Planning for College | Redstone Federal Credit Union

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Most people make investments with an eye toward saving on taxes, and college investments are no exception. A Coverdell Education Savings Account is one vehicle in which earnings grow tax-deferred, and are never taxed if they are used for the beneficiary's qualified education expenses.
Qualified tuition programs are generally tax-favored, and make it possible for you to make contributions now toward education expenses in the future. Interest in Series EE and Series I Savings Bonds grows tax-deferred, and may never be taxed if the bonds are redeemed in a year when you pay your child's college tuition.
You also need to determine who should own the investments that are going towards your child's education. That decision will be made, in part, based on your tax bracket, whether or not you qualify for financial aid and your net worth.

Coverdell ESA

Taxpayers may make nondeductible contributions to a tax-favored account designed specifically for college, elementary, or high school education expenses—a Coverdell Education Savings Account (formerly known as an Education IRA).

Contributions of up to a total of $2,000 per year, per beneficiary, may be made to an account for the benefit of a beneficiary who is under age 18 (students with special needs can be over 18). In 2016 income phase-out for contributions begins for taxpayers with modified adjusted gross income (AGI) above $95,000 ($190,000 for joint filers). No contribution will be allowed once modified AGI reaches $110,000 ($220,000 for joint filers). These limits have been unchanged from 2012.

SUGGESTION: The child's grandparent or other relative may be able to establish the account and make the annual contribution.

SUGGESTION: Contributions can be made to an Education Savings Account regardless of whether or not the owner has earned income.

Earnings in an Education Savings Account grow tax-deferred, and are never taxed, provided they are used for the beneficiary's qualified education expenses. The American Opportunity Tax Credit or the Lifetime Learning Credit can be claimed for the eligible student in the same year as an Education Savings Account distribution as long as the distribution is not used to pay for the same costs used to claim the education credit. If withdrawals are not used for qualified education expenses, withdrawn earnings are included in the beneficiary's taxable income and are subject to an additional tax of 10%.

IMPORTANT NOTE: If the balance of an Education Savings Account is not distributed before the beneficiary reaches age 30, the account must be emptied upon attainment of that age, unless the individual is a special needs beneficiary. The earnings in the account are taxed at the beneficiary's income tax rate and are also subject to a 10% penalty since they will not have been used to pay qualified education expenses. You may roll over the account to another Education Savings Account benefiting a different beneficiary who is a member of the family of the previous beneficiary.

Here are some other facts regarding the Education Savings Account:

  • Contributions qualify for the annual gift tax exclusion.
  • An Education Savings Account can be set up for any child under 18; contributions generally cannot be accepted after the child's 18th birthday, unless the beneficiary is a special needs beneficiary.
  • There is no limit on the number of Education Savings Account that may be established for a particular child, but the maximum aggregate contribution for any one child in any calendar year is $2,000.
  • Contributions are not deductible.
  • Only cash contributions are allowed.
  • Subject to the applicable income limits, any individual may contribute to an Education Savings Account; the contributor does not have to be a relative. A child may contribute to his or her own Education Savings Account.
  • A child may take tax-free withdrawals to pay qualified higher education expenses even if he or she is enrolled at an eligible educational institution less than full-time; enrollment on a half-time or less than half-time basis will qualify, depending on qualifying expense.
  • If the beneficiary dies, the value of the account is includible in his or her taxable estate—not in the account owner's estate.
  • The account is considered an asset of the parent when applying for financial aid if the parent is the owner of the account.

If you are eligible to establish an Education Savings Account and make the maximum annual contribution of $2,000 at the beginning of each year for 18 years, assuming a 6% rate of return, the account will have a value of $65,500.


Qualified Tuition Programs (QTPs) / 529 Plans

Qualified Tuition Programs (QTPs) offer another way to provide for college funding. These programs, also referred to as Section 529 Plans, generally have a tax-favored status. Individuals may participate in either a prepaid tuition plan or utilize a higher education savings account plan.

Prepaid Tuition Plans

These programs are administered by a state or by an eligible educational institution. Under these plans, participants purchase tuition credits or certificates for a designated beneficiary, who would then be entitled to a waiver or partial payment of qualified higher educational expenses. Contract purchasers prepay tuition and fees for a set number of academic years while locking in current tuition rates. In-kind distributions from these plans, such as a waiver of tuition, generally are excludable from gross income for plans maintained by a state. For plans that are maintained by a private institution, in-kind distributions generally will be excludable from gross income. To be excludable, the distributions must be used for qualified higher education expenses.

Higher Education Savings Account Plans

These programs are generally sponsored by a state. Under these plans, participants make contributions to an account that is set up to meet qualified higher educational expenses of a designated beneficiary of the account. There are no income limitations with regard to making contributions to the plan.

Contributions are made to a state's savings account, and are generally managed by private investment or insurance companies. Each state imposes a limit on the amount of contributions that can be made to the plan per beneficiary, and on how large the account balance can grow. Some states allow a state income tax deduction for contributions made. These plans generally allow for the interest earned to be withdrawn tax-free. The withdrawals must be used for qualified higher education expenses. If withdrawals are made for purposes other than qualified education expenses, the amount of earnings that are withdrawn are taxed at the beneficiary's income tax rate and also subject to a 10% penalty.

IMPORTANT NOTE: You can contribute to any state's savings plan. Most plans have no state residency requirements. Therefore, you need not contribute to the plan of the state in which you live or where your child may attend school. By investing in a 529 plan outside of the state in which you pay taxes, you may lose any tax benefits offered by the state's plan. Consider before investing whether you or the designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such states' qualified investment plan.

There are rules that the federal government has established and which must be adhered to under both types of plans. For example, the account cannot be used as security for a loan. There are other rules to be followed and a state or eligible educational institution may also give direction regarding how its particular program works. The American Opportunity Tax Credit and the Lifetime Learning tax credits can be claimed in the same year as QTP distributions, as long as the QTP distribution is not used to pay for the same costs used to claim the education credit.

Individuals can contribute to both QTPs and Education Savings Accounts on behalf of the same beneficiary. Amounts in a QTP can be rolled over to another state's plan once per year.

SUGGESTION: Assets in a QTP are treated as the parent's assets when applying for financial aid if the parent is the donor. Contributions to QTPs qualify for the annual gift tax exclusion. The person contributing the money to the program may elect to treat the contribution as if made over a five-year period for purposes of the annual gift tax exclusion.

Series EE and Series I Savings Bonds

Series EE and Series I Savings Bonds are issued by the U.S. Treasury. These bonds have tax advantages—you do not pay state or local income tax on the interest earned, and federal income tax can be deferred until you redeem the bonds or they reach maturity. In addition, you may never have to pay tax on all or a portion of the interest if you redeem the bonds in the year in which you pay your child's college tuition.

Series EE bonds purchased after 1989 and Series I bonds that are redeemed to pay for college tuition may not be taxed at all—as long as the parent's modified adjusted gross income (AGI) falls below a certain dollar amount. For redemptions in 2016:

The interest is completely tax-free for joint filers with modified AGI less than $116,300 and $77,550 for all other taxpayers (in 2015 these amounts are $115,750 and $77,200 respectively).

The interest is only partially taxable for joint filers whose modified AGI is over the above threshold and less than $146,300 and $92,550 for all other taxpayers (In 2015 these amounts were $145,750 and $92,200 respectively).

The interest is completely taxable for joint filers whose modified AGI is $146,300 and above $92,550 for all other taxpayers (in 2015 these amounts were $145,750 and $92,200 respectively).

This exclusion is not available to married individuals who file separate returns.

In order to get this federal tax break, the bonds generally must be purchased by a parent, the parent must be at least 24 years old, and the bonds can never be in the child's name. Form 8815 (Exclusion of Interest from Series EE and I U.S. Savings Bonds Issued after 1989) is used to figure out how much of the interest can be excluded from income.

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