IT'S ALL ABOUT MONEY
Increases in the costs of a college education are now approaching 10% a year, forcing families to review the available avenues of saving.
By William A. Clemmer and Gary S. Lesser, Esq.
Increases in the costs of a college education are now approaching 10% a year, forcing families to review the available avenues of saving. While current law certainly enhances the value of the Section 529 Plan, the Coverdell Education Savings Account (CESA), formerly the Education IRA, can play an important role in helping pay for a child's education expenses. Reviewing and utilizing multiple plans and strategies well may be wise planning for advisor and client.
The Coverdell ESA (CESA) was established in 1988 as the Education IRA, utilizing the individual retirement arrangement concept (see "Thirteen Faces of IRA" in the November 1999 issue of Rough Notes). The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made significant changes to the Education IRA for taxable years beginning after 2001. Subsequently, the name was also changed to the Coverdell Education Savings Account (CESA).
Note that while all of our comments include EGTRRA changes, these provisions are scheduled to expire on December 31, 2010. This would result, (given no other interim additions or changes) in a reversion of the federal tax treatment to its status prior to January 1, 2001. Note, too, that applicable provisions of EGTRRA were specifically designed to facilitate long-term savings for college; it is possible that the enhanced federal tax status will continue after 2010. In fact, as of this date, such legislation has been introduced in Congress. Although we make the assumption of continuation, we also take note of the potential risk.
A CESA is not a retirement arrangement, but a trust or custodial account created and maintained for the sole purpose of paying qualified education expenses for the designated beneficiary of the account. A CESA distribution may be excluded from gross income to the extent that it does not exceed qualified education expenses incurred by the named beneficiary during that year.
Contributions:
--may be made even if there is no earned income;
--are made with after-tax dollars (no deductions);
--are limited to $2,000 for 2002 ($500 in prior years) until the beneficiary reaches age 18, except for a special needs beneficiary;
--may be further limited (phased out) to those with modified adjusted gross income (MAGI) of $190,000 (increasing to $220,000) for married couples filing jointly and $95,000 (increasing to $110,000) for individuals; The MAGI is the AGI shown on the contributor's federal income tax return increased by certain exclusions for his or her income, relating to non-U.S.-related income or costs;
--will not restrict contributions to any qualified retirement plan, or Roth or traditional IRA.
Excess contributions are subject to a 6% penalty (plus related earnings).
Tax advantages and considerations:
--Earnings accumulate without current taxes.
--Federally tax-free qualified withdrawals are allowed (if withdrawals do not exceed qualified education expenses).
--State income taxes may apply to a distribution from or to annual earnings from a CESA.
--A CESA may be subject to Unrelated Business Income tax (UBIT).
--A CESA is considered part of a deceased beneficiary's estate.
Qualified education expenses:
--expenses for qualified higher education and qualified elementary and secondary schools;
--tuition, fees, books, supplies and equipment;
--room and board (if at least half-time attendance), with some limitations;
--payments to qualified state tuition program (higher education) and special needs services (elementary and secondary)
Other conditions:
--Must withdraw assets at age 30 (except for special needs beneficiary) to escape penalty.
--Savings are considered to be the student's and may reduce financial aid eligibility.
Flexibility and control:
--Can also contribute to qualified state tuition program if amounts used for different education expenses.
--Can claim Hope Scholarship and Lifetime Learning credit and take a qualified distribution from CESA if amounts are used for different education expenses.
--Beneficiary can generally be changed to an eligible member of the beneficiary's family (under the age of 30) with no penalties.
--Assets from one CESA may be rolled over to another CESA. (IRA rollover rules apply.)
--The transfer of a designated beneficiary's interest in a CESA to his or her spouse or former spouse under a divorce or separation instrument is not a taxable transfer without changing the character of the CESA.
--Funds can be withdrawn for non-education purposes with the payment of a penalty (10%).
--Exceptions to early distribution penalties are made if the distribution is:
1. attributable to a qualified education expense;
2. made as a result of the beneficiary's death (distribution is made to estate or beneficiary);
3. attributable to the individual being disabled (see Code Section 72(m)(7));
4. made on account of a scholarship, allowance or payment and does not exceed the amount of the scholarship, allowance or payment (see Code Section 25A(g)(20).
EGTRRA transformed the
all-but-worthless Education IRA ($500 contribution limit) to a worthwhile $2,000 contribution limit CESA. The CESA is considered an asset of the beneficiary while Section 529 ownership and control rests with the grantor. The CESA beneficiary has a greater flexibility of asset allocation. Federal tax treatments of the two plans are similar. Plan comparison should include a review of fees and the impact of state tax deductions (in some states) on Section 529 plans and the ability to contribute larger amounts to a Section 529 plan.
Preference for investment flexibility and control and levels of risk tolerance vary. The ability to move large amounts of assets into a savings plan with reduced investment control may not be feasible or desirable. Families may prefer one savings strategy, or combination of strategies, to another. In making savings decisions, families and their advisors should take into account financial situations and savings goals. Then, together they can rationally evaluate the advantages and disadvantages of each strategy to find the best way to meet the stated college saving needs. *
The authors
William A. Clemmer and Gary S. Lesser, JD, head up Financial Services Agency Consulting (FSAC), a division of The Rough Notes Company. Clemmer has more than 25 years of financial services industry experience on Wall Street. Lesser writes and lectures widely on retirement planning and taxation issues. He is a member of the board of advisors for the Journal of Taxation of Employee Benefits.