Planning for college now requires an understandingof the many available programsand government breaks. Timing of expenditures,tax strategies, and estate planning issues hasbecome more relevant in the college planningarena. The current programs allow for changes,without serious consequences, if a child'splan changes when college rolls around.Funding a college education is a 2-pronged strategy, involving the use of thebest programs available to accumulatefunds and the use of all available taxbreaks when paying for college.
KNOWING THE TAX BREAKS
The best tax breaks right now arethe Hope Scholarship credit and theLifetime Learning credit (www.ed.gov/inits/hope). These are credits,not deductions, and as such theydirectly reduce your tax bill. If youwere in the 31% tax bracket, a $1000deduction would reduce your taxes byonly $310. But a $1000 credit wouldbe taken right off your tax bill.
• Hope Scholarship creditâ€”TheHope credit is only for the first 2 yearsof college. It's a credit equal to 100% of the first$1000 in tuition and fees, 50% of the next$1000, to a maximum credit of $1500. Althoughthis may not seem like much, a $1500 credit forsomeone in the 31% tax bracket is the equivalentof a $4839 deduction.
The credit is phased out between incomes of$40,000 to $52,000 for single taxpayers and$82,000 to $102,000 for joint filers. Note: Thecredit is per student, not per taxpayer.
• Lifetime Learning creditâ€”This credit isfor use after the first 2 years of college. The creditcan be used for both undergraduate and graduateexpenses. The credit is equal to 20% of up to thefirst $5000 of qualified tuition and fees, to a maximumof $1000. The income phaseout is the sameas with the Hope credit. In this case, though, thecredit is per family and not per student. Again,being a credit, it's equal to thousands of dollars indeductions for someone in the 31% bracket.
If you use the Hope or Lifetime credits, youwon't be able to deduct other education expenses,but if your income is too high to qualify for thecredits, this may be another way to get some relief.
For the 2002 and 2003 tax years, if your incomeis less than $65,000 ($130,000 for joint filers), youmay deduct as much as $3000 per year for qualified education expenses paid. This is what's calledan "above the line" credit, meaning that even if youdon't itemize, you can take the deduction. Forsomeone in the 31% tax bracket, a $3000 deductionwould save over $900 in taxes.
Interest paid on student loans can now bededucted regardless of the age of the loan or whenit was paid. Previously, there was a 60-month limitfor deductibility, which no longer applies. Thededuction for student loan interest phases out forsingle people with incomes between $50,000 and$65,000, and between $100,000 and $130,000 forjoint income tax filers.
Coverdell Education Accounts, also known aseducation IRAs, were touted as Congress' attemptto help those saving for college. The benefits werenot all that generous, since the most that could becontributed per child (regardless of the number ofrelatives donating to the account) was$500 per year. Even with an annualreturn of 7%, the most that could beaccumulated over 18 years was $18,189,hardly enough. Also, the qualifyingexpenses were only for college costs.
The law now allows an annual contributionlimit of $2000 per child. Theexpenses that qualify now include elementaryand secondary school costs.Although contributions are not tax-deductible,the funds used for qualifyingexpenses can be withdrawn tax-free.
These accounts have income limitations,which can be avoided by havingnonrelated parties (other than parents)make the contribution. If your income istoo high, you can even gift the funds tothe child and have them make the contribution.If you invest $2000 at thebeginning of each year in a Coverdellaccount for 18 years, earning an average return of7%, you will end up with an account value of$72,758, with $36,758 of tax-free earnings.
Uniform Gifts to Minors Accounts(UGMAs), which have become very popular,were designed to save funds in the child's namewith you, their parent, as the custodian. Until age21 (18 in some states), you would control theinvestment of the money, and the income is generallytaxed at the child's lower rate.
The downside to UGMAs is that the moneybelongs to the child, and at the age of majority, thechild is free to spend the money as they wish. Theydon't need to be used for college. Many custodiansdeal with this issue by simply placing the funds injoint name and instructing the child on how tospend the funds. However, the parent has no legalright to the money.
Another downside is that even if the childdoes use the funds for college expenses, if theyhave no income tax payable, the LifetimeLearning credit, Hope credit, and college tuitiondeduction will not be of any value to the child.These tax breaks will go unused.
SECTION 529 PLANS
Section 529 plans (ie, Qualified State TuitionPrograms) are the newest and most flexible of allaccounts designed to save for education. Theplans are designed under rules set forth by thestates offering the plans.
The funds in the plan (eg, your plan is anArizona or Nebraska plan) do not have to be usedin that state, and you do not have to live in thatstate to set up a plan with that state's design. Manyof the states have similar guidelines, although someare more flexible than others. The following are 3specific features that make these plans attractive:
1. If the child for whom the account is set up(ie, the beneficiary) does not use the money for college,a new beneficiary may be named, possibly ayounger sibling or a grandchild. You can even nameyourself as beneficiary and use the funds for a sabbatical.As long as the money is used for educationat a qualified institution, it is tax-free.
2. The total amount to be contributed is notlimited per student, but rather per donor. With theannual gift tax exclusion currently at $11,000, parents,grandparents, aunts, uncles, and others mayall contribute up to the gift tax limit to the sameaccount. Another perk is that you can elect to use 5years' worth of the annual gift tax exclusion all atonce to fund the plan. This means that a marriedcouple may contribute as much as $110,000 in 1year to a 529 plan without incurring any gift tax.This feature makes for an excellent, simple estateplanning tool, especially for grandparents wishingto begin distributing their estate.
3. The type of expenses Section 529s may beused for while maintaining tax-free status is moregenerous. The funds can be used for books, tuition,and to pay for such things as an apartment up tothe amount specified in school guidelines.
For more information on Section 529 plans,be sure to call 800-400-9113 or visit www.savingforcollege.com.
Patrick J. Flanagan is aNew Jerseyâ€“based registeredrepresentative af-filiated with First MontaukSecurities, memberNASD/SIPC. He welcomesquestions orcomments at 800-969-0899. Any opinions expressedare the author's and do not necessarilyreflect the opinions of First Montauk Securitiesor its officers, directors, or affiliated registeredrepresentatives.