Developing a Plan To Save for College
Jonathan Clements
Jun 17, 2001
If you are saving for a child's college education, it's time to head back to school.
The new tax law could mean thousands of extra dollars for families with college-bound kids. But to enjoy the savings, you have to seize the opportunities.
Got questions about the legislation's education provisions? Here are some answers:
Q: What are the major changes?
A: The law contains four key provisions. First, starting in 2002, the annual amount you can stash in an education individual retirement account rises to $2,000 from the current $500. Education IRA withdrawals are tax-free, as long as the money is used for educational purposes.
Second, withdrawals from state-sponsored 529 plans also become tax-free, provided the money is spent on college costs.
Third, the legislation expands the student-loan interest deduction. You now can claim the deduction if you are single with taxable income below $50,000 and married filing jointly with income below $100,000. Above those thresholds, the allowable deduction phases out.
Finally, the law introduces a tax deduction for college costs. This may not benefit many folks, however, because there is an income threshold and you can't claim the deduction in the same year you claim the Hope or Lifetime Learning tax credits, which often will prove more valuable.
Additionally, the deduction dies after 2005, unless Congress renews it. Indeed, without Congressional action, all of the law's provisions disappear after 2010.
Q: What does this mean for me?
A: If your family income is over $125,000, consider stuffing money into education IRAs and 529 plans, says Kalman Chany, author of "Paying for College Without Going Broke."
Meanwhile, if you earn less than $50,000, Mr. Chany suggests skipping 529 plans and education IRAs. Instead, bank on benefiting from the various education tax credits and deductions and hope to receive college financial aid.
What about families with incomes between $50,000 and $125,000? These folks may be tempted to fund 529 plans and education IRAs. The problem is, money in these accounts could damage their financial-aid chances. "These are the people who are going to have to run the numbers" to see if they qualify for aid, Mr. Chany says.
He figures that, if your family income is above $75,000, you are unlikely to get aid if your child attends a public college. But he says you could qualify for aid at a costly private college, even with a $125,000 family income. To get a handle on aid eligibility, you need to talk to a financial-aid expert or work through one of the college-funding guidebooks.
"You want to save no matter what," Mr. Chany says. "These question is, which vehicle to use? If you think you're going to qualify for aid, you should probably keep the money in the parents' names," because that won't be so damaging to aid eligibility.
Q: Which is better, a 529 plan or an education IRA?
A: Don't think you will qualify for aid? In that case, a 529 college-savings plan or education IRA may make sense. You could invest in both. But which should you favor?
Both offer tax-free growth and both leave parents with a lot of control over how the money is used. But there also are critical differences.
While both education IRAs and 529 college-savings plans will likely hurt your financial-aid chances, education IRAs currently appear more damaging. An education IRA is considered the child's asset, and thus counts against you more heavily in the financial-aid process. By contrast, a 529 plan is considered the donor's asset.
The aid process, however, also looks at income. On that score, it is not clear how education IRAs and 529 plans will be treated, especially following this year's tax changes. "Even if it's tax-free for purposes of federal income taxes, it may still be considered in the aid process," Mr. Chany warns.
With an education IRA, you get greater investment flexibility and your investment costs should be lower. Still, wealthier parents likely will favor 529 plans, for two reasons. First, while you can put just $2,000 in an education IRA each year, each parent could invest as much as $50,000 in a child's 529 plan and then count that as their gift for the next five years.
Second, there is no income test for a 529 plan. But to fully fund an education IRA, you have to be single with taxable income below $95,000 or married filing jointly with income below $190,000. If you don't make the income cut, however, you could always give $2,000 to your favorite aunt and ask her to open the account.
Q: Should I close my kid's custodial account?
A: Following this year's tax changes, many parents will be tempted to swap money out of their child's custodial account and into a 529 plan or education IRA. While custodial accounts enjoy a modest tax break, the gains aren't tax-free and the child gets control of the money at age 18 or 21. Thus, 529 plans and education IRAs would seem to be better bets.
According to experts, you shouldn't trigger any legal problems by shifting money out of a child's custodial account, as long as the money continues to be used solely for that child's benefit.
But does the move make financial sense? Here's the problem: When you close out the custodial account, you could trigger a big capital-gains tax bill.
"If you can do it with minimal tax cost, it's clearly worth it," says Sam Beardsley, head of the investment-tax department at Baltimore's T. Rowe Price Associates. "But if you're going to have to pay a lot of capital-gains tax to make the conversion, it may not be beneficial."
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