As tax laws change, college investment planning becomes increasingly complex. The most beneficial strategies for creating a college fund are quite similar to other investment tactics. Investment products that are tax deferred, tax exempt, or transferable without tax consequences can be especially advantageous.
This is even more effective if you do your planning early.
One important aspect of an investment is its balance of yield and risk. Determine the amount of risk you can tolerate, given the amount of time you have to recover from any potential losses.
Once you've determined how much it will cost to send your children to college, your next prudent step is to develop a systematic investment plan that will enable you to accumulate the necessary funds.
What are your funding options? Which would be best for your situation? We've listed several below, along with a brief description of each.
Section 529 Plans
Section 529 Plans are also known as Qualified State Tuition Programs. These plans are sponsored by individual states and offer higher contributions than Coverdell IRAs along with tax-deferred accumulation. Once withdrawals begin, they are tax exempt as long as the funds are used to pay for qualified higher education expenses.
As with other investments, there are generally fees and expenses associated with participation in a Section 529 savings plan. In addition, there are no guarantees regarding the performance of the underlying investments in Section 529 plans. The tax implications of a Section 529 savings plan should be discussed with your legal and/or tax advisors because they can vary significantly from state to state. Also note that most states offer their own Section 529 plans, which may provide advantages and benefits exclusively for their residents and taxpayers.
The unique advantage with 529 plans is that the value of the 529 account is removed from your taxable estate, yet you retain full control over the account including the right to ask for the money back at any time. No other vehicle affords this combination of control and estate reduction.
Some grandparents are being advised by their attorneys, accountants, and financial planners to gift away assets to younger family members as a way to reduce exposure to the estate tax. You can make up to $13,000 in gifts each year to any other person and not be subject to the gift tax. If you do not use this year's $13,000 annual exclusion opportunity, you lose it. However, like many people who have worked hard to build up their net worth and who are uncertain about what the future may hold, you may be reluctant to follow through with annual gifting because you do not wish to irrevocably part with your assets.
The "excuse" not to utilize your $13,000 annual gift exclusion disappears with a 529 plan. You do not have to give up control. You can ask for the money back whether you really need it or if you just change your mind later on. (Of course, if you take the money back it comes back into your taxable estate. In addition, any withdrawal not used for the beneficiary's qualifying higher education expenses subjects the earnings to tax and 10% penalty.)
If your contributions to a 529 plan for a grandchild, when combined with all other gifts to that child during the year, exceed the $13,000 annual exclusion, you must file a gift tax return (Form 709) and compute any gift tax and generation-skipping transfer tax. Everyone has a lifetime exemption of $1 million for gifts and $2 million for generation-skipping transfers before taxes are owed.
In any year during which your 529 contributions for a particular beneficiary exceed $13,000, you may make an election on Form 709 to spread the contributions ratably over five years (20% per year) for gift-tax purposes. This permits frontloading of up to $65,000 per beneficiary (or $130,000 for a married couple) into a 529 plan without generating a taxable gift, assuming no other gifts to that beneficiary are made during the five calendar-year period. If you make the five-year election and die before the fifth calendar year, the contributions allocated to the years after your death are included in your taxable estate.
There is no guarantee that the plan will grow to cover college expenses. In addition, depending upon the laws of your home state or designated beneficiary, favorable state tax treatment or other benefits offered by such home state for investing in 529 college savings plans may be available only if you invest in the home state's 529 college savings plan. Any state-based benefit offered with respect to a particular 529 college savings plan should be one of many appropriately weighted factors to be considered in making an investment decision. You should consult with your financial, tax or other adviser to learn more about how state-based benefits (including any limitations) would apply to your specific circumstances and also may wish to contact your home state or any other 529 college savings plan to learn more about the features, benefits and limitations of that state's 529 college savings plan. You may also go to www.collegesavings.org for more information.
Coverdell Education Savings Accounts
A Coverdell Education Savings Account (ESA) is an account created as an incentive to help parents and students save for education expenses.
The total contributions for the beneficiary of this account cannot be more than $2,000 in any year, no matter how many accounts have been established. A beneficiary is someone who is under age 18 or is a special needs beneficiary.
Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until distributed. The beneficiary will not owe tax on the distributions if they are less than a beneficiary's qualified education expenses at an eligible institution. This benefit applies to qualified higher education expenses as well as to qualified elementary and secondary education expenses.
There are contribution limits for taxpayers based on the contributor's Modified Adjusted Gross Income. Contributions to a Coverdell ESA may be made until the due date of the contributor's return, without extensions.
If there is a balance in the Coverdell ESA when the beneficiary reaches age 30, it must generally be distributed within 30 days. The portion representing earnings on the account will be taxable and subject to the additional 10% tax. The beneficiary may avoid these taxes by rolling over the full balance to another Coverdell ESA for another family member.
Universal Life Insurance
Universal life insurance policies build cash value through regular premiums and grow at competitive rates. These policies carry a death benefit. In addition to providing cash to your heirs in the event of your death, this death benefit gives universal life insurance policies their tax-free status. Money can usually be withdrawn from these contracts through policy loans, often at no interest. These withdrawals may reduce the policy's death benefit.
Zero-Coupon Bonds
Zero-coupon bonds represent the ownership of principal payments on U.S. government notes or bonds. Unlike traditional bonds, zero-coupon bonds make no periodic interest payments. Instead, they are purchased at a substantial discount and pay face value at maturity. The value of these bonds is subject to market fluctuation. Their prices tend to be more volatile than bonds that pay interest regularly. And even though no income is paid, the inherent interest is still taxable annually as ordinary income.
Mutual Funds
A mutual funds is the common name for an open-end management company that establishes a diversified portfolio of investments that is actively managed, continuously issues new share, and redeems (buys back) old shares representing ownership in the portfolio.
Mutual funds are sold only by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
The information in this article is not intended to be tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor.