SC Lawyer, Jan. 2004, #3. A penny saved ... a degree earned.

• Author: By Gail D. Moore

South Carolina Lawyer

2004.

SC Lawyer, Jan. 2004, #3.

A penny saved ... a degree earned

South Carolina LawyerJanuary 2004 A penny saved ... a degree earnedBy Gail D. MooreMy children recently celebrated their second and fourth birthdays. As I cleaned birthday cake out of my carpet, I thought about what it will cost to send my children to college. According to my research, the total projected cost for my four-year old to attend four years of college in 2017 is $74,000; it increases to $81,000 by the time my two-year-old attends college in 2019. These figures captured my attention and confirmed that although we are saving for college, we are not doing enough.

There is good news for families preparing for college. Congress has enabled many tax-advantaged college savings programs and credits for qualified educational expenses. There are many choices available for saving for college, from the simple savings bonds, to uniform gift to minors accounts, Coverdell Educational Savings Accounts and the qualified tuition programs used for college savings, commonly referred to as "Section 529 Plans." Each of these choices has distinct advantages and disadvantages, as well as differing tax consequences. Each also affects a family's ability to receive collegiate financial aid in a different way. The pros and cons of each savings vehicle are discussed below.

Savings bonds

Series EE or I savings bonds are the simplest way to save for a child's future educational expenses. Savings bonds are easy to purchase and enjoy great flexibility in redemption. In fact, investors can purchase and sell savings bonds via the Internet. Investors can redeem savings bonds as quickly as six months after purchase. Quick redemption is disfavored, however, as a three-month earnings penalty applies to any redemption within five years of the bond's issuance. The maximum investment available in savings bonds is $30,000 per year for Series I bonds and $15,000 per year for Series EE bonds.

Savings bonds' tax features make them attractive for college funding. First, individuals may defer the recognition of interest income until the bonds are redeemed. Additionally, if the proceeds from the redemption are used to pay higher education tuition and fees, subject of family income thresholds, the income may be excluded from recognition in its entirety. To avoid income recognition, the bonds must be issued after December 31, 1989, they must be purchased by an individual who is 24 years old or older and the bond proceeds must be used to pay higher education expenses of the taxpayer, the taxpayer's spouse or their dependent children. The exemption amount is limited to the amount used to pay higher education expenses in the year of redemption.

For financial aid purposes, Series EE or I savings bonds are treated as the parent's assets if the educational expenses are for a dependent child. They are treated as the student's assets if the educational expenses are for a person not claimed as a dependent on another individual's tax return.

Uniform gift to minors accounts

Uniform gift to minors accounts formed under the Uniform Gift to Minors Act (UGMA) are very popular college savings devices. They are simple and inexpensive to create. These accounts enjoy unlimited contributions, but college planners should be aware that any contribution over $11,000 annually is considered a taxable gift. UGMA account proceeds may be used to fund all educational expenses without restriction. Money can be withdrawn at any time for the benefit of the ultimate child beneficiary.

College planners need to be aware of potential disadvantages to UGMA accounts. UGMA accounts must be established in the name of the child-beneficiary. The designation of beneficiary is irrevocable and contributions can only occur up to the beneficiary's 18th birthday. The child beneficiary is entitled to the entire account at the age of majority as determined by the state. There is no direction once the beneficiary is able to obtain the proceeds from these accounts. A beneficiary may use these proceeds for any expense. In August 2002, South Carolina raised the age of majority from 18 to 21. However, the fact that the beneficiary receives this money outright upon attaining the age of majority is perceived as a major drawback for many parents and grandparents.

UGMA accounts have additional tax considerations. While the child is under the age 14, the first $700 of annual income is tax exempt, and the next $700 of annual income is taxed at the child's rate. Any additional income is taxed at the parents' rate. For a child age 14 or older, all earnings are taxed at the child's individual tax rate. Additionally, UGMA accounts are treated as the student's assets for financial aid purposes, reducing a student's chances for financial aid.

Coverdell Education

Savings Accounts

Another popular savings vehicle for educational expenses is a Coverdell Education Savings Account. Coverdell Education Savings Accounts were formerly known as Educational IRAs. Calling the accounts Educational IRAs was a misnomer, however, because the accounts were not truly retirement accounts, but rather savings vehicles for educational expenses.

Through the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Congress made changes to these accounts that make them more useful college savings tools. Beginning in 2002, EGTRRA increased the annual limit on contributions to Coverdell Accounts from $500 to $2,000. This is an aggregate contribution limit of $2,000. Thus, all contributors jointly and collectively may contribute no more than $2,000 to an account in a year. Contribu-tions made by April 15 of any year may be treated as being made by December 31 of the previous year. Gifts to a Coverdell Account qualify for the annual gift tax exclusion.

In contrast to traditional IRA accounts, a contribution to a Coverdell Account does not trigger a tax deduction to the contributor. Rather, after-tax contributions to the account are allowed to grow tax-free. Withdrawals of principal and interest are not subject to taxation if used for qualified educational expenses. The Act expanded the definition of educational expenses as it applies to Coverdell Accounts to include "qualified elementary and secondary school expenses." Therefore, in addition to college expenses, Coverdell Account proceeds can be used to pay expenses for kindergarten through grade 12 at public, private or religious schools. "Educational expenses" broadly includes not only tuition and fees, but room and board, uniforms, transportation and the purchase of any computer technology or equipment or Internet access and related services if such technology or services are used by the beneficiary and the beneficiary's family. This expanded definition of education expenses make Coverdell Accounts a useful planning tool for families who send their children to private school or need technology services for their children's education.

The Hope and Lifetime Learning Tax Credits are the traditional tax credits for educational expenses. Students who use Coverdell Account proceeds to pay educational expenses may claim these traditional tax credits as long as the credits are claimed for different expenses than those paid for by Coverdell Account funds. For example, if qualified tuition is paid individually, traditional tax credits may be taken on this amount, and then Coverdell Account proceeds can be used for items like room and board and technology aids. An account owner should note, however, that qualified room and board expenses are limited to an amount determined by the federal government each year.

Coverdell Accounts do have disadvantages. The annual contribution limit is only $2,000 per beneficiary and can only be made until a child reaches age 18. Thus, for these accounts to be useful, contributions should begin when beneficiaries are very young. Additionally, income limitations affect some people's ability to make contributions to Coverdell Accounts. A single taxpayer with more than $110,000 of adjusted gross income and married taxpayers with more than $220,000 of adjusted gross income cannot contribute to a Coverdell Account. Additionally, Coverdell Accounts are treated as an asset of the beneficiary for financial aid purposes, which could decrease a student's potential financial aid.

Tax consequences may arise if all proceeds are not used for a student's education. A penalty, plus income taxes, will be paid at the child-beneficiary's rate if the proceeds of the account are not used for education by the time the beneficiary is 30 years old. However, to avoid any penalty, if a beneficiary does not use all of his account for educational expenses before he is 30, he may transfer the remaining proceeds to a family member such as a younger sibling or cousin who may then use the proceeds for qualifying educational expenses without additional taxes or penalties.

529 plans

The fastest growing college savings vehicle is qualified tuition programs (QTPs). QTPs are commonly referred to as 529 plans, after the Internal Revenue Code that defines them. All 50 states now have some type of qualified tuition program. These programs allow an individual to create a college savings account to benefit a student. The proceeds from this account will be used to cover the cost of college education at any public or private university. There is no requirement that the beneficiary be related to the contributor. In fact, anyone can establish a 529 plan for his own educational expenses and allow funds to grow tax-free until they are needed for education. Like Coverdell Accounts, if the entire proceeds of the account are not needed or used by the initial beneficiary, the account owner can designate a new beneficiary that is a "member of the family" of the initial beneficiary. This is an important feature for 529 plans because it allows grandparents to establish a 529 plan that could be transferred to any of their grandchildren if necessary.

Prepaid tuition plans fall under the 529 plan umbrella. Prepaid tuition plans lock in tuition at today's prices. This means a parent or grandparent could pay for college in advance using today's tuition dollars rather than 2018 prices. Prepaid tuition plans do, however, limit the selection of schools available to an account holder. An investment in a prepaid tuition plan is like buying a gift certificate that can be used at specific schools outlined by the plan. While this subset of 529 plans provides value, the difficulty in predetermining a student's educational path makes them less attractive than the traditional 529 plan. Consequently, the remainder of this discussion focuses on the traditional 529 plan.

Traditional 529 plans offer many incentives to college planners. 529 plans have no income limitation on the contributor, so high-income taxpayers who are ineligible for other education incentives may contribute to 529 accounts. Additionally, 529 plans have no annual limit on contributions other than the upper limit that can ultimately be contributed for the benefit of one individual, set by the states. South Carolina's contribution limit is $265,000. Even once this upper limit of contributions is reached, the money will continue to grow tax free.

Planners should be wary that aggregate gifts by a single contributor in a single year exceeding $11,000 are subject to gift taxes. To avoid gift tax, contributors should either stay below this threshold or take advantage of gift-averaging. Using gift-averaging, a single person may contribute up to $55,000, and a married couple filing a joint return may contribute $110,000 to a 529 plan. The gifts, although made at one time, are treated as being made over the future five years and no gift tax is due, unless the contributors do not survive the five-year time period.

One aspect of 529 accounts that appeals to parents and grandparents is control. 529 accounts remain in the name of the contributor, and the contributor has the ability to name successor beneficiaries. Significantly, although the account remains in the name of the contributor and the contributor has the right to direct distributions and change beneficiaries, the account value is not included in the estate of the contributor. This tax benefit cannot be overstated. Equally important, the contributor is considered the owner for financial aid purposes, which may assist a student receiving financial aid based on his own assets.

529 plans offer other tax benefits. There is no tax to the beneficiary when proceeds are deposited into the account, and the principal and interest accumulated in a 529 plan can be withdrawn tax free if used for "qualified higher education expenses." Also, a contributor may be eligible for a state tax deduction for amounts contributed to a qualified 529 plan. For example, a South Carolina resident who makes a contribution to South Carolina's 529 plan may deduct the entire amount from South Carolina taxable income. There is currently no corresponding federal tax deduction.

Like the Coverdell Account, 529 plans interact very well with traditional tax credits. A taxpayer can take a traditional tax credit and a distribution from a 529 plan in the same year, provided they are for different education expenses. Much like the Coverdell Accounts, qualified higher education expenses as they pertain to 529 savings plans include tuition, fees, books and equipment required for enrollment or attendance. However, 529 plans may only be used for higher education expenses at a college, university or certain vocational schools, and not primary or secondary school. Room and board are included as a qualified expense if the student carries at least half of what is considered a full-time student's hours. Similar to Coverdell Accounts, room and board expenses are limited to an amount determined by the federal government.

A shortcoming in 529 accounts is the lack of control over investments in the account. 529 plans, by law, are prohibited from giving the contributors direct or indirect control over the investments. A contributor chooses at the date of contribution the investment strategy he wishes to follow. These college savings programs offer many options based on the age of the beneficiary and the contributor's tolerance for risk. Most plans now have age based investment choices that range from conservative to aggressive, and an account owner can customize his allocation by choosing investments based on the portfolios offered by that plan. That is, a contributor could decide to put 20 percent of the account in each of five different portfolios offered by the plan. However, a contributor cannot invest in any fund or portfolio not offered by the plan. A contributor can choose his investment for each contribution made. The contributor can change his investment at least once every year or when the account beneficiary is changed.

Finally, the "tax-free" status of distributions made for "qualified educational expenses" only lasts through 2010, the year the "sunset" provisions take effect on EGTTRA. Beginning in the year 2011, a 529 account is no longer tax-free, but merely tax-deferred. No taxes will be due on the income until distributions are made, and at that time, the income is taxed at the beneficiary's rate, which in most cases is lower than the contributor's rate. However, this sunset provision is something that all planners should keep in mind when preparing any college savings plan.

Because most investments are made well before a beneficiary will attend college, there are always risks and uncertainties about whether the child will attend college. However, the tax benefits of these investments outweigh the risk. There are provisions in both the Coverdell Accounts and the 529 plans for the eventuality of death, disability and scholarships.

The ability to assist children and grandchildren financially so they may attend college is a major financial goal for most people. Saving money and investing it well are critical for meeting that goal.

Gail D. Moore, JD, CPA practices with Greene & Company, LLP in Greenwood.

Copyright (c) 2004 by the South Carolina Bar. All rights reserved. No part of this publication may be reproduced without written permission.