Evaluating the Incentives for Education Savings

12/3/2001

With the cost of education continuing to rise at twice the rate of inflation, individuals are giving greater attention to the funding issues while Congress has continued to expand the tax incentives for various approaches to financing. In addition, a new Minnesota college savings plan, a compliment to plans currently available in over 40 states, focuses attention on the alternatives available to Minnesota residents. Because these plans are available to all under federal law, this article is applicable to all individuals, whether Minnesota residents or not. Lommen Nelson is pleased to provide you with information about how both the new and old provisions may impact your education funding plans. Our job includes keeping you informed so that you can make wise choices. If you would like to set up a meeting to address specific concerns, please contact us at: 612-339-8131 (Minneapolis), 715-386-8217 (Hudson), or 800-752-4297 (toll-free); or drop us an email or a note. If you would like more information about education savings incentives or other topics such as estate planning or tax planning, please contact Scott Nelson at 612-336-9320 or scott@lommen.com.

WHICH EDUCATION SAVINGS PLANS FIT YOUR NEEDS?

What are the pros and cons of the various education savings options? Learning more about the methods available will help you select the ones that fit your needs.

Section 529 Plans. Perhaps the most popular program is the “Section 529 Plan,” otherwise known as a qualified tuition program. These plans should not be confused with the earlier and different plan called a “Prepaid Tuition Program,” which allowed you to prepay the tuition for a particular state’s University system, but did not allow the funds to be used at private schools, or at state institutions in other states. The 529 Plans are extremely flexible and a powerful financial planning technique. These plans are sponsored by a particular state and a reputable financial company, in most cases a mutual fund company or brokerage firm. Although there is no tax deduction for the money that is contributed to a 529 Plan, the earnings grow tax-deferred, and beginning January 1, 2002, are completely tax free if used for tuition, room and board, books, supplies and fees at an undergraduate or graduate institution. Unlike many other tax benefits, there are no income limits on who can contribute. Perhaps the most unique characteristic of these plans, however, is that the individual making the contribution can continue to control the account, but the assets in the account are not treated as part of the person’s estate for estate tax purposes. The amount contributed is treated as a gift for gift tax purposes, but there is no gift tax consequence if the amount is less than $10,000 per beneficiary per year. There is also a special rule which allows you to accelerate five years of gifts and put in $50,000 immediately. If a person dies within the five years, then a portion of the accelerated gift may be attributed to their taxable estate. Although the plans are sponsored by a particular state, the funds can be used to pay school expenses at any accredited higher education institution. Beginning in 2005, 529 Plans can also be sponsored by any accredited post-secondary institution (including independent colleges) or a consortium of such institutions.

Perhaps the biggest complaint about these plans is the limited investment options that may be available. Typically a plan will allow a choice among three or four different investment mixes, and usually in a mutual fund or similar investment. The new tax law allows transfers between plans once every 12 months and contributions to a 529 Plan no longer preclude the funding of an Education IRA, or claiming the Hope or Lifetime Learning credits, in the same year. It is also expected that the 529 assets will be treated as the assets of the contributor for financial aid purposes. If a parent establishes the account, then the assets will be treated as the parent’s assets when the child applies for financial aid. If the grandparents set up the account, it will be treated as the grandparents' assets and not included at all in the financial aid calculation.

If withdrawals are made for non-education expenses, then the portion of the withdrawal treated as coming from earnings will be subject to ordinary income tax as well as a 10% penalty. In some cases there also may be an additional 10% state penalty on the earnings withdrawal. The amount that can be contributed to each plan differs with the projected cost of education in that particular state. For Minnesota residents, the new Minnesota plan currently allows a maximum contribution of $122,484, while the most liberal plans in the country currently allow contributions of up to $265,620. Depending on the desired level of funding, individuals may need to consider use of the plans in states that allow a higher maximum contribution. For Minnesota families with incomes less than $80,000, the state has a matching grant of up to $300 available for contributions to the Minnesota plan.

Employer-Paid. Congress has extended the availability of employer-paid education expenses of up to $5,250 per year for tuition, fees, books, supplies (but not room and board). They have included graduate school expenses and specified that the education does not have to be work-related.

Coverdell Accounts. Because of the popularity of Section 529 Plans, the Education IRA’s (now referred to as “Coverdell Education Savings Accounts”) will not be as popular. They can be established for children under the age of 18 for the purpose of paying qualified educational expenses, but no deduction is available on contributions. Earnings again grow tax free and can be withdrawn for qualified expenses with no income tax on the earnings. No more than $2,000 can be contributed by everyone for the benefit of a particular beneficiary, and there are restrictions on who can fund such an account, based on adjusted gross income. The one advantage over the 529 Plan is that withdrawals can be made for tuition, fees, academic tutoring, books, supplies, room and board, uniforms, transportation, computer technology or equipment for kindergarten through grade 12 at any school. From a planning perspective, clients may wish to consider making maximum contributions to a Coverdell Account to cover the costs of K-12 education, and make larger contributions to 529 Plans for higher education. The new tax law also allows entities other than individuals, such as corporations, to make contributions to a Coverdell Account for employees, without regard to the contributor’s or beneficiary’s income level. Although Section 529 contributions must be made by the end of the calendar year, Coverdell Accounts can be funded up to the time of filing a timely tax return for the tax year.

Tuition Deduction. For certain taxpayers with an adjusted gross income of less than $130,000, a deduction will be available “above the line” for tuition and fees paid during the year. The limit in 2002 and 2003 will be $3,000 for tuition and fees at an accredited undergraduate or graduate school, while the limit will increase to $4,000 in 2004 and 2005. The amount of the deduction decreases as AGI increases. A deduction is not available when taking a Hope or Lifetime Learning credit in the same year, or for amounts withdrawn from a Coverdell Education Savings Account, but is allowed for the principal or contribution portion withdrawn from a 529 account. The deduction is currently scheduled to expire in 2006.

Loan Interest. An above the line deduction is also available for the amount of student loan interest paid, with a maximum annual deduction of $2,500. A deduction is not allowed to an individual if that individual is claimed as a dependent on another taxpayer’s return for that taxable year. The amount deductible is phased out for married taxpayers with an AGI greater than $100,000 ($50,000 for single filers).

Hope and Lifetime Credits. Finally, for families with an AGI of $100,000 or less, there is an annual Hope and Lifetime Learning tax credit available for expenses during the calendar year. For joint returns with an AGI of $80,000 or less (single filers with an AGI of $40,000 or less) the maximum credit is $1,500 toward federal income taxes due, for tuition and/or fees required for attendance. The Hope credit is 100% of the first $1,000, plus 50% of the next $1,000, paid for each eligible student at an accredited college for a maximum two years for each student. The Lifetime Learning credit is 25% of the first $5,000 paid for qualified expenses for all eligible students in the family. It is available for undergraduate and graduate school and has no limit on the number of years that it can be taken. Both the Hope and Lifetime Learning credits can be claimed in the same year as a withdrawal from a Coverdell Education Savings Account or 529 Plan, so long as the distribution from the Coverdell or 529 account is not used for the same qualified educational expenses for which a credit is being claimed.

The following is a chart that will help to compare these various options:

1. Per Prop. Reg. 1.25A-1(g), parents may elect to forego claiming student as dependent to allow credit in child’s return.
2. Same tuition/fee expenses cannot be used for both privileges.
3. Except no higher education deduction is allowable for amounts distributed from an Education IRA.
4. Except no higher education is allowable for the tax-free income portion of 529 plan distribution.

For more information, contact Scott Nelson at 612-336-9320 or scott@lommen.com.