- Funding Education
Get Educated on Getting Family Educated
As most of us are aware, tuition and fees at American colleges have increased exponentially in recent years, dramatically above the pace of inflation. Given this trend, financing college clearly requires advance planning. Families of means should give particular consideration to the most tax efficient ways of paying for higher education. Probably the most popular avenue for this planning is the Section 529 Savings Plan (the “529 Plan”). (Section 529 prepaid tuition plans are more limited in nature and are beyond the scope of this article.) Other alternatives include annual gifts to a Texas Uniform Transfers to Minors Account (“TUTMA”), a minor’s trust (in particular, a Section “2503(c) Trust”), and the direct payment of tuition to institutions of higher learning, which is not treated as a gift under Section 2503(e) of the Internal Revenue Code. Perhaps the simplest approach is the direct payment of tuition. However, its greatest disadvantage is that the donor (parent or grandparent paying for the education) must be alive at the time of the college experience in order to remove the education funds from his or her estate in this way. By contrast, a donor can make advance annual gifts qualifying for the gift tax annual exclusion through a TUTMA or 2503(c) Trust. (This exclusion amount started at $10,000 per donor/per year and is adjusted annually for inflation.) TUTMA gifts can easily be made by the donor into an account in the donor’s name as “custodian” for the minor, but it is important to recognize that the child owns the TUTMA account unrestricted at age 21. (Note that Texas law allows the custodian the right to transfer a TUTMA account into a 2503(c) Trust for the benefit of the minor. Let us know if you wish to explore this option.) The 2503(c) Trust differs from the TUTMA in that the child may be granted a mere thirty days upon reaching age 21 to demand the trust property, in lieu of which the trust may continue for a specified period, such as when the child reaches age 30. Income in a TUTMA is taxed to the child, whereas the income of a 2503(c) Trust is taxed to the Trust itself unless distributed to or for the child, or unless the child has reached age 21. Also note that children under age 18 (and full-time students under age 24) are now generally subject to the “kiddie tax,” under which their unearned income is taxed at their parents’ tax rates. The 529 Plan stands out above these alternatives as a superior means of securing funds for college in a tax efficient manner. This is largely because all income earned within a 529 Plan is tax-free, as long as it is used toward qualified higher educational expenses. These include tuition, room and board, fees, books and equipment required for enrollment in post-secondary schools (also, limited expenses on pre-collegiate tuition). Contributions to a 529 Plan qualify for the gift tax annual exclusion. In fact, 529 Plans enjoy the singular ability to “front-end load” annual gifts, using the donor’s coming 5 years’ of annual exclusion gifts for the named beneficiary of the 529 account, simply by electing on a gift tax return in the first year. It is imperative that the donors elect the five-year forward spread of the gifts on gift tax returns in year 1. The election avoids use of any of their gift tax exemptions, but they must also keep in mind that they have thereby used their annual gift tax exclusions for that child or grandchild for years 2 through 5. In addition, these gifts are no longer a part of the donor’s estate for Federal estate tax purposes, assuming the donor lives the full five years. Remarkably, even though these are completed gifts for transfer tax purposes, the tax law allows the donor to control the 529 account. The donor may change not only the investments (within the limits allowed by the Plan, generally once a year among a choice of portfolios), but may even change the ultimate beneficiary of the 529 account, with no adverse gift tax consequences as long as the new beneficiary is in the same family and generation as the initial beneficiary. The donor can go so far as to withdraw funds from the account for a purpose other than the beneficiary’s education, though such withdrawals are indeed income taxable and, to the extent representing income, are also subject to a 10% penalty. Also note that state income tax issues may arise in states other than Texas, depending on the residency of the beneficiary. Though qualification for financial aid is not usually a focus of affluent families, it is worth noting that 529 Plans enjoy more favorable treatment in this area than the TUTMA (which is fully countable) and the 2503(c) Trust, which is more subjectively counted as a resource for determining financial aid eligibility. A 529 Plan of which the student is the owner is generally excluded for this purpose, as is one owned by a grandparent. If a parent is the owner of the 529 Plan, it is countable as a family resource as opposed to a resource of the student. Keep in mind that all states have a 529 Plan (some have more than one) and your residency and choice of colleges are not relevant for investment in a given state’s 529 Savings Plan. In choosing a Plan, a donor should consider its investment return/choices, annual fees and exit fee to move to another state’s Plan if that becomes advisable. We invite you to consult resources that compare various attributes of the multitude of 529 Plans, including: www.morningstar.com, www.savingforcollege.com and www.529consulting.com. Farner & Perrin, L.L.P., values its part in assisting you in leaving a lasting legacy. Let us assist you in developing strategies to provide for the education of your family so as to enhance their lives and contributions to society.