Tuesday, November 24, 2009

The Costs & Rewards of a College Education

Part 4 - College Funding Options: Savings Bonds & UGMA/UTMA Accounts

Education Bond Program

529 Plans and Coverdell Education Savings Accounts are good bets for some, but if you think your child may opt not to go to college, or if you just want more control over your investments, you may want to consider education bonds.

EE bonds and Series I bonds are both part of the Education Bond Program created by the Treasury Department in 1990.  A benefit of this program over the 529 plans is that with these investments you won't have to pay a penalty if you decide not to use them for your child's (or your own) education. If you do use them to pay for school, you will not be required to pay federal income tax on the interest you earn.  Bonds are available in denominations from $50 to $10,000 for EE bonds, and from $50 to $5,000 for I bonds.

EE bonds are purchased at 50% of their face value.  Therefore, a $100 EE bond will cost $50 to purchase it.  In contrast, I bonds are purchased at face value; therefore a $100 I bond will cost $100.

The Department of the Treasury sets the fixed rate for Series EE Savings Bonds administratively. The rate is based on 10-year Treasury note yields and adjusted for features unique to savings bonds, such as the tax deferral feature and the option to redeem the savings bonds at any time after the initial holding period.  Series EE Savings Bond rates are set every May 1st and November 1st, with each new rate effective for all bonds issued in the six months following the adjustment.

Series EE Savings Bonds issue dated on or after May 1, 2005 will earn a fixed rate of interest for 20 years, at which time the bond should have reached its face value. If the bond has not reached its face value, the Treasury will make a one time adjustment up to the face value. These EE bonds will increase in value every month instead of every six months. Interest is compounded semiannually. After the initial 20 yr period an additional 10 year extension and rate update will be initiated, for a total of 30 years of interest earning.

I bonds are inflation-indexed bonds with yields pegged to the inflation rate. You can learn more about these bonds online at www.savingsbonds.gov.  The bonds come with their share of caveats, so be sure you meet the requirements before you make a purchase.

Because of the $20,000 total bond limitation which began Jan. 2008 - you can now only purchase a maximum face value of $10,000 ($5,000 cash) in paper EE Savings Bonds a year. You may also purchase up to $5,000 in Electronic EE Savings Bonds, $5,000 in paper I Savings Bonds and $5,000 in Electronic I Savings Bonds - all in one calendar year.

To qualify for the tax exclusion, you must meet certain income guidelines when you redeem the bonds. For the 2008 tax year, for example, a single taxpayer's modified adjusted gross income must be less than $67,100 to take full advantage of the exclusion. The exclusion begins to be reduced at that point, and is eliminated for adjusted gross incomes of $82,100 and above. For married taxpayers filing jointly, those two numbers are $100,650 and $130,650, respectively. The good news is that those numbers are adjusted annually, so the ceilings may be much higher when you redeem your bonds.
Keep in mind that your adjusted gross income for the year you redeem your bonds includes all the interest earned on the bonds you cashed in. Ironically, this may actually push some families past the cut-offs, reducing or even eliminating their exclusion.

You can use the proceeds for tuition and fees, but not for room and board or books. Qualified expenses must also take into account any scholarships, fellowships, or other forms of tuition reduction and you must incur the expenses the same year you redeem the bonds.

If you redeem more cash in bonds than you use for educational expenses, the interest you earn will be taxed on a pro-rated basis.  For example, if you have a $10,000 bond consisting of $8,000 principal and $2,000 interest, and have $6,000 in expenses, you could exclude 60 percent of the earned interest, or $1,200. The other $800 would be subject to taxes.

UGMA/UTMA Custodial Accounts

A custodial account provides a way for a donor (usually parents or grandparents) to gift cash and/or assets to a minor via a simple and cost effective account.  The Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) account enables the custodian to provide management of the account and to direct distributions for the benefit of the child until the child reaches the age in which they can control the account, usually age 18 or 21.  For estate tax purposes, if the donor and the custodian is the same person and if they predecease the beneficiary before the age of majority, the gift amount will not be considered a completed gift.  Specific terms of UGMA and UTMA accounts are determined by state statute.

Neither the donor nor the custodian can place any restrictions on the use of the money when the minor becomes an adult. At that time the child can use the money for any purpose whatsoever without requiring permission of the custodian, so there's no guarantee that the child will use the money for education purposes. Since UGMA and UTMA accounts are in the name of a single child, the funds are not transferable to another beneficiary.

The income from the custodial account must be reported on the child's tax return and is taxed at the child's rate. There is no special tax treatment for UGMA/UTMA accounts.

Uniform Transfer to Minors Act (UTMA) is the most common custodial account and allows for a minor to own securities and other types of property, such as real estate, fine art, patents and royalties, and for the transfers to occur through inheritance.  The Uniform Gift to Minors Act (UMGA) allows for a minor to own securities.  UTMAs are slightly more flexible than UGMAs.   For college financial aid purposes, custodial accounts are considered assets of the student. This means there is a high impact on financial aid eligibility.

Next week I will touch on some final, less popular, college funding options which include using your IRA accounts, using variable life insurance policies, and the loyalty/rebate programs.

Thursday, November 12, 2009

The Costs & Rewards of a College Education

Part 3 - College Funding Options: Coverdell Education Savings Accounts

The Coverdell Education Savings Account is also referred to as an Education IRA, although it is important to note that a Coverdell Education Savings Account is not an IRA.  It allows qualified taxpayers (usually parents and grandparents) to establish and contribute up to $2,000 per year for each designated beneficiary under the age of 18; current tax law prohibits contributions once the designated beneficiary reaches the age of 18.

Contributions are nondeductible but can be invested in any U.S. stock, bond or mutual fund.  A contributor’s income could potentially limit the amount of contributions made in a given year.  To contribute fully in 2009, a person must make no more than $95,000 if filing as a single taxpayer, $190,000 if married filing jointly.  Limited contributions are allowed for single taxpayers earning up to $110,000 and married couples making up to $220,000.  Beyond those higher income levels, a person cannot contribute.  However, there are no requirements that contributions come from earned income.  Therefore, if a parent or grandparent is not eligible to make a contribution due to their income they can simply gift the amount to the child who can then make a contribution into their account.

For members of the military and their families, if you received a military death gratuity or a payment from Servicemember's Group Life Insurance (SGLI) after October 6, 2001, you may roll over all or part of the amount received to one or more Coverdell ESAs for the benefit of members of the beneficiary's family. Such payments are made to an eligible survivor upon the death of a member of the armed forces.  This rollover contribution is subject to the contribution limits discussed earlier. The amount you roll over cannot exceed the total survivor benefits you received, reduced by contributions from these benefits to a Roth IRA or other Coverdell ESAs.  The contribution to a Coverdell ESA from survivor benefits received after June 16, 2008, cannot be made later than 1 year after the date on which you receive the gratuity or SGLI payment. If you received survivor benefits before June 17, 2008, with respect to a death from injury occurring after October 6, 2001, you can contribute to a Coverdell ESA no later than June 17, 2009.  The amount contributed from the survivor benefits is treated as part of your basis (cost) in the Coverdell ESA, and will not be taxed when distributed.  The limit of one rollover per Coverdell ESA during a 12-month period does not apply to a military death gratuity or SGLI payment.

Coordination of contributions should be closely monitored.  The annual exclusion for making gifts to any individual is $13,000 for 2009.  If a parent is making contributions for a child to both a Coverdell Education Savings Account and, say, a state-sponsored 529 savings plan that parent needs to make sure they do not put more than the annual exclusion amount collectively into both plans.  Unlike 529 plans, there is no 5-year averaging allowed for Coverdells.

Withdrawals are tax-free if the money is used for qualified higher education expenses.  One of the main advantages of Coverdell Education Savings Accounts, as compared to other educations savings vehicles such as 529 plans, is that distributions can be used for educational expenses of any grade level; like parochial elementary, private high school or a public college.  The educational expenses that qualify are broken into two categories: Qualified Elementary and Secondary Education Expenses, and Qualified Higher Education Expenses.

Qualified Elementary and Secondary Education Expenses are related to enrollment or attendance at an eligible elementary or secondary school.  To be qualified, some of the expenses must be required or provided by the school.  The following expenses must be incurred by a beneficiary in connection with enrollment or attendance at an eligible elementary or secondary school: tuition and fees, books, supplies, and equipment, academic tutoring, and special needs services for a special needs beneficiary.  Other qualified expenses must be required or provided by an eligible elementary or secondary school in connection with attendance or enrollment at the school:  room and board, uniforms, transportation, and supplementary items and services (including extended day programs).  The purchase of computer technology, equipment, or internet access and related services is also a qualified elementary and secondary education expense if it is to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in elementary or secondary school.

Qualified Higher Education Expenses are expenses related to enrollment at an eligible postsecondary school.  To be qualified, some expenses must be required by the school such as tuition and fees, books, supplies, and equipment and some must be incurred by students who are enrolled at least half-time, such as room and board.  These expenses must be reduced by the amount of tax-free benefits received, such as scholarships, to determine how much can be distributed without incurring a taxable event.

There are a few key limitations of the Coverdell Education Savings Account.  Any balances not used by a child’s 30th birthday must be distributed or transferred to another family member (can include niece and nephew).  If not, the balance will go to the child and will be subject to income tax and a 10% penalty.   Additionally, the $2,000 contribution limit is per beneficiary, regardless of the number of accounts opened for the child.  Any excess contributions are subject to a 6% excise tax penalty.  Excess contributions, and any earnings on the excess contributions, can be withdrawn before May 31st of the following year without incurring the 6% penalty.  The earnings, however, will be subject to income tax.

In the past, distributions could not be used in conjunction with the Hope or Lifetime Credit, which are described in more detail below.  The Internal Revenue Service now allows a distribution from the account in the same year that the Hope or Lifetime Learning Credits are claimed as long as the money is not used to pay for the same expenses.

As with 529 plans, if a parent owns the plan it is considered a parental asset and therefore has a minimal effect on the amount of financial aid available.

Please do not hesitate in contacting me with any questions you may have regarding the Coverdell Education Savings Account.  I welcome any and all comments and suggestions!

Next week, I will discuss the basics of yet a few other college savings options - U.S. Savings Bonds and UTMA/UGMA Savings Accounts.

Wednesday, November 4, 2009

The Costs & Rewards of a College Education

Part 2 - College Funding Options: 529 Plans

Recognizing the economic and social benefits of promoting education, federal and state lawmakers have developed a number of investment plans, government programs, and tax incentives to make higher education financially accessible to more Americans. 

Probably the most recognized savings vehicle for funding college educations today is the 529 Savings Plan.  Named after the section of the federal tax code that allows them, they offer significant tax benefits.  There are three basic types of 529 plans: the State-Sponsored 529 Savings Plan, the State-Sponsored 529 Prepaid Tuition Plan, and the Independent 529 Plan. 

State-Sponsored 529 Savings Plan

With a 529 Savings Plan, earnings accumulate tax-deferred and withdrawals can be made, tax-free, when it’s time to pay for a child’s college expenses including tuition, fees, room and board, and books.  Investment minimums are low, as little as $25 per month, and there is no restriction on how much you can contribute every year unless the account is nearing the lifetime cap.  For 2009 each individual is allowed to gift $13,000 per year to any individual gift-tax free.  A special caveat to this applies to funding 529 plans:  You may contribute as much as $65,000 in one year ($130,000 with your spouse) without incurring gift taxes, provided you do not make any further gifts for the following five years.  Each state determines its own lifetime contribution limits, ranging from $100,000 to over $300,000.  Contributions can only be made in cash; transfer of securities into plans is prohibited

Each program sponsored by a state offers an array of stock and bond funds for a participant to invest in.  There is also an ‘age-based’ portfolio option given to investors.  An aged-based portfolio will automatically adjust its allocation towards a more conservative position as your child grows older.  Therefore, by the time your child is of college age, the portfolio will be almost exclusively in fixed income and cash positions.  Under IRS rules, you may reallocate investments within a plan once a year.  A special provision was created for the 2009 calendar year which allows an account owner to reallocate up to two times during the year.  Unless extended, the original provision of one reallocation per year will return in 2010.  Further, you can move from one state plan to another state plan with no tax consequences.  As in the case of changing allocations, you can only move between state plans once a year.  You will also want to pay attention to any fees you may incur by moving between state plans. 

Many states do provide added benefits on their own in-state plans by providing state income tax deductions on contributions and exemption from state income tax for qualified plan distributions. Additionally, certain plans are provided asset protection from lawsuits and creditors.  For example all 529 accounts, including out-of-state 529 accounts, having a Texas resident as owner or beneficiary is provided creditor protection by the Texas government.

What if your child does not go to college or doesn’t require the use of the funds set up for their benefit?  You can get a full refund, but you’ll pay taxes plus a 10% penalty on your investment earnings.  These penalties are waived if your child becomes disabled or dies.  Further, if your child receives a scholarship, most plans will waive the penalties on withdrawals up to the scholarship amount. 

An alternative to withdrawing the money is to change the plan’s beneficiary to another child or family member.  A change of beneficiary must be to a first cousin or closer to the original beneficiary; otherwise, there may be adverse tax consequences.  Each state has its own definition of ‘family member’ so be sure to contact your plan’s administrator if any clarification is needed.

Suggested State-Sponsored 529 Savings Plans

The general selection criteria for a savings plan program is usually centered on (1) fees and expenses, (2) investment options, and (3) other incentives that may be offered to in-state residents.   A few suggestions when reviewing plans are: avoid high annual expense ratios and loaded funds, review the quality of the fund selection by each asset class, review extra benefits like state income tax deductions and asset creditor protection.

The quality of each 529 plan, rules and regulations, may vary dramatically by each program sponsor and by state plan.  Some of these limitations can include age contributions limits, required distribution for beneficiaries over a specified age, minimum contributions amounts, and additional fees for out of state residence.  It is very important to review the program details to insure complete understanding of the plan agreement before applying.   More information on 529 plans can be found at www.savingforcollege.com. 

Other factors such as risk tolerance, time frame and family financial situation may affect what college savings vehicle or method is optimal for you.  A prepaid tuition plan may offer features that provide greater advantages for your particular circumstances than a savings plan. Please contact MTR Financial Services for additional information and considerations.

Review established 529 plans periodically to evaluate investment performance, plan agreement changes, and to monitor your specific college-funding objective. 

State-Sponsored 529 Prepaid Tuition Plans

A Prepaid Tuition Plan lets you purchase units of tuition for any state college or university at today’s prices.  A semester’s worth of prepaid tuition purchased at 2009 prices would pay for a semester’s worth of tuition at any future date, no matter what the cost of tuition is at that time.  Prepaid plans are simple in design and offer better rates of return on investment than bank savings accounts and certificates of deposit. The plans also involve no risk to principal, and often are guaranteed by the full faith and credit of the state.

Prepaid plans are typically more restrictive than 529 Savings Plans in that (1) enrollment qualifications require the beneficiary or account owner be a resident of the state, (2) the enrollment period is only open during a limited time frame during the year, (3) the plan is only available to children within a certain age range or grade level (4) plan benefits must begin distributions prior to certain age and (5) prepaid plans are most beneficial for in-state tuition and undergraduate degrees.  Also, due to market conditions in the past several years, some state’s are now charging a premium for their prepaid plans over current tuition prices or revamping in order to regain financial stability, due to lower investment returns over the past several years.  

Prepaid tuition plans are most attractive to conservative investors since the plan guarantees to pay for their student's tuition. Similarly, prepaid tuition plans might be a wise choice for students who are three to seven years away from college since, with such a short investment time horizon, they should be playing it safe. Again, since the risk of being able to cover the rising costs of tuition is being assumed by the plan, you'll pay a premium; you can't expect someone to take on a financial risk for nothing. Also, keep in mind that most prepaid tuition plans do not allow enrollment of students beyond the 9th or 10th grades. 

Some prepaid plans cover just tuition and fees; other plans will also pay for room and board. If you participate in a plan that does not cover room and board, you'll have to save separately for those expenses. Like the other college savings options, a prepaid tuition plan can be transferred to another family member.  Review all plan details carefully, before taking any action.

Independent 529 Plans

The Independent 529 Plan is a national prepaid tuition plan exclusively for a select list of private and independent colleges.  Created in 1998 by a group of 18 southern colleges, it now has over 247 participating private colleges in 38 states and the District of Columbia.  Its members include a wide range of institutions including large research institutions (Stanford, University of Chicago), traditional liberal arts colleges (Amherst, Middlebury), women’s colleges (Smith, Wellesley), historical black colleges (Spelman, Dillard), religiously-affiliated colleges (Notre Dame, SMU), and technically-oriented institutions (Rice, MIT).  A full list of colleges and universities currently participating can be found at www.independent529plan.org.

The allure of Independent 529 Plans is that a parent or grandparent can lock in future tuition costs at less than today’s price.  Member colleges offer discounts to current year tuition rates, typically between 0.5% and 1%.  When an account is established, the account owner will ‘choose’ a college from the list of schools currently participating and base their contributions on that school’s current discount and tuition rate.  The college chosen as a benchmark has no bearing on admission to that school.  It simply establishes a starting point for future contributions.  Account owners will have the opportunity to select up to five ‘sample’ colleges to monitor.  Quarterly reports will be sent to the account owner displaying the value of the account in terms of the accumulated tuition benefit based on these ‘sample’ colleges.

To illustrate, if the account owner chooses to base their contributions on the current tuition of the University of Notre Dame, and Notre Dame currently offers a 0.5% annual discount through the Plan, then the account owner will know that a payment of $35,135 today will pay for one year’s tuition at Notre Dame 10 years from now ($36,847 ‘08-09 tuition less 0.5% discount annually over 10 years = $35,135).  Assuming the annual increase in college tuition remains at 6%, one year’s tuition at Notre Dame ten years from now will be close to $66,000.  Therefore, by prepaying $35,135 today, the account owner will realize a tax-free savings of almost $31,000.

This unique way of paying for college tuition offers the security of a guarantee against tuition inflation and the flexibility to choose from some of the nation’s top colleges. 

There are certain contribution limits to Independent 529 Plans.  The most that can be contributed in any given account is based on five years of undergraduate tuition at the highest-priced participating institution in the program today.  For the 2008-09 program year the maximum lifetime contribution limit was $183,000. 

As is the case with State-Sponsored 529 Plans and Prepaid Tuition Plans, the Independent 529 Plan offers potentially significant estate and gift tax benefits.  For 2009, the annual gift tax exclusion is $13,000, meaning any individual is able to gift this amount to any number of individuals during the year without triggering a gift tax in that year.  If you are married, your spouse may elect to split the gifts made to purchase a tuition certificate for a beneficiary, thereby doubling the amount of the annual gift tax exclusion from $13,000 to $26,000.  All 529 Plans benefit from a 5-year averaging provision with contributions, meaning you can elect to treat up to $65,000 as having been made in 5 equal gifts of $13,000 over a 5-year period.  If married and file a joint tax return, this amount can double to $130,000.  Caution must be taken if you are able to take advantage of this provision – no additional contributions can be made by the account owner, and spouse if applicable, to the account over the next five years.  Any additional contributions made during the five-year period by the account owner and/or spouse could result in gift taxes being owed in the year of excess contribution.

With the growing popularity of the Independent 529 Plan, more private colleges will be adding their names to the list of participating institutions in the years to come.  These institutions, when added to the list, are obligated to honor all certificates purchased prior to its inclusion in the Plan, provided the beneficiary is admitted into the college or university.  What happens when a college or university removes itself from the list of participants?  If a college should ever withdraw from the Independent 529 Plan, it would still be obligated to honor all certificates that were purchased prior to its withdrawal.  No certificates purchased after its withdrawal will be honored by that specific college.

Certificates purchased can only be redeemed for undergraduate tuition and mandatory fees at participating institutions.  Mandatory fees are those fees required to be paid by all students attending the particular college as a condition of enrollment.  Currently, costs for other expenses including room and board, text books, supplies, and miscellaneous expenses are not covered under the Independent 529 Plan.  Once a certificate is purchased, it must be held for 36 months before it can be used.  Further, the certificates must be used within 30 years from the date of purchase or else it will mature.  Once a certificate matures the account owner has the following options:

1.    Receive a refund, explained below, and retain all the tax benefits for the withdrawal portion if used for qualified higher education,
2.    You can change the beneficiary, or
3.    You can roll over an Independent 529 Plan account tax-free into a state-sponsored 529 plan.

A refund may be received at any time after the one-year (12 calendar months) anniversary of purchase, adjusted for fund performance.  As with any 529 program, if you do not use the money for qualified higher education expenses, any increase in the value of your initial purchase amounts (the difference between your contribution amount and the amount refunded) will be subject to federal income tax as well as an additional 10% tax.  If you take a refund, rather than redeem your certificates for its intended purpose, the refund will be adjusted based on the net performance of the Program Trust, subject to a maximum increase of 2% per year and a maximum loss of 2% per year.

What happens if the student receives a scholarship or decides not to attend college at all?  If the student receives a scholarship that covers the costs of qualified expenses, you can withdraw the funds from your account up to the amount of the scholarship without penalty or additional tax.  Earnings that are refunded due to scholarships are taxable income but are not subject to the 10% additional federal income tax.  If the student decides not to go to college, you still have options:

1.    You can leave the account open for future use – for up to 30 years,
2.    You can change the beneficiary to another ‘member of the family,’ within the federal 529 rules, or
3.    You can take a refund adjusted for fund performance.

Financial aid concerns must also be considered if you are not able to fully you’re your child’s education.  Congress has passed a new law that significantly improves the financial aid rules governing prepaid 529 plans. Simply put, Independent 529 Plan accounts are now treated the same as any other parent asset, including 529 savings plans. This new law means that, beginning in 2006, prepaid 529 plans — such as the Independent 529 Plan — will no longer be treated as an available student resource when determining your potential financial aid award. Now, no more than 5.6% of your 529 college savings will be used to assess need if you apply for financial aid under federal guidelines.  The impact 529 plans have on financial aid will be discussed in greater detail later in the report.

Please do not hesitate in contacting me with any questions you may have regarding the various 529 plans available to everyone.  I welcome any and all comments and suggestions!

Next week, I will discuss the basics of another college savings option - the Coverdell Education Savings Account.