 of income of a dependent child will incur no tax. The next $950 of income is taxed at the 10% rate; however, due to the kiddie tax rules, additional income is taxed at the parents' rate. 3 There still may be an advantage to shifting additional income to children because it lowers parents' AGI, which can affect certain phase-outs.
Exhibit 1 demonstrates the possible benefit from transferring assets to a child. In this example, a married couple has taxable income of $100,000 from wages, $2,500 from taxable investment interest from personal savings, and $3,800 investment interest on savings of $100,000 for their two children's educations. Exhibit 1 shows the total tax from keeping the educational assets in the parents' name versus transferring them into accounts in the children's names. If the educational assets are kept in the parents' account, the total tax is $11,860. If the educational assets are transferred into separate accounts for the children and the parents file a tax return on behalf of each child, the total family tax is only $11,100, which saves the family $760. This savings occurs because the first $950 of interest that each child receives will be eliminated by the $950 standard deduction for dependents. After the first $950 per child, the next $950 of investment income is taxed at the child's rate, which is 10% instead of the parents' rate of 25%. The $760 amount is a sizable 20% of the $3,800 income the family earned on the educational assets; the effective tax rate on the $3,800 of earnings is only 5% ($190 / $3,800) instead of 25% ($950 / $3,800).
Exhibit 1. Assets in a custodial (UGMA) account
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Combined Parents Only Child A Child B Family Total
-------- ------------ ------- ------- ------------
Wages $100,000 $100,000 $0 $0 $100,000
Personal
Savings $2,500 $2,500 $0 $0 $2,500
Children's
Education
Savings $3,800 $0 $1,900 $1,900 $3,800
Adjusted
Gross
Income $106,300 $102,500 $1,900 $1,900 $106,300
Standard
Deduction $11,900 $11,900 $950 $950
Personal
Exemptions $15,200 $15,200 $0 $0
Taxable
Income $79,200 $75,400 $950 $950
Tax $11,860 $10,910 $95 $95 $11,100
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There is no contribution limit on custodial accounts. It is important, however, to note that the tax benefit does not increase as the amount of investment interest increases. This is because the kiddie tax rules require the children's investment income in excess of $1,900 to be taxed at the parents' rate. In the example above, the $100,000 of assets earn 3.8% ($3,800) in a year. There would be no further tax savings from increasing the account balance beyond $100,000 (or $50,000 per child) because any additional amount would be taxed at the parents' tax rate under the kiddie tax rules. Transferring additional income-producing assets to the children will reduce the parent's adjusted gross income and can provide an additional benefit by reducing phase-outs in some situations.
One drawback in using a custodial account is that once assets are transferred to the account, they cannot be reclaimed by the parent if the child decides not to attend college. The assets will go to the child when he or she is no longer a minor (age 18 to 21, depending on the state), and the parents lose control.
Education savings bonds
U.S. savings bonds can earn interest tax-free if the proceeds from the bonds are used for education. The taxpayer must be at least 24 years old before the bond is purchased to qualify. Eligible bonds include Series EE bonds (issued January 1990 and later) and all Series I bonds. For 2012, a taxpayer can buy $10,000 of EE bonds and $10,000 of I bonds per year through the U.S. Department of Treasury's TreasuryDirect.gov website.
Series EE bonds earn a fixed rate of return if issued in 2005 or after, or a variable rate if issued earlier. Series I Bonds earn both a fixed and variable rate of return. From 2009-2011, interest rates have remained at historical lows. However, savings bonds offer predictability. Also, the variable portion of the Series I Bond interest rate is tied to general inflation (as measured by the CPI-U). Interest earned on these savings bonds will result in no federal tax if used for tuition and fees; but unlike other plans, room, board, books, and equipment costs are not qualifying education costs. 4 However, the proceeds from the bonds can be put into a Coverdell ESA or a Section 529 plan, which prevents the interest from being taxable. The educational distributions from these plans can then be used for room and board, books, and other required educational supplies. 5 Interest on savings bonds is always exempt from state taxes, even if the child does not go to college.
One difficulty when using savings bonds for education is that federal taxes are paid on withdrawals if parents' earnings are high at the time of withdrawal. It is possible that parents' salaries will rise significantly between purchase and redemption, which could undo potential federal tax savings. For 2012, the interest exclusion phases out for married taxpayers filing a joint return for incomes between $109,250 and $139,250. 6 For single taxpayers and head of household filers, the exclusion phase-out takes place for incomes between $72,850 and $87,850. Interest on the bonds is normally recognized on a cash basis when the bonds are redeemed; however, taxpayers have the option of recognizing the interest annually on an accrual basis. A potential way around the income limitations is to purchase the bonds in the child's name and file an annual income tax return in the child's name. The interest is taxable for federal tax purposes but the child's standard deduction will prevent tax on the first $950 of interest per year if the child has no other income.
Section 529 plans—state sponsored college savings plans
Section 529 plans (also known as qualified tuition programs) are a popular savings approach for college. They are established and maintained at the state level. All 50 states (and the District of Columbia) have at least one 529 plan, and many states sponsor multiple plans. Assets in 529 plans earn returns that are tax-free for federal tax purposes if used for qualified educational expenses. 7 A 529 plan for a child has a high total contribution amount, usually about $300,000, depending on the state. There is also a five-year, one-time gift-tax allowance. 8 This means that a parent can put as much as $65,000 ($130,000 for a couple) immediately into a 529 plan for each child and stay within the gift-tax annual exclusion, which is $13,000 per year. Also, there are no income limitations for contributions, meaning that families with high incomes are able to make these contributions.
For 2012, distributions from a Section 529 plan can be used for tuition, fees, books, and supplies. 9 Also, students who attend school at least half-time can use distributions to pay the cost of room and board. 10 Commonly, there are state income tax benefits for 529 plans. Residents are not limited to investing in their own state's plan. If they do, however, 34 states (of the 43 that have state income taxes) currently allow some type of deduction for contributions made to that state's 529 plan. For instance, Virginia plans allow up to $4,000 of annual contributions to be deductible for state taxes, with unlimited carry-forward. Also, five states allow state tax deductions for contributions to any state plan, not just their own state plans.
In the past, Section 529 plans were usually available through financial advisors. However, these plans no longer have to be advisor-sold: direct-sold plans are becoming widely available. Direct-sold plans have favorable cost structures. Fidelity and Vanguard are two well-known investment companies that offer direct-sold plans. Investors can choose the more traditional actively managed mutual funds with annual expenses of around 0.8%, or choose more passive index funds with expenses of about 0.3% annually. An advisor-sold plan will normally lead to higher expenses. However, depending on the state a person lives in, a home-state advisor-sold plan might lead to better overall returns even if fees are higher, due to the state tax benefits.
Coverdell education savings accounts (ESAs)
Coverdell ESAs (formerly Education IRAs) have many similarities to 529 plans. Their chief limitation is a $2,000 maximum per child per year contribution limit. 11 One key reason why some parents might want to put their first $2,000 per year into an ESA instead of a 529 plan is investing flexibility. In an ESA plan, individual stocks can be selected. This can potentially allow for a higher risk level than is achievable with the more regimented 529 plans. Alternatively, a portfolio of stocks with low volatilities could be selected. A second advantage of Coverdell accounts is that they can be used for private school tuition for grades K-12. 12 A family interested in capturing either of these two advantages could put $2,000 per year (per child) into a Coverdell, and then additional amounts into a 529 plan. If investing flexibility is of foremost concern, parents can put $2,000 per year (per child) into a Coverdell account, then additional amounts into a custodial (UGMA) account.
In addition to the $2,000 annual maximum, there are other limitations. Parents' income is limited to $95,000 for making the maximum contribution, 13 or $190,000 if married filing jointly. No contributions are permitted after the child turns 18, 14 and assets automatically transfer to the child at age 30, regardless of the parents' wishes. 15 These restrictions are not present with 529 plans. Coverdell accounts can be set up through banks, and they can be established with larger brokerage services.
Benefits and risks of educational savings plans
Exhibit 2 illustrates a scenario demonstrating the cumulative effect of tax savings. Two parents have a child who is two years old. For college savings, parents contribute $3,000 per year for the next 16 years until the child becomes 18. These contributions could be made to a 529 plan, or split between a Coverdell plan ($2,000 per year) and a 529 plan (the remainder). The example assumes that the stock-based portfolio earns an average of 7.5% annually. The first row in Exhibit 2 shows that the total contributions of $48,000 have grown to $93,774 by the time the child becomes 18. Under a Section 529 plan, the $45,774 of income is not taxable if used for qualified educational expenses. The second row in Exhibit 2 shows that if these funds had been invested in a taxable investment account, capital gains taxes would apply. At the current maximum long-term capital gains rate of 15%, instead of $45,774 of earnings, only $38,908 would have been earned after-tax. If the capital gains tax rates increase in the future, even more of the earnings will be lost to taxes. Additionally, any dividends or portfolio changes during the 15-year period could trigger early tax payments and further erode total returns.
Exhibit 2. Tax savings or penalties from education accounts
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Contributions Earnings Taxes-15% Penalties-10% Total
------------- -------- --------- ------------- -----
College Plan
- Section
529 Plan
or Combined
529 and
Coverdell $48,000 $45,774 $93,774
Taxable
Investment
Account $48,000 $45,774 ($6,866) $86,908
College Plan
- If No
Child Attends
College $48,000 $45,774 ($6,866) ($4,577) $82,331
Section 529
Plan from
Home State* $50,400 $48,083 $98,462
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* It is assumed that an additional 5% from state tax savings will be
invested each year.
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The third row in Exhibit 2 shows the result of putting the money in a college plan if the child does not go to college and the assets are not transferred to another family member for education. This result is even worse than the taxable account because of the additional 10% penalty on the earnings. The final row in the table shows the result of using a home state Section 529 plan. The state tax benefit is assumed to be 5% and the additional savings are used to increase the yearly contribution from $3,000 to $3,150. Clearly, the advantage of putting the assets in an educational account is material if the child or another family member can use the funds for college.
Individual retirement accounts (IRAs)
A married couple with limited resources and young children may consider funding two IRAs (Roth or traditional) before contemplating specific college savings. Each spouse can contribute $5,000 to an IRA (subject to income limitations) for a total of $10,000 per year. If the funds are needed for the children's education, early withdrawals from an IRA are penalty free if the amounts are used to fund a child's higher education. Taxes will still be paid on traditional IRA withdrawals just as they would at retirement. Taxes on the earnings portion of Roth IRA withdrawals will also need to be paid. Although it would be best to leave the assets in the IRA until retirement, the funds could be used for college in an emergency.
Savings and financial aid
The federal government uses the FAFSA (Free Application for Federal Student Aid) application when determining a family's ability to pay college expenses. In general, the greater the family's ability to pay, the less government assistance the child gets. In this formula, assets owned by the child are assessed a 20% rate; in other words, 20% of these assets are deemed to be usable to pay college costs. Fortunately, Section 529 and Coverdell accounts are treated as assets of the parent, and the corresponding rate is only 5.6%. Also, withdrawals from these accounts do not count towards family income. Income of parents is evaluated on a sliding scale, with an ultimate rate of between 22% and 47%.
Savings bonds likewise count as assets of the parent. In the past, custodial accounts have counted fully as assets of the child, which severely curtailed financial aid qualification. However, starting with the 2009-2010 educational year, UGMA assets count as assets of the parent, provided that the child is a dependent. IRA assets have an even better treatment, as they do not count at all as eligible assets; however, withdrawals from IRAs count as parental income.
Child decides not to attend college
What happens if parents save substantial assets for their child to attend college in an education savings account, and then the child decides not to attend college? In both Section 529 16 and Coverdell 17 plans, the account can be transferred to another family member. Otherwise, taxes and a 10% penalty on earnings will apply. The outcome is better with savings bonds. Although interest earned on bonds become taxable, there is no 10% penalty applied. With UGMA accounts, if the child does not attend college, the only potential concern is that the assets will transfer to the child. There is no tax issue because the income has already been recognized on the child's tax returns.
Grandparents
Grandparents are often in a position to help their grandchildren with college expenses. Grandparents can make contributions to a Section 529 plan subject to the $13,000 gift tax exclusion. A family can even have parents create one 529 plan, and grandparents create a second 529 plan. A grandparent's 529 plan does not count at all in the financial aid process; however, distributions from this plan count as student income, which drastically affects financial aid qualification because 50% of student income is considered usable to pay college costs. One potential strategy is to use a grandparent's 529 plan only for the senior year to eliminate this effect. If such management is too much trouble, it might be easier to have a parent-only 529 plan and let grandparents contribute to it.
If a Coverdell account is created, only $2,000 of contributions (per child) from all sources (including grandparents) is permitted. Finally, with respect to U.S. savings bonds, grandparents who purchase savings bonds are normally not eligible for any tax benefits. They could, however, provide resources to help the parents purchase bonds in the parents' names.
Scholarships
What if parents save substantial assets for their child to attend college in an education savings account and then the child gets a scholarship? The savings assets could be used to pay for the non-tuition elements: room, board, supplies, and computers, or it could be transferred to another family member. However, if the combination of savings assets and the scholarship are more than enough to pay for all college expenses, taxes will apply on the portion of the withdrawals that is not used for qualified expenses. Fortunately, the 10% penalty on 529 and Coverdell accounts will not apply as long as the taxable portion of the distribution does not exceed the amount of the scholarship. 18
Conclusion
There are several tax-advantaged means of investing money for future college expenses. Each approach has advantages that might be best for a particular family but each also entail different risks. Exhibit 3 provides a general overview comparing some of the major advantages and disadvantages of savings options. If parents expect their children to attend college, early planning may be necessary. Tax professionals can help parents research the choices available to them, given their financial situation, risk tolerance, expected college choices, and time horizon.
Exhibit 3. Comparison of educational savings options
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Leave Assets in UGMA Account Education Savings
Parent's Name Bonds
--------------- ------------ -----------------
Advantages Complete flexibility First $950 not Low risk. Interest
of investments. No taxed, next $950 is tax free if
obligation or taxed at child's used for qualified
penalty if child rate. Does not educational
does not attend have to be used expenses. Tax
college. for college applies but no
expenses. penalty if
not used
for college.
Disadvantages Income is taxed Income over Low rate of return.
currently at $1,900 is taxed
parent's rate. at parent's rate.
Assets
automatically
transfer to child
at 18 or 21
depending on the
state.
Phase out NA None Single $72,850-
$87,850, Married
$109,250-$139,250.
Contribution
Limit NA None Treasury limits
purchases to
$10,000 per year
per social security
number for Series
EE and I Series
bonds.
(www.treasury
direct.gov)
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(CONTINUED)
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Section 529 Plan Coverdell ESA
---------------- -------------
Advantages Earnings not taxed Investment
if used for flexibility.
educational expenses. Earnings not
Can be used for taxed if
room and board used for
as well as tuition, educational
fees, books, and expenses.
supplies. Can be used
for room and
board as well as
tuition, fees,
books, and
supplies.
Disadvantages Interest and Interest and
penalties apply if penalties apply if
not used for not used for
education. education. Assets
transfer to child
at age 30 if
not used for
education.
Phase out None Single $95,000-
$110,000, Married
$190,000 - $220,000.
Contribution
Limit None $2,000 per child.
JOSEPH D. BEAMS is an associate professor of accounting at the University of New Orleans in Louisiana and JOHN W. BRIGGS is an associate professor of accounting at James Madison University in Harrisonburg, Virginia.