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A Grandparent's Guide to College Funding
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Grandpa Chuck
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Aug 16, 2001 16:54 PDT
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Morningstar.com
A Grandparent's Guide to College Funding
By Sue Stevens
According to the U.S. Census Bureau data, investing in education pays
off big in future rewards. The median income for an individual with a
high school diploma is $19,500 (rounded). That jumps to $31,500 for
those fortunate enough to earn a bachelor's degree. At the top of the
scale, professional degrees propel the median income level to $56,900.
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Education is the key to all of our futures.
Grandparents often want to help their grandkids take advantage of every
possible educational opportunity. Today that means giving the
grandchildren access to a computer and helping them learn how to
navigate the Internet as well as giving them the opportunity to study
advanced intellectual concepts.
The playing field has greatly expanded with the enactment of the
Economic Growth and Tax Relief Reconciliation Act of 2001. Here are the
pros and cons of the most popular college-funding vehicles today:
1) Education IRA
2) Section 529 Savings Plans
3) Section 529 Prepaid Tuition Programs
4) UTMA/UGMA (Uniform Transfer to Minors Act/Uniform Gifts to Minors
Act)
5) 2503(c) Minor's Trust
6) Pay Tuition Directly to College
7) Gift Money to Parents
8) IRA Withdrawal
9) Savings Bonds
10) Hope Scholarships, Lifetime Learning Credits, and Tuition Tax
Deductions
<subhead>Education IRA</subhead> This is not a retirement vehicle, but a
college savings account. Can be set up with almost any broker or mutual
fund company.
Pros: -Great flexibility of investment choice. -Expenses may be lower
than in some state 529 plans. -Money can be used for primary and
secondary education expenses starting in 2002. -Tax-free withdrawals for
qualified education expenses (tuition, fees, tutoring, books, supplies,
related equipment, room and board, uniforms, transportation, extended
day programs, computers, Internet access). -Can make contributions up
until April 15 of the following year. -Anyone can contribute if they
meet the earnings requirements (not just family members; corporations
may contribute starting in 2002). -Can contribute to both an education
IRA and a 529 plan starting in 2002, but watch out for gift tax
consequences if you contribute more than $10,000 per person in the same
tax year. -Can still claim HOPE and lifetime learning credits as long as
the payout from the education IRA isn't used for the same expenses for
which credit is taken. -If you don't meet the earnings requirements (see
below), you can gift $2,000 to the beneficiary and let them set up their
own account.
Cons: -Total contributions may not exceed $2,000 a year per beneficiary.
-No matter how many people contribute, total contributions per child
can't exceed $2,000. -Earnings restrictions: If you earn
$95,000-$110,000 (single) or $190,000-$220,000 (married filing joint),
contributions will be limited; if you earn more than $110,000 (single)
or $220,000 (married filing joint), contributions are not allowed.
-Beneficiaries must be under age 18 when contributions are made (except
special-needs beneficiaries). -Money must be used by age 30 or earnings
are taxed as ordinary income plus a 10% penalty (except special-needs
beneficiaries). To avoid this taxation, accounts can be rolled over into
another family member's Education IRA. -Beneficiary owns the account. If
they don't go to college or use the money for primary or secondary
school, the donor can't get his/her money back. -Since the beneficiary
owns an Education IRA, less financial aid may be available. -No state
tax deduction for contributions. -No guarantee of positive investment
returns. Account can lose money.
<subhead>Section 529 Savings Plans </subhead>These are state-sponsored
college savings plans. Anyone can contribute money on behalf of a
beneficiary. Contributions are invested according to options directed by
the state.
Pros: -Money can be used for any college in the U.S. -Can be state tax
breaks for contributions.Tax-free distributions for qualified expenses
(tuition, fees, books, supplies, required equipment, room and board)
starting in 2002. -Can still claim HOPE and Lifetime Learning Credits as
long as the payout from the 529 plan isn't used for the same expenses
for which credit is taken. -Can roll over to another plan once every 12
months for same beneficiary. -Can roll over more often than once every
12 months if changing beneficiaries to another family member. Family
members include child, grandchild, sibling, stepsiblings, parents,
grandparents, stepparents, nieces, nephews, cousins, aunts, uncles,
in-laws, and spouses. -Can gift up to $50,000 a year per child without
triggering gift tax (gift assumed to be $10,000 ratably over five
years). Effectively removes this money from your taxable estate (if you
die within five years, a portion may be included in your taxable
estate). If you gift split with your spouse, you can get $100,000 out of
your estate without triggering gift tax. -Can contribute to both an
Education IRA and a 529 plan starting in 2002, but watch out for gift
tax consequences if you contribute more than $10,000 per person in the
same tax year. -Can contribute more than $50,000 a year and use
increased unified credit ($1,000,000 starting in 2002) to offset the
gift tax. Check with each state plan to verify the maximum contribution.
-Donor retains control of account. If beneficiary doesn't go to college,
donor can get his/her money back although they would owe tax on the
earnings and a 10% penalty. -No earnings restrictions. -Since donor owns
these accounts, beneficiary may be eligible for more financial aid than
if the child owned the account. -No limited enrollment period. -No date
by which the funds must be used. -Some states will allow you to
contribute by using your credit card. You may be eligible for rewards
from your credit card company (check to make sure there are no monthly
caps on rewards. For instance, on some credit cards there is a $10,000
per month reward cap. So in that case, you might want to contribute
$10,000 per month for five months to get the maximum rewards.)
Cons: -Must use state chosen investment options. -You could lose money
in more aggressive investment options. -Expenses of the plan may be
higher than what you'd pay if you invested the money yourself. -A
nonqualified withdrawal (used for purposes other than specified
education expenses) will be taxed on earnings and will incur a 10%
penalty. Exceptions to the penalty include death or disability of the
beneficiary or if the beneficiary receives a scholarship. -States may
limit contribution amounts. -Since donor owns the account, it may be
tapped by Medicaid if the donor should need nursing home care and not
have other funds available. All the more reason to have long-term care
insurance (read ``Why You Need Long-Term Care Insurance''). -Not all
states have protections against donor's creditors.
Choosing among state 529 savings plans: If you think a 529 savings plan
is the way to go, you should first look at the plans in your own state
or the state in which the beneficiary lives. Go to
www.savingforcollege.com for information on individual state plans as
well as general information.
Look for state tax breaks on either contributions or distributions. Your
next step will be to compare those state plans to other state plans to
see what types of investment options are available. Here's a guide to
some of the fund families that are managing these plans:
TIAA-CREF California (4 caps*) Connecticut (4 caps*) Idaho (3 caps*)
Michigan (2 caps*) Mississippi (3 caps*) Missouri (4 caps*) New York (4
caps*) Oklahoma (4 caps*) Tennessee (2 caps*)
Vanguard Iowa (3 caps*) Utah (4 caps*)
Fidelity Delaware (4 caps*) Massachusetts (4 caps*) New Hampshire (4
caps*)
*As rated by www.savingforcollege.com for non-residents
<subhead>Section 529 Prepaid Tuition Programs</subhead> These are
state-sponsored programs that allow anyone to purchase tuition credits
or certificates on behalf of a beneficiary.
Pros: -Benefits federally tax-exempt (starting in 2002) if used for
qualified expenses. -Starting in 2002, private institutions can offer
these plans. (Right now only states offer them.) Tax-free benefits
starting in 2004. -If child attends in-state school, costs are covered
by credits or certificates purchased. -By buying prepaid tuition
credits, you lock in future tuition costs at today's rates. -There may
be state tax breaks when you contribute. -No investment risk, unless the
state mismanages the funds.
Cons: -May have limited enrollment period. -May significantly reduce
opportunities for financial aid. -Limited availability: Typically the
donor or beneficiary must be a resident of the state. -If child attends
out-of-state school, not all the costs may be covered.
<subhead>UTMA/UGMA (Uniform Transfer to Minors Act/Uniform Gifts to
Minors Act)</subhead> This is a custodial account set up on behalf of a
minor.
Pros: -No earnings restrictions, although amounts in excess of $10,000
per person ($20,000 if gift splitting with spouse) will be subject to
gift tax. (May be able to use unified credit to offset excess gift tax.)
-Can invest in wide variety of investment vehicles. -Easy to open. -Less
expensive than setting up a trust. -Psychological benefit of earmarking
funds for college funding.
Cons: -Child takes control of the money at the age of majority (18 or
21). -Income taxed to the child each year. When the child is under age
14, first $750 is not taxed due to standard deduction. The next $750 is
taxed at the child's rate (starting in 2002, the lowest tax rate will be
10%) and anything above $1,500 will be taxed at the parents' rate. At
age 14 and older, income is taxed at the child's rate (first $750 not
subject to tax due to standard deduction). Parent is responsible for
making sure an income tax return is filed on the child's behalf. -If you
serve as custodian of the account and you die, the UTMA/UGMA will become
part of your taxable estate. -Since child is owner of account, more of
this money will be counted toward the family contribution when
determining financial aid eligibility. -Gifts made to UTMA/UGMA accounts
are irrevocable. -Accounts must be terminated once the child reaches age
of majority. -No guarantee of investment results; accounts can lose
money.
<subhead>2503(c) Minor's Trust</subhead> This is a separate entity set
up to manage money on behalf of a minor.
Pros: -Trustee has ability to spend money on behalf of the minor until
they reach age 21. -Can contribute an unlimited amount, but amounts in
excess of $10,000 per year per beneficiary ($20,000 if gift splitting)
may be subject to gift tax. (May be able to use unified credit to offset
gift tax.) -Trust can continue after child turns 21 if child agrees.
-Trustee can invest in a wide variety of investment vehicles.
Cons: -May be expensive to set up. -Child gains control at age 21.
-Income taxed at trust rates. -Gift to trust is irrevocable. -May
decrease chances of receiving financial aid. -No guarantee of investment
results.
<subhead>Pay Tuition Directly to College</subhead> Pros: -Unlimited gift
tax exemption if you pay tuition directly to the educational
institution.
Cons: -Only applies to tuition--other expenses are excluded. So you may
want to use a combination of college funding vehicles like a Section 529
plan (for nontuition expenses) and direct tuition payment. -Mortality
risk. You may die before you can pay the tuition directly. -Limits
financial aid.
<subhead>Gift Money to Parents</subhead> Pros: -Parent controls the
account. -Money can be invested in wide variety of vehicles (funds,
stocks, bonds, etc.). -Assets owned by the parents are included to a
lesser degree than assets owned by the child in financial aid formulas.
Cons: -Parent could spend the money on something other than education
for the kids. -No tax breaks. -No psychological benefit of earmarking
certain funds for college funding. -Poor investment results may mean
money isn't there when child enters college.
<subhead>IRA Withdrawal</subhead> Pros: -No 10% penalty if used to pay
qualified higher education expenses (college tuition, books, fees,
supplies and equipment) of the taxpayer, spouse, child, or grandchild.
Cons: -If traditional IRA, ordinary income tax will be due on
distributions. -If Roth IRA owner hasn't been invested for five years,
ordinary income tax will be due only on earnings portion of the
distribution. -Withdrawals may limit financial aid available.
<subhead>Savings Bonds</subhead> Pros: -Safe. Backed by the U.S.
government. -EE-bonds purchased after 1989 and all I-bonds allow
tax-exempt distributions if used for qualified education expenses
(tuition and fees) and if income limits are met (see below). -Interest
exempt from state and local taxes.
Cons: -You forfeit three months of interest if you redeem before five
years. -You have to be at least 24 years old to buy the bond. -If your
income is more than $113,650 (married filing joint) or $70,750 (single),
you can't exempt the interest even if the proceeds are used for
qualified education expenses. -Only tuition and fees are qualified
education expenses. -Only the bondholder, his/her spouse or dependent
get the interest exclusion. If the grandparent holds the bond, he/she
can't claim any interest exclusion unless grandchild is dependent. -The
interest exclusion may be reduced by other education tax breaks (Hope
scholarship, Lifetime Learning Credit, scholarships, Education IRA
withdrawals, Section 529 plan withdrawals) when used in the same tax
year.
Here's more you should know about college-related tax incentive plans:
Hope Scholarship: -Taxpayers can deduct 100% of the first $1,000 of
qualified education expenses plus 50% of the amount paid over $1,000.
-Maximum credit per student per year is $1,500. -Can only use credit for
two years. -Can't be used if student has already completed two years of
college. -Can't apply same expenses to both Hope Scholarship and
Lifetime Learning Credit. -Can't claim if modified adjusted gross income
is more than $50,000 (single) or $100,000 (married).
Lifetime Learning Credit: -Taxpayers get a credit on their income tax
return of 20% of up to $5,000 for qualified education expenses actually
paid. Starting in 2003, the $5,000 limit is increased to $10,000. -No
limit to number of years the credit can be claimed. -Can't apply same
expenses to both Hope Scholarship and Lifetime Learning Credit. -Can't
claim if modified adjusted gross income is more than $50,000 (single) or
$100,000 (married).
Tuition Tax Deduction: -Starting in 2002 taxpayers who fall within
certain income limits may be able to deduct money spent on tuition and
related education expenses. -If adjusted gross income is less than
$65,000 (single) or $130,000 (married filing joint), up to $3,000 may be
deducted. (The deduction increases to $4,000 in 2004-2005.) A partial
credit is allowed if adjusted gross income is less than $80,000 (single)
or $160,000 (married filing joint). -Can't use the deduction if claiming
HOPE or Lifetime credit in the same year. -Can't use if expenses were
paid by tax-free withdrawals from Education IRA or U.S. Savings Bonds.
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