Disclaimer: Information contained below was accurate as of the date of publication. Due to frequent tax law changes, information may no longer be accurate. For the latest tax information, please contact a member CPA.

COLLEGE SAVINGS CONFUSION

by Andrew D. Schwartz, CPA

Back in the old days, saving for a child's college education was much simpler.  Not only was sending a child to college more affordable, but there were also a lot fewer college savings options available.  You either socked away as much money as possible in your savings account, or, during the pre-"kiddie tax" days that ended in 1986, you might have opened an account in your child's name.  Let's take a look at the variety of college savings opportunities that are now available to you.

Just Say EE's

The first tax advantaged opportunity was instituted back in 1990.  Known as the Education Savings Bond Program, you don't pay taxes on the interest earned on certain government bonds redeemed to pay for a child's tuition. 

To qualify:

• The bond must be in your name or the name of you and your spouse - which means bonds issued in the name of your child aren't eligible.  Plus, you must have been at least 24 when the bond was issued.

• Upon redemption of the bonds, the tax break is limited to the amount spent that year to pay tuition and fees.

• If you redeemed any bonds in 2003, you didn't benefit from this tax break unless your income was less than $117,750 if you're married or $73,500 if you're single.  This threshold is indexed for inflation.

Only EE bonds and I bonds (which we addressed in our April, 2004 Newsletter) qualify.  More information on government bonds can be found at www.treasurydirect.gov.

529's & ESA's

If you'd prefer to invest in mutual funds to save for a child's college education, take a look at 529 Plans and Education savings Accounts (ESA's).  Both plans offer tax-deferred growth as long as the money remains invested.  Here's how these two plans differ:

• Maximum annual contribution:  You can contribute up to $2,000 per year per child into an ESA versus $11,000 per year per donor into a 529 plan.  Want to put away even more money? The 529 plan allows you to frontload five years of contributions, up to $55,000, all in one year.

• Tax-Free Distributions:  Unless the current rules are extended, distributions from a 529 plan used for eligible college expenses will only be tax-free through 2010.  Starting in 2011, distributions will be taxed at the child's rate.  With an ESA, distributions continue to be tax-free after 2011, and you can also use ESA money for private kindergarten, elementary school and high school.

• Investment Control:  With a 529, you buy into a set portfolio managed by a financial institution based on your child's age.  With an ESA, you get to choose the underlying investments.

• Income Limitation:  Earn more than $220,000 if you're married ($110,000 if you're single), and you're not eligible to contribute to an ESA that year.  You can generally always find someone else to contribute, however.  With a 529 Plan, there are no income limitations.

Wondering which plan is better?  It all depends on your specific situation and how much you're looking to put away for your child's education. 

Tax Credits For College Credits

Back in 1997, Congress enacted a few new tax credits to help people pay for a college education.  The Hope Credit applies for the first two years of post-secondary education and provides up to a $1,500 tax savings.  This credit is equal to 100% of the first $1,000 spent on tuition, fees and other eligible expenses, and 50% of the next $1,000 spent. 

The Lifetime Learning Credit takes over in the third year of a child's education, and includes graduate level courses as well.  Originally, this credit was maxed out at 20% of the first $5,000 of qualified educational expenses incurred, which meant a savings of $1,000.  Currently, the maximum allowable expenses have doubled to $10,000, increasing the potential tax break to $2,000.

Unlike a tax deduction, a tax credit is a dollar for dollar reduction in what you owe the government, so the Hope Credit could increase your tax refund by $1,500 annually for two years, while the Lifetime Learning Credit could mean up to $2,000 in your pocket every year after that.

Like every other provision mentioned in the article, there is an income threshold for this tax break as well.  Single individuals who earn more than $51,000 and married couples who earn more than $103,000 aren't eligible for either of these education tax credits.

And There's More

Believe it or not, there are still more tax breaks available to students.  If you're working full time while taking classes, the government allows your employer to pay up to $5,250 towards your education each year.  Tuition, books, supplies and equipment paid on your behalf through your employer's education assistance program isn't taxable to you.  Under the current rules, this tax-free benefit applies to undergraduate and graduate level classes.

There is also a tax deduction for students that is scheduled to expire at the end of 2005.  Known as the Tuition and Fees Deduction, this tax break allows you to claim a deduction of up to $4,000 annually in connection with your higher education expenses, as long as your income is less than $130,000 if you're married or $65,000 if your single.  If you're income exceeds that threshold, but falls below $160,000 ($80,000 if you're single), you can still deduct $2,000.  You don't need to itemize to claim this deduction.

And don't forget about the student loan interest deduction.  Each year, you can deduct up to $2,500 of student loan interest paid.  This deduction, which is also available to non-itemizers, phases out for married couples who earn between $100,000 and $130,000, and for single individuals who earn between $50,000 and $65,000.

Eight Breaks

Eight different education tax breaks were addressed in this article.  Coordinating these opportunities to minimize the after-tax cost of sending a child to college is quite a challenge - even without factoring in that many of these rules are scheduled to change or expire when the 2001 Tax Act sunsets in 2010.  Plus, it's important not to overlook how each of these strategies might impact the financial aid package your family ultimately receives.

So if you'll be sending a child to college at some time in the future, I only have two words of advice for you...."Plan Ahead".  And based on the current college savings confusion, I guess I have two additional words of advice for you..."Good Luck!"

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THE NEW INDEPENDENT 529 PLAN

by Andrew D. Schwartz, CPA

Worried that your child's college savings nest egg won't keep pace with the rising cost of tuition?  If so, take a look at the new Independent 529 Plan.

Managed by TIAA-CREF, this 529 Plan is a nationwide pre-paid tuition plan rather than a portfolio of mutual funds managed by a financial institution.  Currently, more than 230 colleges and universities around the country participate in this program.

Here's how the Independent 529 Plan works.  Let's say that tuition at the school your child ends up attending is running at $20,000 per year right now.  If you contribute $10,000 into the Independent 529 Plan this year, you'll own half a year's tuition at that school.  How the stock market performs between now and when your child enters college, and how expensive the cost of attending that school might become, doesn't matter. 

What's the downside?  If your child ends up attending a non-participating college or university, or you want to roll your money over into another 529 plan, then the rate of return you'll receive on the money invested is limited to just 2% per year.

Should you take a look at this type 529 plan?  Yes, if you tend to be risk adverse with your investments and are concerned that the price tag for your child's or grandchild's college education will continue to skyrocket.

To find out more about this new tax-advantaged college savings opportunity, visit www.independent529plan.org.

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