New Education Strategies

A tax change from 2006 potentially exposes investment income earned by your under-age-18 dependent child to the dreaded Kiddie Tax. Before 2006, the Kiddie Tax1 only affected the under-14 crowd. Why should you care? Because the Kiddie Tax rules can cause part (maybe most) of your child's investment income to be taxed at higher federal rates (possibly as high as 35%). Not good!

The unfavorable Kiddie Tax change wipes out two time-honored college-savings strategies. However, you can still save for college in at least three tax-smart ways. So life continues to be good as long as you keep your wits about you. Here's what you need to know.


Custodial Accounts and Crummey Trusts No Longer Work for College Savers

The new age-18 threshold for escaping the Kiddie Tax can greatly reduce or even eliminate expected federal income tax savings from setting up a Crummey Trust or an UGMA or UTMA custodial account to hold and invest funds intended to finance your child's future college costs.

For example, say you set up a Crummey Trust or a custodial account for your college-bound child a few years ago. You then gifted money to the trust or account and arranged for the funds to be invested. Since Crummey Trusts and custodial accounts are considered legally owned by your child, any gains or income from the investments are taxed to the child. To the extent the Kiddie Tax rules apply, however, the gains or income are taxed at your higher marginal federal rate. Not good!

Before 2006, it was pretty easy to dodge the Kiddie Tax problem by having the Crummey Trust or custodial account invest in growth stocks, tax-efficient stock mutual funds, and tax-deferred Series EE U.S. Savings Bonds. By hanging onto these investments until the year during which the child reached the Kiddie-Tax-free age of 14 (or a later year), the gains and accumulated interest income were generally taxed at rates paid by an unmarried taxpayer. This typically translated into a federal income tax rate of only 10% or 15% on interest income and only 5% on long-term gains. Sweet!

Sadly, the age-18 Kiddie Tax rule eliminates the advantage of following this "buy-and-hold" strategy — unless the investments can be held until at least the year during which your child turns 18. This is no problem for Series EE Savings Bonds, because they have no investment risk. But it's generally a bad idea for equity investments. You probably don't want to be forced into holding onto these more-volatile issues until right before your child's college bills start coming due.

If the Kiddie Tax problem isn't reason enough to give the cold shoulder to Crummey Trusts and custodial accounts, there's more. Funds in a custodial account will fall under your child's legal control after he or she reaches the state-law age of majority (usually 18 or 21, depending on where you live). Somewhat similarly, funds in a Crummey Trust will eventually have to be dished out to the child under terms that were established when you set up the trust. In other words, once you've contributed money to a child's Crummey Trust or custodial account, you can't get it back. It must be used for the benefit of that child.

Bottom Line: Please take my advice and forget all about establishing a Crummey Trust or an UGMA or UTMA custodial account as a college-savings vehicle. Before 2006, they had tax advantages that made them worth considering. Not anymore.


The Good News: These Three Strategies Still Work Just Fine!

While the Kiddie Tax age-18 rule makes Crummey Trusts and custodial accounts unworthy as tax-smart college-savings vehicles, you still have other attractive choices. Here are the top three, in order of how well I think they work.

Tax-Smart Option No. 1: Contribute to a 529 College Savings Account
Section 529 college-savings accounts have a great big tax advantage. Briefly, these state-sponsored programs are allowed to accumulate income and gains free of any federal-income-tax hit. When the account beneficiary (your child) begins his or her college career, federal-income-tax-free withdrawals can be taken out of the account to cover qualified education costs. Most, if not all, Section 529 plans now accept contributions of over $250,000. So you can fund the entire cost of an expensive education with a Section 529 account. Better yet, there are no income restrictions. These tax-smart college savings vehicles are available even to the "rich."

When funneling gobs of cash into an account intended for a your child's college costs, I think you should be quite concerned about what will happen to your dough if things don't go as expected. After all, your kid could decide to focus on body surfing instead of higher education. Happily, a Section 529 account gives you admirable flexibility to deal with such things. Specifically...

• You're allowed to change the account beneficiary without any adverse federal-tax consequences — provided the new beneficiary is a member of the original beneficiary's family and in the same generation or an older generation. So you effectively can take money out of a Section 529 account established for one child and move it into an account set up for another child, or even into an account set up for yourself without running up a bill with the IRS.
• Should you need to get the Section 529 account balance back into your own hands, that's permitted, too. You can pull back all or part of the money. However, you'll owe federal income tax, plus a 10% penalty on any withdrawn earnings. No tax or penalty is due on withdrawn contributions. That's a reasonable price to pay for being allowed to recover the money.

Warning: The preceding explanation describes what the federal tax law allows. Most Section 529 college-savings plans conform to these guidelines, but they are not required to do so. Make sure any plan you're considering does conform before making any contributions. For more information on Section 529 college savings plans, including state-by-state comparisons, I strongly recommend visiting savingforcollege.com2.

Tax-Smart Option No. 2: Contribute to a Coverdell Education Savings Account
Provided your modified adjusted gross income (MAGI) isn't too high, you can make annual contributions of up to $2,000 to a Coverdell Education Savings Account (CESA) set up for a child under 18. What's a CESA? It's an account set up by a "responsible person," which means you, to function exclusively as an education-savings vehicle for the "designated account beneficiary," which means your child. If you have several children, you can contribute up to $2,000 annually to separate CESAs set up for each one.

While CESA contributions are nondeductible, the account's income and gains are permitted to grow free of federal income tax. Then, federal-income-tax-free withdrawals can be taken out later to pay for your child's college tuition, fees, books, supplies, and room and board.

There's one big catch: Your right to make CESA contributions is phased out (gradually eliminated) between MAGI of $95,000 and $110,000 if you're unmarried or use married-filing-separate status. If you're a married joint filer, the phase-out range is between MAGI of $190,000 and $220,000. Fortunately, it's often pretty easy to work around this restriction. Here's how: If your MAGI precludes contributions, you can recruit another individual who has MAGI below the magic number to act as the "responsible person." Then that person can set up and make contributions to your child's CESA. For example, you may be able to enlist your parent to be the responsible person for your child's CESA. If so, you can simply give your parent the money each year to make the desired annual contributions to your child's account.

Now for a few more ground rules. CESA contributions are prohibited after the account beneficiary (your child) reaches age 18. If the CESA still has a balance after your kid hits turns 30, the account must be liquidated and all the money distributed to him or her within 30 days. But there's often a better solution. The "responsible person" (presumably you) can roll over the account balance tax-free into another CESA set up for a new beneficiary who is under age 30 and a member of the original beneficiary's family, like one of your other children.

The rollover privilege effectively allows you to use CESA funds for another beneficiary's education costs if the original beneficiary doesn't attend college or turns out to not need the money (perhaps because of scholarships). However, once you plow contributions into a CESA, you can't get the money back for yourself. Also, you lose all control over the account if you have to recruit someone else to be the responsible person. These two negative considerations don't apply to Section 529 accounts, which give us two more reasons to like them better.

Tax-Smart Option No. 3: Save With Your Own Taxable Brokerage Firm Account
You can keep things really simple by saving and investing for your child's college costs in your very own taxable brokerage-firm account. The maximum federal-income-tax rate on long-term capital gains and qualified dividends is locked in at only 15% between now and the end of 2010. This is a pretty good deal.

What if you still have some appreciated shares in the college account when your child hits college age? Consider giving some to the child. He or she can sell the shares, pay the capital gains tax hit at a lower rate (probably only 5% or less), and use the money for college. If your college account has some shares that have dipped below cost, you can sell them and claim the resulting capital losses on Schedule D of your Form 1040. Then use the cash to pay for college.

The Bottom Line
While the age-18 Kiddie Tax rule shuts some college savings doors, others remain wide open. The three options explained here are your best tax-smart choices in the current environment. Please take advantage.

Links in this article:
1 smartmoney.com/taxmatters/index.cfm?story=20060711
2 savingforcollege.com

By Bill Bischoff

The Kiddie Tax

Finally setting up a college savings fund for your little one, huh? Then you've got to decide whether to put the account in her name, or in yours. And before you make that decision, you'll need to know the lowdown on the "kiddie" tax.

This meddlesome tax (but which ones aren't, right?) was established in 1986 to catch rich parents who were trying to circumvent taxes on their investments by putting the investment assets in the names of their little children. The tax applies only to children under the age of 14 as of Dec. 31 of the year in question. (After that, a child is taxed just like an adult.)

The kiddie tax rules allow a child under 14 to receive $750 in 2003 in investment income (from interest, dividends or capital gains) free of tax. The next $750 is taxed at the child's rate — presumably 10% or 15% for income and short-term capital gains, and 10% for long-term capital gains. Anything after that is taxed at the parents' rates, which can be as high as 38.6% for 2003. That means that $504 is the most you can save in 2003 taxes when the kiddie tax applies to your child's investment income.

Here's what you give up for that savings. First, you lose control of the money once your child turns age 18 or 21, depending on your state. "If your kid decides he wants to skip college and ride a Harley around Europe for a year, he can take that money and go," warns Joan Chasen, a Framingham, Mass.-based fee-only financial planner. Second, you may be reducing your child's chances of getting financial aid. Here's why: Colleges will expect a child to contribute 35% of the assets in his or her own name to cover college expenses while parents are expected to contribute only 5.6% of theirs.

But for some parents there is a big tax advantage that may balance the drawbacks listed above: If you are bumping up against the threshold to qualify for Roth IRA and Education IRA accounts (now called Coverdell Education Savings Accounts), which are limited to certain adjusted gross incomes, you can increase your chances of qualifying by moving income to your children . "Every dollar you keep out of your adjusted income helps in terms of the myriad phaseouts in the tax code," explains David Foster, a fee-only financial planner in Cincinnati. "If you take $50,000 and put it in your kid's name, you may have removed $5,000 [of investment earnings] from your 1040 and kept AGI under $150,000." Thus, you would just meet the cutoff for opening a Roth.

Once you decide to put assets in your child's name, there are a couple ways to minimize your exposure to the kiddie tax. One is to buy tax-exempt bonds or series EE or Series I U.S. savings bonds, the interest of which isn't taxed until maturity or redemption. You can wait until the kids have grown out of the kiddie tax to cash them in, and avoid the issue altogether. Or, if the interest on bonds is less than $750 annually, you can report that income every year and pay nothing. Then, when the bonds mature, you'll pay no taxes on them. But these investments won't provide the kind of capital appreciation you probably want in a college-savings account.

If that's the case, go for stock or equity mutual funds instead. For example, you can minimize your tax bill by buying index funds, which sell stocks infrequently and thus generate few taxable gains. There are also funds specifically designed to minimize taxable gains and income by carefully selecting shares to sell so that capital losses offset capital gains or low-dividend stocks with the potential for lots of capital appreciation. You can then sell your child's stock or mutual fund shares after he or she is 14. At that point, the kiddie tax rules won't spoil the tax savings.

The 529

State-run college savings plans (aka 529 plans) are a great tool for parents. We tell you who should get a 529 and how to pick the right one.
For parents struggling to save for their children's college bills, tax breaks have been few and frustrating.
Custodial accounts? The tax savings are minimal, and you give up control of the assets to your kid. State-run prepaid tuition plans? They lock you into sub-par returns.
The Coverdell Education Savings Account (formerly known as the Education IRA) is a decent option, since all savings grow tax-deferred and withdrawals are tax-free. But you can put away only $2,000 a year, hardly enough to cover the rising cost of college.
Little wonder that most parents end up saving in taxable accounts -- thereby sacrificing a big piece of their profits to Uncle Sam -- or raiding their retirement accounts.
Enter the 529. These state college savings plans, named after the section of the tax code that governs them, are the more attractive siblings of prepaid tuition programs.
A state's prepaid plan allows you to pay now -- at today's tuition rates -- for school tomorrow. But 529s, now offered in most states, are far more flexible.
The money may be used at any school you choose and for all qualified higher education expenses, including room and board (not so with a pre-paid plan).
Most 529 savings plans offer a menu of age-based portfolios, and some also offer a small selection of stock and bond funds. In the former case, your annual contributions get invested in a pre-selected portfolio of stocks and bonds. Early on, the portfolio is tilted toward stocks, and as the time for college nears, the weighting shifts more heavily toward bonds. States contract out to investments companies, such as TIAA-CREF and Fidelity, to manage the portfolios.
You never have to worry about annual taxes on dividends and gains, and withdrawals are tax-free too (at least until 2010, when Congress has the option of extending the break). What's more, if you invest with your own state's 529, you may get state-tax deductions on contributions or exemptions on withdrawals (you may, however, choose to forego the state tax break if another state has a better 529).

Contribution limits are generous

Investment minimums are low (plans may let you sock away as little as $25 a month), and there is no restriction on how much you may contribute every year unless the account is nearing the lifetime cap.
Each state determines its own lifetime contribution limit, ranging between $100,000 and $270,000.
Just because you can contribute as much as you want, however, doesn't mean you should -- annual contributions of more than $11,000 ($22,000 if contributing with a spouse) are subject to the gift tax.
One caveat to the gift-tax limit: You may contribute as much as $55,000 tax-free in one year ($110,000 with your spouse), but that contribution will be treated as if it were being made in $11,000 installments over the next five years. In other words, you can't make such a large contribution every year without tax consequences.


Who should get one

So how do you know if a 529 is for you? Shortcomings and all, 529 plans are a hard-to-beat way to boost your college savings -- provided you meet one of these four criteria.
You're in an above-average federal tax bracket, with time to save. The critical advantage of 529 plans is tax-deferred compounding. The higher your tax bracket and the longer your time horizon, the greater the benefit of tax-sheltered compounding.
In theory, you could build a tax-efficient college savings portfolio without a 529: Simply buy and hold top-quality individual stocks or mutual funds that keep taxable distributions to a minimum. That way, you won't pay taxes until you need your money.
The problem, however, is that as your child nears college age, you should start shifting savings out of stocks and into lower-risk bonds and cash. All that asset shifting triggers tax bills -- something that doesn't happen with 529 plans. "The real-world advantage of investing tax-sheltered in a 529 beats the theoretical advantage of investing for low capital-gains taxes," notes Raleigh, N.C. financial adviser Brian Orol.
When you compare a 529 plan with a balanced fund that shifts between stocks and bonds, the tax advantages are obvious. According to TIAA-CREF, an investor in the 31 percent tax bracket who saves in a 529 plan for 18 years would come away with 20.5 percent more than someone who puts the same amount in the typical taxable balanced fund.

You are unlikely to qualify for need-based financial aid. As adviser Raymond Loewe of College Money, a planning firm in Marlton, N.J., puts it, "The tax savings you get in a 529 plan blow up when it comes time to qualify for aid."
Here's why. Under financial aid formulas, 529s are counted as the parents' asset until you withdraw the money. And parents' assets are assessed at the lowest possible rate for financial aid purposes. But gains from a 529 count as the student's income, up to 50 percent of which is considered available to pay tuition.
All this means is that anyone who might need a lot of aid is better off saving outside a 529.
What if your financial situation changes after you've begun funding a 529? If you later find yourself in a position where you are likely to be eligible for financial aid, try and wait to take withdrawals from your child's 529 until the last year of college, when it won't be counted against future financial aid.

You live in New York, Michigan or another high-tax state with significant 529 tax breaks. If your state offers a generous tax deduction on 529 contributions, take a serious look at the plan even if you are in a lower tax bracket. In New York, for example, residents earning more than $40,000 are taxed at a rate of 6.85 percent; if you live in New York City, add on 3.78 percent. The state's 529 plan, run by TIAA-CREF, offers a state-tax deduction on contributions of up to $10,000 per household a year (no matter the number of kids), which can save New York City residents as much as $2,038 a year.

You're a grandparent looking to reduce your estate. You can deposit up to $55,000 ($110,000 for a married couple) into a 529 plan without incurring the federal gift tax, making 529s an ideal way to move a big sum out of your estate quickly. A $55,000 contribution is counted against your $11,000 annual gift exclusion over five years, so you won't be able to make another tax-free gift to that beneficiary for six years.


How to pick the right plan

Which is the best 529 for you? No two programs are alike -- they differ dramatically in many ways, from investment choices to costs to tax breaks. Your first step should be to look at your own state's plan (if it has one). In some states you may qualify for a matching grant or scholarship. More important, many states give residents a tax deduction on 529 contributions and most exempt the earnings on withdrawals.
If your state taxes are high and your local plan offers generous tax benefits, you can stop reading here: You're best off staying at home. But if you live in a state with low or no taxes, or with limited tax breaks, then it's time to shop around. Use the following three rules as guidelines.

Shop for a manager, not a performer. Given the short track record of 529 plans, you can't glean much from the funds' performance history. So stick with plans run by investment companies with successful records managing retail mutual funds and pension plans, such as Vanguard, Fidelity, and TIAA-CREF.

Stick with low-cost plans. Expense ratios vary considerably, from less than 0.3 percent to more than 2 percent. Some states' plans are sold by brokers, which layers on additional costs. You could also pay other fees. Several states charge to open an account and tack on $25 or so in annual fees. The less you pay in fees, the more your contributions can work for you.

Look for the right investment choices, not the most. The typical 529 menu is still fairly limited. In most plans, the key offering is an age-based portfolio, which gradually shifts the asset allocation as your child ages. For children under three, for example, some 80 percent of the portfolio may be stashed in stocks. As your child grows, the equity portion shrinks so that by the time he or she is 18, the assets are held mainly in bonds or cash.

Increasingly, states are adding conventional stock and bond funds. But because you can't switch your money around freely the way you can in a 401(k), a vast number of choices isn't much of an advantage -- and is potentially riskier.
For most investors, the best choice is an age-based portfolio. In the past, these funds were criticized for being too heavily oriented toward fixed-income assets, even during the child's youngest years. But a conservative strategy is often a sensible one. "People forget that they usually have fewer years to save for college than for retirement -- most often 10 years or less, since they tend to start late," notes TIAA-CREF vice president Timothy Lane. "If you lose a lot in the early years, it's very hard to make it up."
You can also create your own stock and bond mix by opening more than one account in the child's name -- one for each asset class -- and controlling your own allocation by the amounts you invest in each. Another strategy: If you don't like the asset mix designed for your child's age, find out if you can use a portfolio for a different age. Some states let you pick your own starting point.

The most frequently asked 529 questions

Q. What's so great about 529 plans?
A. You never have to worry about annual taxes on dividends and gains, and withdrawals are tax-free too. What's more, if you invest with your own state's 529, you may get state-tax deductions on contributions or exemptions on withdrawals.

Q. Can anyone open a 529 account for any child?
A. Generally, you ("the account holder") can open an account on behalf of nearly any child ("the beneficiary"), regardless of your income. Grandparents, for example, can save on behalf of grandchildren. You can even put away money for someone who's not a family member. A handful of states open their plans only to state residents -- but most are available to everyone.

Q. Can two people open an account for the same child?
A. You can open more than one account in a single state for the same child, and more than one person can fund a 529 for the same beneficiary. No matter the number of accounts, the state's maximum contribution limit still applies to the beneficiary. States don't have to count balances in out-of-state accounts when determining whether you've met your limit, but some have started doing so.

Q. What if I need to tap the plan?
A. You can make a withdrawal anytime, but you'll pay taxes plus a penalty on the earnings -- usually 10 percent -- if the money is not used for higher education.

Q. Does my child have to go to a state school?
A. No. You can use the money at any accredited degree-granting school, whether it's private, public, undergraduate, or graduate.

Q. What kind of educational costs can the money be used for?
A. In all states, tuition qualifies. Most states also permit 529 money to be used for other costs, such as room, board, fees and books.

Q. What if my child doesn't go to college or has money left over?
A. You can take out the money, paying taxes and penalties. In most states, you can leave money in the plan indefinitely, in the hope that your child will eventually go to college. A third option is to name a new beneficiary on the account. If your child dies or becomes disabled, most states will waive penalties on withdrawals.

Q. Can I switch investment options?
A. Not without going through the rollover process described above. An easier alternative is to open another account for the same beneficiary and invest future contributions in a different fund.

Q. Can I also fund a Coverdell Education Savings Account?
A. Absolutely -- that restriction changed at the beginning of 2002. You can contribute up to $2,000 annually to a Coverdell, regardless of how much you contribute to a 529.

Student Loan Interest Deduction

Student Loan Interest Deduction

You may be able to deduct interest you pay on a qualified student loan. And, if your student loan is canceled, you may not have to include any amount in income.

The deduction is claimed as an adjustment to income so you do not need to itemize your deductions on Schedule A Form 1040.

You cannot claim the deduction if:

1. Another taxpayer claims an exemption for you as a dependent,
2. Your filing status is married filing separately, or
3. You are not legally obligated to make payments on the loan.

A qualified student loan is a loan you took out solely to pay qualified higher education expenses. The expenses must have been:

1. For you, your spouse, or a person who was your dependent when you took out the loan,
2. Paid or incurred within a reasonable time before or after you took out the loan, and
3. For education furnished during an academic period when the recipient was an eligible student.

Qualified higher education expenses are the costs of attending an eligible educational institution, including graduate school. The costs of attendance are determined by the eligible educational institution and include tuition and fees, an allowance for room and board, and an allowance for books, supplies, transportation and miscellaneous expenses.

Costs you incur have to be reduced by:

1. Non–taxable employer – provided educational assistance.
2. Non–taxable distributions from a Coverdell education savings account,
3. Non-taxable distributions from a qualified tuition program (QTP),
4. U.S. Savings Bond interest that is non–taxable because it is used to pay qualified higher education expenses,
5. The non-taxable part of scholarships and fellowships,
6. Veterans educational assistance, and
7. Any other non–taxable payments (other than gifts, bequests, or inheritances) received for educational expenses.

The student must have been enrolled in a degree, certificate, or other program leading to a recognized educational credential at an eligible educational institution and must have carried at least one half of a normal full–time work–load for the course of study being pursued.

The deduction will start to phase out when modified AGI exceeds certain amounts, please refer to Publication 970 for these limits.

If you paid $600 or more of interest on a qualified student loan during the year, you will receive a Form 1098-E (PDF), Student Loan Interest Statement, from the financial institution, from a governmental unit (or any of its subsidiary agencies), from educational institutions, or any other person to whom you had paid student loan interest of $600 or more in the course of their trade or business.

More information on student loan interest deduction and other education benefits is available in Publication 970, Tax Benefits for Education.