Contributed by Sara Zaro, Pres.
Elite Bookkeeping & Tax Services
Planning for educational expenses can be challenging when there are so many options out there for your clients to choose from. The following information outlines some of the choices available to them and explains the tax benefits associated with these options. Together you can use this newsletter to review options and potentially come up with a feasible plan for managing educational expenses.
Planning for educational expenses is no easy task. It’s hard to know how much to set aside or where to invest it. Here is a brief summary of some of the options available to you and the tax benefits associated with these options. This is by no means an exhaustive list; however it should provide you with a general knowledge with which to move forward. If after reading this you find that you have questions or would like to discuss any of the information in more depth, please give me a call.
College Facts
Before we explore the different options available for paying and saving for college, let’s first look at what going to college costs. The following information refers to the 2010-2011 school year. Keep in mind that tuition and fees at public four year colleges and universities has gone up an average of 5.6% per year beyond the rate of general inflation.
Public 2 yr: $2,713, R&B negligible
Public 4 yr, In-state: $7,605, R&B $8,535
Public 4 yr, Out of state: $19,595, R&B $8,535
Private 4 yr. Nonprofit: $27,293, R&B $9,700
Private 4 yr. For profit: $13,935, R&B neglible
By the time your child or grandchild graduates high school, it’s hard to know what your savings goal should be. There are several websites that offer a calculator that helps you predict how much a higher education will cost. Savingforcollege.com is one such website and it also offers up a wealth of information about paying for college.
Paying for College
There are a lot of ways a college education can be paid for, including both out of pocket expenses and financial aid such as scholarships, grants, loans, fellowships and work study programs. Financial aid is an important thing to keep in mind when planning how to pay for a college education. Colleges calculate student financial aid by calculating the cost of attendance (COA) then subtracting the expected family contribution (EFC). Most colleges use the information obtained from the student’s Free Application for Federal Student Aid (FASFA) form to calculate the EFC.
The formula for this calculation is made up of four parts outlined below:
1. 50% of student’s income (Adjusted Gross Income (AGI) plus untaxed income and benefits, less income protection allowance, less deductions for certain taxes)
2. 20% of certain student’s assets
3. 22-27% of parents income (AGI plus untaxed income and benefits, less income protection allowance, less deductions for certain taxes, less employment expense)
4. 2.6-5.6% of certain parent’s assets less asset protection allowance.
It’s important to remember that tax savings are often dwarfed by potential financial aid awards. Shifting assets into your child or grandchild’s name now in order to shift the tax burden of the income may later reduce their financial aid eligibility. Be sure to discuss the future impact of any tax saving transactions with your tax professional to help reduce the potentially negative impact on financial aid.
Saving for College
There are several ways to invest and save specifically for the expense of college. Having a working understanding of your options will help you to decide which is best for your needs and circumstance. Here are four options to consider. The tax benefits of the following options come from using the funds for qualified higher education expenses. In each case it is important to remember to reduce the qualified higher education expenses by tax exempt educational benefits such as the American Opportunity Tax Credit, the Lifetime Learning Credit, QTP payments or reimbursements, Coverdell Education Savings Account payments, VA benefits, grants, scholarships and fellowships.
Education Savings Bonds
Savings bonds have long been given to a child or grandchild as an investment in that child’s future. They are a very safe investment with a low to moderate return. The interest earned on the savings bond is tax free if the bond proceeds (principal plus interest) are used to pay for qualified higher education expenses. If you elect to exclude the interest on your tax return, it must be done in the year you redeem the savings bond.
Traditional and Roth IRA’s
IRA’s are usually thought of as a way to save for retirement because there is typically a 10% penalty for funds withdrawn before age 59 ½. However, they should not be overlooked when considering saving for education. With a traditional IRA, your contributions can be tax deductible and can grow tax deferred. With a Roth IRA, your contributions aren’t deductible, but they do have the potential to grow tax free. With either option, you can contribute 100% of your earned income up to the annual contribution limit ($5,000 or $6,000 for 50 and older). With a traditional IRA, if you and/or your spouse have earned income and you are filing jointly, you are eligible to make contributions until the year you reach 70 ½ years old. There is no age limit with a Roth IRA, however your modified adjusted gross income must fall within certain limits depending on your filing status. If you aren’t eligible to contribute to a Roth Ira, consider converting your Traditional IRA over and enjoy tax free earnings in the future.
Coverdell Education Savings Accounts (CESA)
Coverdell Education Savings Accounts are a very attractive college savings vehicle for many people. With a CESA you can make non-deductible contributions to a specially designated investment trust account. The account grows federal tax free and when used for qualified higher education expenses, withdrawals are also tax free. If funds are used for something other than qualified education expenses, then there is a 10% penalty and income tax must be paid on the earnings.
CESAs allow anyone to deposit up to $2,000 a year for an eligible beneficiary without being taxed on earnings, so long as their modified adjusted gross income falls within the allowable limits. Contributions can come from family, friends, neighbors and even corporations. The eligible beneficiary must be under age 18 at the time of deposit and must use the funds before age 30. If the funds are not withdrawn before the beneficiary reaches age 30, a portion of the earnings on the account will be taxable and subject to an additional 10% tax. These taxes may be avoided by rolling the account over for another family member. The age 18 and age 30 limitations are waived in special needs cases. Beneficiaries of CESAs should receive a form that shows the amount contributed during the year. If the amount reported exceeds the $2,000 limit, corrective action should be taken as soon as possible in order to avoid a 6% excise tax.
As mentioned earlier, some of these savings options can have an adverse impact on the beneficiary’s eligibility for financial aid. CESAs are treated as an asset of the account holder. If the account holder is a student, this could have a high impact on eligibility; however, if the account is owned by a dependent student, it is considered an asset of the parent for financial aid purposes. If the account is owned by the parent, there is a low impact on financial aid regardless. Also, qualified distributions from a CESA are not counted as income on the FASFA and therefore do not reduce eligibility.
529 Plans
A 529 Plan is an education savings plan operated by a state or educational institution designed to help families set aside funds for future college costs. The state sets up the plan with an asset management company of its choice and you open an account with that asset management company according to the state’s predetermined plan features. Every state now has at least one 529 Plan available, and it is up to each state to determine what its plan will look like. Fortunately, you are not restricted to your state’s 529 Plan. You can live in Vermont, choose a plan from Iowa and go to school in California. It pays to research a variety of plans being offered to ensure that you choose the one best suited to your needs.
The benefits of a 529 Plan are similar to those of a CESA. You pay no federal taxes on the accounts earnings provided that when they are withdrawn they are used for qualified education expenses. In most states, earnings are also tax deferred. As with a CESA, 529 Plans should be reported as a parental assent when owned by a dependent student. Anyone can contribute, but unlike a CESA there are no income limitations that might make you ineligible. There is also no age limit for when money has to be used. If the beneficiary chooses not to attend college, the account can be rolled over to another family member. If the beneficiary ends up getting a scholarship, any unused money can be withdrawn without paying a penalty, just the taxes. Perhaps the greatest difference between a CESA and a 529 Plan is who has control of the account. With a CESA, the beneficiary typically gains control of the account at age 18. However, with a 529 Plan, you retain control of the account.
There are two types of 529 plans. The first is a prepaid tuition plan that is state sponsored and has residency requirements. This option allows you to lock in tuition prices at eligible colleges and universities, which provides a hedge against tuition inflation. All prepaid plans cover tuition and mandatory fees, though some allow you to purchase a room and board option or use excess tuition credits for other qualified expenses. The second type of 529 Plan available is the college savings plan. While this option doesn’t allow you to lock in college costs at today’s rate, it can be more appealing due to its high flexibility. There are no age or residency restrictions and no contribution limits. All investment options come with risks; however there are age based portfolios available that automatically shift towards more conservative investments as the beneficiary moves closer to college age which reduces the risk.
You can find more information regarding specific plans in their offering circular, or disclosure statement. The National Association of State Treasurers created the College Savings Plan Network which provides links to most 529 plan websites.
Planning for education expenses is no small task. Your tax professional can give you more detailed information about the options discussed here. It is important to ask questions so you can be as informed as possible when moving forward. Naturally, the earlier you begin saving for college, the more money you will accrue. All of these options will have some impact on financial aid, so be sure to take everything into consideration.
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