Michael Goldman & Associates, L.L.C. - Consulting & CPA Services

Education Tax Breaks as a Result of the 2001 Tax Act

Here are two excellent vehicles for funding a child’s or grandchild’s education: Education IRAs and Qualified Tuition Plans. Both allow funds to earn interest tax-free, and when the money is withdrawn to pay school expenses, it is not taxed as income. Contributing to either vehicle does not trigger gift tax, and reduces the donor’s taxable estate.

Education IRAs  

You can set up an Education IRA (also called Coverdell Education Savings Accounts, or CESAs) for any beneficiary – your child, grandchild, or anyone else – who is less than 18 years old. In addition, people with disabilities or "special needs" can be beneficiaries beyond the age of 18.

Beginning in 2002, you can contribute up to $2,000 per beneficiary each year to an Education IRA. These contributions are similar to Roth IRAs – the contributions are on an after-tax (i.e. non-deductible) basis, but the earnings are allowed to build up tax-free.  

The maximum amount of your contribution depends on your adjusted gross income (AGI) in the same calendar year. Here are the contribution limits: 

• If your AGI is less than $95,000 individually ($190,000 as a married couple filing jointly), you can contribute up to $2,000 to each Education IRA.
• The limit gradually phases to zero for individuals with AGI between $95,000 and $110,000 (between $190,000 and $220,000 for couples).
• If your individual AGI is more than $110,000 ($220,00 for couples) you cannot contribute in that year. But you can still contribute to a state tuition plan.

The beneficiary can withdraw funds from an Education IRA tax-free to pay for tuition, books, supplies, computers, room and board, uniforms, transportation, tutoring, and many other expenses that are educational in nature. The student can be in elementary school, secondary school, or college; and it doesn’t matter if the school is public, private, or religious. 

Distributions

Withdrawals are tax-free when they are used for qualified education expenses. If a beneficiary withdraws funds that exceed those expenses, he or she must pay income tax on the excess funds as well as a 10 percent early-withdrawal penalty. Exceptions to the 10 percent penalty rule apply when the beneficiary is disabled, or in some cases upon the donor's death.  

All funds remaining in the Education IRA must be withdrawn when the beneficiary reaches age 30, or dies at a younger age. An exception is made, as usual, for special-needs beneficiaries.  

Rollovers

What happens if the beneficiary does not go to college, or drops out, and there are still funds in the Education IRA? You, the donor, have two choices, both of which have no adverse tax consequences: 

• Roll over the funds from one IRA into another one for the same beneficiary or for a member of his or her family, or
• Change the designated beneficiary to a member of the first beneficiary’s family.

Two caveats

If you think your grandchild will be eligible for financial aid in college, establishing an Education IRA for him or her might be a bad idea. That’s because eligibility for financial aid is usually based on the income and assets of both the parents and the student. An Education IRA in the student’s name might disqualify him or her for aid. 

Another caveat: The Tax Relief Act of 2001 – including the provisions that expand the use of Education IRAs – will expire in 2010 unless Congress extends them. But funds in an IRA will continue to grow tax-free, and distributions for education expenses will not be taxed, even if the provisions expire. The restrictions and limits will return to 2001 levels. 

Education IRAs usually offer more generous tax advantages for donors who qualify than do state tuition programs. On the other hand, the state programs typically permit much larger annual contributions. Therefore, some donors contribute up to $2,000 to an Education IRA, and then contribute remaining funds to a state tuition program for the same beneficiary.

Qualified Tuition Plans  

Qualified tuition programs (also called QTPs or Section 529 plans) provide numerous benefits:

•  Accounts are allowed to grow tax-free. Payouts will be tax free if used for paying qualified expenses incurred while attending most accredited institutions of higher education in the U.S. – including public and private schools, out-of-state schools, graduate schools, and certain vocational schools. Payouts can also be used for fees other than tuition, such as books, required supplies, and all or some portions of room and board.

• Under a special provision of Section 529 plans, gifts of up to $50,000 in a given year are non-taxable since it is treated as five annual gifts of $10,000 (this can be doubled for married couples)

• Most states offer plans that are open to both residents and non-residents. You can choose which ever plan best meets your needs, but be aware that earnings from most plans are only exempt from state income tax for state residents.

• The account donor maintains control of the account. If the child decides not to attend college, the owner of the account can change the account’s beneficiary or withdraw the funds for himself. Non-qualified withdrawals such as these will incur regular income tax plus a 10% additional tax on the account’s earnings.

• The account is considered the donor’s asset in financial aid calculations.  Since the student’s assets are counted more heavily in financial aid calculations, the QTP may be a more advantageous investment vehicle if you expect that you will apply for aid.

• QTPs are available to all taxpayers regardless of income – there are no phase-out limitations.

Information on the state of Illinois QTP can be found at www.brightstartsavings.com.

Which to Choose?

Most taxpayers will have both Education IRAs and QTPs available to them, and if this is the case they can invest in one or both types of plans. QTPs offer more favorable financial aid consideration and much greater funding limits than Education IRAs.

On the other hand, Education IRAs give you more control over how your funds are invested – QTPs generally force you into choosing from a very narrow selection of investment options, and since all of these are professionally managed they may incur much higher costs than you incur by self-investing in an Education IRA. QTPs only maintain tax-favored status if used to pay for college expenses, while Education IRAs can be used to pay costs associated with virtually any school.

There are no generic answers - like most things in life, which you choose and how you proceed depends on your individual circumstances.

Other benefits

Married taxpayers with adjusted gross income of less than $130,000 and single taxpayers with adjusted gross income of less than $65,000 will now be able to deduct up to $3,000 of college tuition for themselves or their dependents whether or not they itemize their deductions.

The phase-out limits for deducting college loan interest have been increased for all taxpayers, and the 60-month rule has been eliminated. As a result, many more taxpayers are likely to qualify for this deduction.

Other Savings Options

The Government offers I Bonds and EE Bonds that grow at stated rates of interest tax-free until cashed.  Bonds that are cashed to pay for qualified educational expenses may be eligible to have the accumulated interest completely or partially excluded from Federal income tax.  Interest on these bonds is not taxable by states.  These bonds may offer a lower return than other available investments, but both the principle and earnings are guaranteed by the government.  Holding these bonds for education avoids management fees and expenses that are incurred in professionally managed programs such as QTPs.  For more information see www.savingsbonds.gov.

© Michael Goldman 2002

For more information, please go to www.michaelgoldman.com 

Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser.

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Last modified: March 31, 2007