- the Hope Scholarship Credit, and
- the Lifetime Learning Credit.
- Taxpayer has two children that are enrolled as full-time students at a private university
- Qualified tuition and related expenses paid by the taxpayer are $7,500 per semester, per child
- In 2004, both children are 18 years old and enrolled as freshmen
- In 2005, both children are sophomores
- In 2006, both children are juniors
- income limitations on the donor, and
- age of the beneficiary.
College Prep Guide: Planning and Saving for a Child's Higher Education
by Mark H. Gaudet
As the cost of higher education continues to increase at a rate that is roughly two to three times inflation, parents are often left wondering how they will be able to save enough to send their children through college.
Fortunately, there are steps that can help you and your children negotiate the expense path toward higher education. First, Ill highlight the federal tax credits related to post-secondary education that are available to parents and/or their children. These credits offer tax savings for individuals currently assisting in the funding of their childrens college education.
Second, Ill focus on some of the common tools that are being used by parents and even grandparents to prepare for upcoming college expenses. These include the use of custodial accounts, Section 2503(c) trusts, Coverdell education savings accounts and qualified tuition plans, also known as 529 plans.
Two non-refundable tax credits are available to individuals who pay higher education costs:
|How Education Tax Credits Work: An Example|
Maximum Credit Allowed Each Tax Year
* Credit limited to $1,500 per eligible student
Both credits are available for qualified tuition and related expenses which are incurred by an individual, their spouse, or a dependent claimed on the individuals tax return for a student at a qualified educational institution.
Qualified tuition and related expenses does not include room and board, books, insurance, medical expenses and transportation.
Both credits are only available to individuals that have modified adjusted gross income (MAGI) below certain levels. In 2004, taxpayers with modified adjusted gross income greater than $52,000 (for single taxpayers) and $105,000 (for married filing joint return taxpayers) will not be eligible to claim a credit. The credits are phased-out for single taxpayers with modified adjusted gross income between $42,000 and $52,000 and married taxpayers filing a joint return with MAGI between $85,000 and $105,000. Taxpayers with modified adjusted gross income below the phase-out levels may be eligible to claim the full credit.
An individual may not claim both the Hope Scholarship Credit and the Lifetime Learning Credit for the same student during the same tax year.
Hope Scholarship Credit
The Hope Scholarship Credit allows an individual to claim a 100% tax credit for the first $1,000 of qualified tuition expenses and a 50% tax credit for the second $1,000 of qualified tuition expenses paid. The maximum credit allowed per student is $1,500 per year.
In order to qualify for the Hope Scholarship Credit, the eligible student must not have claimed the credit in any two previous years, and not have completed the first two years of post-secondary education before the beginning of the current tax year. In addition, the student must be enrolled at least half-time of the normal full-time work load for the students course of study and be enrolled in a program that leads to a degree, certificate or other recognized educational credential. Finally, a student must not have been convicted of any felony-class drug offense for possession or distribution. The Hope Scholarship Credit is available annually for each student. Therefore, a taxpayer may have more than one eligible student in any given tax year.
Lifetime Learning Credit
The Lifetime Learning Credit allows an individual a tax credit that is equal to 20% of the amount of tuition paid by the individual, limited to the first $10,000 of tuition expenses. The maximum annual credit allowed per taxpayer is $2,000. To qualify for the Lifetime Learning Credit, the eligible student must be enrolled in at least one course at a qualified educational institution. This credit is available for students during undergraduate and graduate school, in addition to any student acquiring or improving their job skills. There is no limit on the number of years that an individual can claim the credit for each student.
Unlike the Hope Scholarship Credit, the maximum Lifetime Learning Credit is calculated per taxpayer and does not vary based on the number of students in the taxpayers family.
As illustrated in the accompanying box below, the tax credits do not provide individuals with large tax savings when paying for college education expenses.
In addition, the credits are only available to low- and middle-income taxpayers. Therefore, parents and grandparents are often forced to look for additional ways to combat rising education costs. Some of these methods include common savings vehicles that allow taxpayers to plan ahead for college tuition expenses.
The use of a custodial account is a common method for a parent or grandparent to set aside funds for a childs education.
A custodial account is an account that is established at a financial institution for the benefit of a minor child and managed by the parent or another designated custodian. Generally, minors are not legally allowed to own or manage property. Consequently, each state has instituted either the uniform gift to minors act (UGMA) or the uniform transfers to minors act (UTMA). A custodial account that is created under a states UGMA/UTMA is similar to a trust, but no separate trust document is required as the terms of the account are determined by state statute.
In general, UGMA and UTMA are substantially similar. However, there are key differences between the two acts.
First, UGMA accounts are more restrictive on the types of property that they may hold. For example, a UGMA account may not be able to hold real estate or limited partnership interests, whereas this type of property could be held in a UTMA account.
The second key difference between the two accounts involves account termination. Typically, UGMA accounts will terminate when the minor reaches the age of 18, whereas UTMA accounts do not terminate until the minor reaches the age of 21.
Assets that are transferred to a custodial account are controlled by the custodian and can only be used for the benefit of the minor child. Any income that is earned by the account will be taxed to the child. This may result in significant tax savings for the family. However, if the child is under the age of 14, the kiddie tax rules will apply, causing investment income in excess of approximately $1,500 to be taxed at the custodians tax rate.
Since custodial accounts are governed by state statute, the cost associated with establishing and maintaining an account is relatively low. As the account is not a trust, no trustee costs will be incurred and no separate tax return is required to be filed.
The main drawback to establishing a custodial account is that the minor child gains complete access to the account when he or she reaches the age of majority, defined as 18 or 21, depending upon the state.
If you live in a state in which the age of majority is 18, the child has the ability to withdraw all of the funds from the custodial account before their first year of college has ended. Therefore, utilizing a custodial account for college savings does not guarantee that the account will actually be used toward the childs education.
Also, transfers to a custodial account are irrevocable. Unfortunately, as the account is governed by the states statute, there is no ability for the donor to customize the setup in order to control some of the aforementioned disadvantages.
Impact on Financial Aid
Custodial accounts are assets recorded in the childs name and are included in their asset base for the federal financial aid formula.
The federal financial aid formula is a complex calculation consisting of numerous factors. One factor of the formula is represented by the childs and parents asset bases. The inclusion of the assets in either the childs or parents asset base will effectively lower the childs eligibility for federal financial aid.
However, since it is an assumption for the calculation that the child will effectively contribute a larger percentage of their asset base, the effect of the assets included within the parental asset base should not cause the same reduction in the childs financial aid award.
Individuals who are uncomfortable with the rules surrounding custodial accounts may want to consider establishing a 2503(c) trust. This type of trust can be created by either a parent or grandparent. A 2503(c) trust is established for the benefit of a minor child and controlled by a trustee until the child reaches the age of 21.
The main advantage of a 2503(c) trust over a custodial account is that it ensures that the minor child will not be able to access the funds prior to reaching the age of 21. Since the child is unable to gain control of the trust until they are 21, the funds accumulated inside the trust should be available to cover the majority of the childs college costs before the trust property must be distributed to the child.
In order to qualify as a 2503(c) trust, the trust property and any accumulated income must be distributed to the child when they reach the age of 21. However, the trust may contain a provision that would allow the child to extend the term of the trust beyond their 21st birthday.
When a child is under the age of 21, contributions to 2503(c) trusts qualify as present interest gifts for gift tax purposes. Therefore, the donor may take advantage of the $11,000 annual gift tax exclusion for contributions made to the trust.
Similar to custodial accounts, contributions made to a 2503(c) trust are irrevocable. Once the trust is funded, it will remain in place until the child reaches the age of 21.
Also, once the donor designates the trust beneficiary, the beneficiary designation cant be changed to another individual. Unlike custodial accounts, the fees associated with establishing and maintaining a 2503(c) trust may become costly. An individual will be burdened with attorneys fees associated with the drafting of the trust document as well as a possible annual trustee fee.
In addition, the trust will be required to file an annual income tax return. Trust tax rates are similar to individual income tax rates; however the tax brackets are compressed. In 2004, a trust with taxable income in excess of $9,550 would be taxable at the 35% federal income tax rate. Conversely, a married couple filing a joint tax return in 2004 would require taxable income in excess of $319,100 in order to reach the top federal income tax bracket of 35%. Therefore, there is an unfortunate possibility that the trust would remit a higher tax liability than if the donor retained the assets and paid the tax on their individual income tax return.
Impact on Financial Aid
A 2503(c) trust will be included in the childs asset base for the federal financial aid formula.
A Coverdell Education Savings Account (ESA) is a savings vehicle that allows individuals to accumulate money in a tax-deferred manner. Contributions to ESAs are funded with aftertax dollars. If the account is utilized to pay qualified education expenses of the beneficiary, all distributions are exempt from federal income tax. State taxation of qualified withdrawals varies amongst the states.
Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001, the Coverdell ESA was known as the Education IRA. The Education IRA was not a very popular college savings tool, as contributions to this type of account were limited to $500 per beneficiary, per year.
With the passage of the 2001 Tax Act, Education IRAs were modified to Coverdell ESAs, which include several new features unavailable for the original Education IRA. Starting in 2002, the contribution limit to an ESA was increased from $500 to $2,000 per beneficiary, per year.
One of the major advantages of establishing an ESA is that the account can be used to cover not only college expenses, but funds may be distributed to cover the beneficiarys elementary and secondary school expenses.
Another advantage of establishing an ESA is the availability of unlimited investment options. An ESA provides complete control of investment options, which can be tailored to satisfy both taxpayer and beneficiary objectives.
In addition, an ESA can be rolled over to another ESA established for the same beneficiary or a family member of the original beneficiary without subjecting it to any income tax or penalty.
Distributions from an ESA do not preclude an individual from utilizing either the Hope Scholarship Credit or Lifetime Learning Credit. However, in order for the distributions to be tax-free, qualifying withdrawals from the ESA must not be used as qualified tuition and related expenses for purposes of the calculation of these credits.
There are two main drawbacks regarding contributions to an ESA:
If the parents are unable to contribute because of the income limitation, an ESA could be established by a grandparent or family friend for the benefit of the child.
Generally, contributions to an ESA can only be made for beneficiaries that are under the age of 18.
In addition to the age limit on contributions, all remaining funds in the ESA must be distributed when the beneficiary reaches the age of 30. These distributions will be treated as taxable income to the extent of earnings, plus a 10% tax penalty. Since contributions are made with aftertax dollars, the portion of the distribution that represents the original contribution is not subject to income tax or penalty. If the beneficiary is an individual with special needs, there is no age limit on when contributions can be made to the ESA or when distributions must be paid.
Impact on Financial Aid
A Coverdell ESA is included in the parents asset base for the federal financial aid formula. Additionally, distributions from an ESA used to cover qualified education expenses are not considered income of the parent or student for federal financial aid purposes.
Section 529 of the Internal Revenue Code established two types of qualified tuition programs: savings plans and prepaid tuition plans. The 529 plans are tax-deferred savings vehicles that allow individuals to accumulate money for their childrens or grandchildrens college education. These plans were first introduced with the passage of the Small Business Job Protection Act of 1996, but they were significantly modified in the 2001 Tax Act, and have since become extremely popular college savings options.
|Prepaid Tuition and Savings Plans: A Quick Comparison|
Generally, money contributed to a qualified tuition program accumulates on a tax-deferred basis for both federal and state income tax. Distributions from the plan used to cover the beneficiarys qualified education expenses are completely tax free for purposes of federal income taxation. However, state taxation of 529 plan distributions varies by state. The federal tax-free treatment of qualified withdrawals is scheduled to expire after December 31, 2010, unless Congress extends the tax-free provision.
Individuals of all income levels may make contributions to 529 plans. Unlike Coverdell ESAs, there is no income limitation for individuals to participate. Additionally, contributions to qualified tuition plans are considered completed, present interest gifts for federal gift tax purposes, which allows contributions to the plans to qualify for the $11,000 annual gift tax exclusion. There is a special election available that allows an individual to contribute up to $55,000 in a single year to a 529 plan and treat the gift as made over a five-year period for gift tax purposes. Depending on the state in which the plan is established, total contributions to the plan could be as high as $250,000.
State income tax benefits/incentives for 529 plans vary by state. These benefits may include a state income tax deduction or credit for contributions to the plan, as well as full or partial exemptions from state income tax on qualified withdrawals. However, some states only offer these benefits/incentives to their own residents.
Starting in 2002, individuals were permitted to make contributions to a 529 plan and Coverdell ESA in the same year for the same beneficiary without incurring any tax penalties. Prior to 2002, if an individual made contributions to both types of accounts, they were subject to an excise tax on the contributions.
Additionally, an individual may claim either the Hope Scholarship Credit or Lifetime Learning Credit in the same year as a qualifying withdrawal from a 529 plan.
However, as is the case with ESAs, any tuition expenses covered from 529 plan withdrawals may not be included in the calculation of either credit.
A type of Section 529 plan, 529 savings plans are typically established by states and managed by an experienced financial institution designated by the state. These savings plans allow individuals to contribute money to an investment account for the benefit of their childs college and/or graduate school education.
One advantage 529 savings plans offer is professional money management. Individuals have the ability to invest their funds in structured portfolios with asset allocations predetermined by the plans money manager. If an individual is dissatisfied with the investment performance of a given portfolio, they have the ability to roll over their existing 529 savings plan to a new 529 savings plan or modify the investment portfolio of their current 529 savings plan.
An individual may roll over an existing 529 savings plan to a new plan once every 12 months without any federal tax penalty; however, the state may charge a fee or assess a penalty if the individual decides to exit their plan. If the individual decides to modify their existing plan, these changes to the current investment portfolio may occur once per calendar year. Account owners have the ability to change the plans beneficiary. If the new beneficiary is a family member of the old beneficiary, no federal income taxes or penalties will be assessed.
The Internal Revenue Code defines family members for this purpose as children and their descendants, stepchildren, siblings, parents, stepparents, nieces, nephews, aunts, uncles, in-laws and first cousins. If the new beneficiary is at least one generation below the original beneficiary, gift tax consequences will apply as a result of the beneficiary change.
Since state savings plans are managed portfolios, there is no guaranteed rate of return. Savings plans have the ability to outpace the rate of college inflation. However, the risks of not keeping pace with rising college costs as well as the potential to lose part of the originally contributed funds are also factors that should be carefully considered. In addition, annual maintenance and administrative fees as well as investment expenses could significantly reduce the plans overall investment return.
For distributions used to cover expenses other than the beneficiarys qualified education expenses, the earnings portion of the distribution will be subject to federal income tax and a 10% federal income tax penalty. Non-qualified distributions will also likely be subject to state income taxes and possible state income tax penalties.
Impact on Financial Aid
Savings plans are treated as parental assets for the federal financial aid formula. Distributions from savings plans are not considered income of the parent or child for the determination of federal financial aid.
The other type of Section 529 plan is the prepaid tuition plan, which allows an individual to prepay some or all of a beneficiarys undergraduate college tuition at predetermined prices for use sometime in the future. Prepaid tuition plans may be either state-sponsored plans or, as of 2002, may be a plan sponsored by private colleges and universities.
In general, you can purchase tuition plans either by buying a contract plan or a unit plan.
Contract plans promise to cover a predetermined amount of tuition expenses in the future, in exchange for a lump sum or a series of periodic payments.
Unit plans allow an individual to purchase a certain percentage of units or credits and guarantees that whatever percentage of college costs the units cover today, the same percentage of college costs will be covered in the future.
Prepaid tuition plans allow individuals to purchase college tuition for use by the beneficiary in the future. This allows individuals to lock in the future cost of college tuition at todays dollars. These plans will keep pace with the inflation rate of college tuition and offer the account owner some guaranteed rate of return.
In order for the beneficiary to receive the maximum benefit under a prepaid tuition plan, they must attend one of the participating colleges under the plan. State-sponsored plans are designed to cover tuition costs at in-state public colleges. If the beneficiary decides to attend a different college, they will typically only receive a refund of the original contributions and nominal earnings on those contributions.
Generally, state-sponsored prepaid tuition plans are only available to residents of the state. Therefore, if you believe that the beneficiary may not attend an in-state public college, this type of plan may not be the best alternative.
Prepaid tuition plans often only cover a beneficiarys undergraduate tuition costs. Unlike 529 savings plans, prepaid tuition plans may not allow for the payment of graduate school tuition costs. Additionally, most prepaid tuition plans require that all withdrawals be made from the plan within 10 years of the time that the beneficiary starts college and by the time the child reaches the age of 30.
Impact on Financial Aid
Prepaid tuition plans are not treated as an asset of either the parent or child for the federal financial aid formula. However, every dollar distributed from a prepaid tuition plan will reduce the childs federal financial aid award, dollar for dollar.
For individuals with children or grandchildren, the rising cost of college tuition and expenses may cause a great deal of concern for the family. It is strongly encouraged that individuals consult with a professional tax adviser or financial planning adviser to tailor an education savings plan to best satisfy their financial and family needs.
Additionally, such planning will assist in determining the tax ramifications of the desired savings strategy in the taxpayers resident state as well as any impact on the childs future financial aid eligibility.
Mark H. Gaudet, CPA, CFP, is a senior manager of Private Client Advisors for Deloitte & Touche, LLP, in Cincinnati.