Alternatives for Education Savings
There’s more to education funds than 529 plans and Coverdells. Five alternate choices for your clients.
August 11, 2011
It is difficult to beat a well-chosen Section 529 plan as the vehicle of choice for funding education costs. Choosing a plan with flexible provisions, a reasonable number of well-managed investment options and a reasonable cost structure should probably be a central feature of most education funding strategies.
But Section 529 is not the only game in town. After a brief overview of Section 529 plans, this article explores other education funding options, such as Education Individual Retirement Accounts (IRAs), custodianships, trusts for minors, U.S. Savings Bonds, cash-value life insurance and individually-owned assets or savings.
Section 529 Plans
Qualified Tuition Programs (QTPs) are usually state-sponsored programs that may be Section 529 savings accounts or prepaid tuition programs. Both are referred to as QTPs or Section 529 plans, because they are described in Internal Revenue Code (IRC) Section 529. Eligible private institutions, such as colleges and universities can also sponsor prepaid tuition programs, but not savings account plans.
Any U.S. citizen can set up most QTP accounts for any beneficiary. However, some states limit participation to their residents. Interested persons should shop around for the state plan that offers the most attractive program. For example, investment options and contribution limits vary among plans, expenses and cost structures differ and state tax benefits may be offered.
Contributions to a QTP are not deductible for federal income tax purposes, but some states offer tax benefits to their residents. Contributions are considered a completed gift of a present interest from the account owner to the designated beneficiary, qualifying for the annual exclusion for both gift tax and generation-skipping tax (GST) purposes.
An account owner may elect to treat a single year’s gift as if it were made over five years for purposes of applying the annual exclusion. Thus, in 2011, one person can contribute up to $65,000 ($13,000 annual exclusion times five years) and a married couple electing gift-splitting can contribute $130,000 for each beneficiary.
QTP earnings are not taxed currently. They are also not taxed upon distribution, if the funds are used to pay qualified higher education expenses. Otherwise, distributions are taxed as ordinary income, with an additional 10-percent penalty, unless an exception is met. Earnings may also be exempt from state income tax.
The balance in a QTP is generally not included in the estate of any individual for federal estate tax purposes. The only exception is if a donor to a QTP elected the five-year annual exclusion treatment and dies within the five-year period. In this case, the “unearned” exclusion amount is included in the donor’s estate.
The estate tax exclusion applies even though the account owner retains the power to direct when distributions will be made, can change the designated beneficiary and can even demand return of the account balance. These rules can make Section 529 plans a powerful estate-planning tool.
Education IRAs (Coverdell Education Savings Accounts)
Education IRAs can also be used to pay qualified higher-education costs. Unlike Section 529 plans, Education IRAs can also be used to pay for qualified elementary and secondary education expenses for grades K through 12. Thus an Education IRA can be used to fund private school tuition. Education IRAs have greater investment latitude than do Section 529 plans and are not subject to varying state rules.
Nothing prevents a contributor from establishing both an Education IRA and a Section 529 plan for the same beneficiary.
A major drawback is the annual contribution limit, currently $2,000 per beneficiary. In addition, the designated beneficiary must be under age 18 or a special needs beneficiary.
Contributions are not permitted by higher-income taxpayers. For 2011, no contribution is permitted for joint filers with modified adjusted gross income (AGI) over $220,000 ($110,000 for all others).
Earnings are not taxed currently and they are also not taxed upon distribution, if the funds are used to pay qualified education expenses. Otherwise, distributions are taxed as ordinary income, with an additional 10-percent penalty.
A custodianship created under a uniform transfer or uniform gifts to minors act allows distributions to the beneficiary or payments for the beneficiary’s education expenses or for any other purpose. The advantages of custodianships are that contributions can be made in kind (e.g., appreciated securities) as well as in cash. The custodian has wide investment latitude and the assets can be used by the beneficiary for any purpose (e.g., education, travel, starting a business, etc.).
On the other hand, earnings in the account are taxed currently to the beneficiary. Also the account must go outright to the beneficiary at the statutory age (usually age 21). At that point, the beneficiary has absolute control over the funds.
If the custodian invests the funds in a Section 529 plan, the beneficiary will gain ownership of the account at the statutory age and the original donor cannot recover the funds.
Trusts for Minors
The trustee can be given authority to use trust income or assets for any purpose, including education of the beneficiary. Like a custodianship, contributions can be made in kind and earnings of the trust are taxed currently — to the trust if accumulated or to the beneficiary if paid out. In the case of an IRC Section 2503(c) trust, the assets must go outright to the beneficiary at age 21, unless the beneficiary consents to their remaining in trust. And if the donor retains the power to recover the trust assets, they will be included in the donor’s estate.
Some QTPs allow trustees to open Section 529 plans for trust beneficiaries with cash from the trust. In this case, the trust is the account owner and the trust beneficiary is the designated beneficiary of the QTP. The trustee can direct qualified distributions, change the beneficiary or recovery the QTP account. Of course, the trustee has a fiduciary duty to the trust beneficiaries to properly administer the assets of the trust, including the QTP account.
U.S. Savings Bonds
Two kinds of savings bonds now being issued are Series EE (or E) and Series I, which are inflation-adjusted. There are also Series HH bonds, but they are no longer being issued.
When investors redeem EE and I bonds, the difference between the purchase price and the redemption value is taxed as ordinary income. However, investors can elect to be taxed annually as the interest accrues. In addition, Series I bonds and some EE bonds used for tuition and fees at colleges, universities and qualified technical schools, can be excluded from the bond owner’s income under certain conditions.
To qualify for the exclusion, the bond must be issued after 1989 to an individual who was at least 24 years of age at the date of issuance. In the year of redemption, the bond owner must pay qualified education expenses for himself, his spouse or a dependent. The exclusion is also available for contributions to a QTP.
The exclusion is available only if the bond owner’s modified AGI is below a statutory amount in the year the bond is redeemed. For 2011, the maximum is $136,650 for joint filers and $86,100 for all others. Because the bond owner’s income could rise above the threshold before the bonds are redeemed, there is a possibility that the exclusion will not be available.
Cash Value Life Insurance
Some parents purchase life insurance policies on themselves to accumulate cash value, which can be used for education expenses, either through policy loans or withdrawals, if the insured survives. If the insured should die or become disabled before the education is completed, the death proceeds or waiver of premium benefit are accessible to complete the education plan. An irrevocable life insurance trust can also own the policy for estate-tax reasons.
Traditionally, people have saved or accumulated assets in anticipation of using those funds to pay for their children’s education. This approach is simple and has a number of advantages. The owner controls the assets and their use. If the education plans do not materialize to the parents’ satisfaction, they still own the assets.
Income from those assets will be taxed to the owner and the assets will remain in the owner’s estate. The owner can use the unlimited gift-tax exclusion for direct payments of tuition. The choice of investments can be tailored to the owner’s overall investment strategy.
ConclusionA Section 529 plan should probably be a core part of most education funding strategies. However, like so many aspects of one’s financial life, there are advantages to a diversified approach.
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Michael R. Redemske, CPA, is an instructor in residence at the University of Connecticut where he teaches federal income taxes and personal financial planning.