By: Randall A. Denha, Esq.
Lets first begin with the premise that it’s never too late to begin saving for your child’s future. Parents and grandparents have a few options for saving for a child depending on how the money is ultimately used. Gifting is an integral part of estate planning and the skyrocketing rise of education costs has made gifting to fund educational expenses an important consideration for many families. Thankfully, we have a few strategies that fall squarely within the objectives of saving for the child’s future. Internal Revenue Code Section 529 provides that a “529 Plan” can be used to pay for post-secondary education, while a separately maintained “Trust Fund” can be put to any purpose. When these techniques are used together, the tax deferral, savings and benefits that can be reaped will far outweigh the costs of maintaining these strategies.
529 Plan Defined
In 1996, Section 529 of the Internal Revenue Code established a type of savings plan that parents could use to save for their child’s college costs. A 529 plan is sponsored by the state, so the specific details of each plan vary from state to state. Plan holders are not limited to holding a 529 in their state of residence. The 529 plan can be held in the state the child is planning to attend college. Two types of 529 plans exist: a prepaid tuition plan and a savings plan. Prepaid tuition plans purchase credits at a specific school, while savings plans set the money aside for future use at any school. After-tax dollars are contributed to these accounts which then grow federal income tax free for the benefit of the beneficiary of the account. The funds must be used for college tuition and related expenses (i.e. tuition, fees, books, supplies, required equipment and room and board.) If the beneficiary does not use all the funds, the beneficiary can be changed to another child. To the extent funds are used for non-educational purposes, they are subject to income tax and a 10% penalty on the earnings of the account. The penalty can be avoided if the beneficiary dies, becomes disabled or receives a scholarship.
Savvy Strategy #1: While it may not be as tax and investment efficient, some Grantors with excess income and assets have overfunded a 529 plan strictly from the standpoint of asset protection, or protecting those assets from the claims of future creditors. Many states provide special creditor protection for 529 plans and its beneficiaries. Thus, careful consideration should be given to who the owner of the account should be if done for these reasons. This strategy appeals to certain Grantors (i.e. physicians or other high risk professionals) who will generally exploit this opportunity reasoning that they have maximized retirement plan contributions and are looking for additional ways to save tax and achieve wealth planning. Of course this technique only works if the transfers are free of any fraudulent intent.
The alternative to the 529 Plan is the creation of an irrevocable gifting trust. The gifting trust would be created by a parent or grandparent for the benefit of a child or grandchild. A trust could be funded with any form of property (i.e. cash and cash equivalents, real property, LLC membership interests, etc.). The funds in the trust do not grow federal income tax free. The trust or the person who created the trust, known as the Grantor, will be required to pay income tax on its earnings to the extent income is not distributed. However, the gifting trust allows for greater flexibility in its use allowing the trustee to make discretionary distributions to the beneficiary not only for education but additionally for health, maintenance, and support or other legitimate reasons. The gifting trust could exist for a term of years, for the beneficiary’s life, or until the beneficiary finishes his or her education at which time the trustee could distribute all remaining trust property free of any penalties. Thus, a person could fund the gifting trust with more than may be necessary to assist with educational costs without fear of being subject to penalties.
Savvy Strategy #2: As mentioned above, there are two ways a trust can be taxed-to the Grantor or to the Trust itself. If taxed to the Grantor then the trust can continue to grow undiminished by the income tax and the Grantor can continue to pay the income tax thereby reducing his/her own estate in the process. However, if taxed to the Trust itself then the Trust will pay income tax on trust income at the highest marginal income tax bracket of 39.6% if the income of the trust exceeds $12,150! As such, most grantors who can afford to do so will opt to pay the income tax so that more can pass to the next generation.
It is also important to note that a donor can pay for a child or grandchild’s educational expenses directly as a tax-free gift, which is in addition to (and not limited by) the $14,000 per donee per year gift tax annual exclusion.
Financial Aid Concerns
Calculating the impact on financial aid by 529 plans is relatively simple where a parent is the holder of the 529 plan. The impact on financial aid is complicated when the plan is in the student’s name. This is something to consider when you take out a 529 plan.
The amount in a 529 plan and in a UGMA/UTMA trust needs to be reported if a student applies for financial aid using the Free Application for Federal Student Aid (“FAFSA”.) Beginning with the 2009 to 2010 school year, 529 plans are now counted as parent assets, not the dependent student’s, due to the Higher Education Reconciliation Act of 2005. Assets owned by students are counted at a rate of 20 percent toward the family’s expected contribution, while assets in the parent’s name are counted at a rate of 5.64 percent at the time of publication. This treatment confers a financial aid benefit as the parental rate of 5.64% is considerably less prejudicial than the 20% rate on non-529 assets owned by the student.
529 distributions treated favorably
Along with favorable asset treatment, a 529 account also garners favorable treatment in the income portion of the financial aid eligibility formula. A tax-free distribution from a 529 plan to pay this year’s college expenses will not be part of the “base-year income” that reduces next year’s financial aid eligibility.
Here is a simplified example of how this all works:
You file the FAFSA aid application when your child is a senior in high school. Let’s say you have a 529 savings account with $20,000 in it, of which $10,000 represents your original contribution and $10,000 is earnings.
Year 1: Your child’s eligibility for federal financial aid this year will decrease by no more than 5.64% of the account value, or $1,128 ($20,000 x 5.64%). Assume there is no further appreciation in the account and you withdraw $5,000 in the fall to pay for the first semester college bills.
Year 2: You have $15,000 left in the account when your child applies for aid for sophomore year, and it will again be assessed up to 5.64% of the account value or $846 ($15,000 x 5.64%). The $5,000 withdrawal brought $2,500 of excluded earnings with it, but as indicated above, none of the withdrawal is counted as financial aid income.
The federal aid formula is more complicated than what is described here, but this gives you a general idea of how to calculate impact. This is a quite complicated area and is often changing. It’s also worth noting that each school can set its own rules when handing out its own needs-based scholarships, and many schools are adjusting awards when they discover 529 plans in the family.
Don’t Forget The Kiddie Tax
As previously discussed in past blogs, Congress first introduced the kiddie tax as part of the Tax Reform Act of 1986 to discourage wealthy parents from sheltering their investment income in accounts under their children’s names, thereby avoiding paying taxes on the amounts. The rules have been tweaked periodically ever since. Although the kiddie tax once applied only to the unearned income of children under age 14 (hence the nickname), it now impacts all children under age 19 (as well as full-time students under 24), provided their earned income does not exceed half of the annual expenses for their support.
Moreover, the kiddie tax is not just a wealthy person’s problem: Any outright gifts parents or grandparents bestow on young children, whether to avoid triggering the gift tax or simply out of generosity, could actually generate investment earnings that would be subject to the kiddie tax if they exceed a threshold amount.
Savvy Strategy #3: It is recommended that trusts be structured to distribute any amount of investment income only after the beneficiary attains the age of 24, provided they are full time students.
Keep in mind that whatever techniques you employ that each strategy impacts other tax and non-tax related areas.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.