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August 25, 2012

Educational Funding in Difficult Times (article)

For many years, parents assumed they would be in a position to fund the costs of their children's college education through their increasing home equity and investment portfolios. Needless to say, these assumptions are no longer reasonable given the housing bust and the increasing volatility in investment portfolios. How to effectively deal with the educational expenses (public or private) of elementary, secondary, college or graduate education should be a critical strategic component of a family's financial plan. This strategy involves coordinating investment considerations, tax savings and financial aid considerations to help ease this burden.

In many situations, educational planning can involve multiple generations. Often as grandparents review their estate planning options, they express a specific interest in assisting in the funding of their grandchildren's education. This often combines their desire to take advantage of lifetime gifting opportunities while moderating a common concern about "spoiling" their grandchildren.

For grandchildren who are currently attending school, direct payments of tuition to the educational institution are gift tax free. This is in addition to the annual gift tax exclusion, currently $13,000 ($26,000 per couple), which could be used to pay for other expenses such as books or room and board.

Grandparents may also wish to consider qualified tuition programs known as Section 529 plans for college education funding. A Section 529 plan is a program where a person can purchase prepaid tuition credits (prepaid plans) for a specific school or make cash contributions to an account (savings plans) for the benefit of a specific beneficiary for payment of qualified higher educational expenses. The savings plans are more popular since it is difficult to predict in advance the school where a student will be admissible and will want to attend. Savings plans typically have a built in asset allocation matrix that is based on the age of the beneficiary (ranging from all equity for a newborn to mostly fixed income for a high school senior). Other asset allocation models are available depending on the options provided by the plan sponsor.

A contribution to a Section 529 plan has several tax favorable benefits:

  • The contribution is considered a completed gift for estate, gift and GST tax purposes yet the donor retains the flexibility to change the beneficiary.
  • The earnings of the Section 529 plan are tax free if used to pay qualified higher educational expenses.
  • Certain states provide income tax deductions for a portion of the contributions.
  • An election can be made on a gift tax return to use five years of annual exclusions so that lump sum contributions to Section 529 plans can be made without using any of the donor's lifetime gift exclusion. For 2012 gifts, a donor could fund $65,000 (or $130,000 for a couple) into a Section 529 plan for each beneficiary with this election to accelerate annual exclusion use.

For 2012, the lifetime gift exemption is $5,120,000 so even larger gifts could be made to Section 529 plans without having to pay gift tax. After December 31, 2012 the lifetime gift exemption is reduced to $1,000,000 making 2012 an especially good year to consider major gifts.

There are several other tax breaks for higher education that can help pay for the escalating cost of higher education by allowing income tax deductions or tax credits. These include:

  • Tuition and fees deduction (expires after 2011 tax year) — up to a $4,000 deduction.
  • Student loan interest deduction — up to a $2,500 deduction for interest paid.
  • American Opportunity Tax Credit — up to a $2,500 tax credit for each eligible student pursuing a degree or other recognized educational credential.
  • Lifetime Learning Credit — up to a $2,000 credit per tax return for postsecondary tuition and fees. There is no degree requirement.
  • Coverdell Education Savings Account — total contributions for a beneficiary are limited to $2,000 per year. Contributions are not deductible. Earnings are tax free if used to pay qualified educational expenses of the beneficiary.

Eligibility for these tax breaks varies and they are subject to Adjusted Gross Income limitations before being phased out completely. See IRS Publication 970 – Tax Benefits for Education for specific details on income limitations and phase-outs.

The best educational funding plans are those that involve long-term savings and investment strategies. Students entering college are generally eighteen years old, thus providing a long-term investment horizon for those plans that start when a child is born. The initial decision of whether to invest in the parent's or child's name is often determined after an analysis of whether "need based" financial aid can reasonably be expected for a specific family situation. It is important to understand the government financial aid eligibility rules established by the U.S. Department of Education (see the Free Application for Federal Student Aid, known as FAFSA). For purposes of need-based financial aid, assets of a child are assessed at a higher rate in determining a family's Expected Family Contribution (ECF) than assets held in the parent's name, which can reduce financial aid that would be otherwise available. The family's ECF should be estimated to determine if need-based aid is even a possibility. Additionally, the parents should realize that many financial aid packages contain a significant amount of loans that will need to be repaid.

Merit-based aid is another source of educational funding that is often overlooked. The offer of merit-based aid can vary widely between educational institutions depending on many factors such as the school's endowment and the relative desirability of your student compared to the average student's academic profile at that school. This is something that can be negotiated for students who are actively recruited by multiple schools that are competitive with each other.

The benefit of shifting investment income to children for lower tax rates has been greatly reduced with the extension of the "kiddie tax" to children under age 19 (and under age 24 if a full-time student). When the kiddie tax applies, investment income in excess of $1,900 (in 2011 and 2012) is taxable at the parent's tax rate. The kiddie tax rules used to apply only to children under age 14, which provided greater flexibility and planning opportunities.

Many of the benefits listed above have additional limitations not described here including certain restrictions on the use of multiple incentives in the same year. Therefore, the use of these tools and techniques should be coordinated as part of an overall strategy to optimize the amount of financial aid and savings while keeping loans at a reasonable level.

When faced with volatile financial markets, soaring educational costs and difficult job prospects for graduates, it is more critical than ever to carefully plan to achieve the educational goals for your family. Contact your local CBIZ MHM tax professional to help you devise a strategy that meets your needs.


Copyright © 2012, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we inform you that-unless specifically indicated otherwise-any tax advice in this communication is not written with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue Code, or to promote, market, or recommend to another person any tax related matter. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

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