Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)

Part III. Investment Income and Deductions

Chapter 13. Education Investment Strategies

Where the “Smart Money” Invests for Education

There are a number of tax-benefited ways to fund a college education, each with its own set of rules. In addition, many non-investment tax strategies help with the cost of higher education. These other strategies are discussed in Chapter 20 and Chapter 30. This chapter focuses on the methods for reducing the taxes on investments set aside for education expenses, including the following:

·     529 plans and Qualified Tuition Programs

·     Coverdell Educational Savings Accounts

·     Education Savings Bonds

·     IRAs and Roth IRAs

·     Gifting appreciated items

529 Plans and Qualified Tuition Programs

529 plans and Qualified Tuition Programs (QTPs) are programs run by a state or by an educational institution, such as a private college or university, designed to help families save for future higher-education tuition costs. QTPs are basically pre-paid tuition plans, in which an institution accepts tuition payments at current prices in payment for future tuition costs for the beneficiary. 529 plans are savings instruments, similar to IRAs, which can be used for tax-deferred growth, which becomes tax-free growth if it is used for qualified educational expenses.

At the federal level, no tax deductions are given for contributions made to 529s and QTPs. However, some states do offer a tax deduction for con-tributions made to the state-sponsored plan, assuming you pay income taxes to that state. Growth on the investments in the plan is tax-deferred, and withdrawals of the funds (both principal and growth) are tax-free when used for qualified expenses. Expenses that qualify for tax-free treatment are:

·     Tuition

·     Books

·     Fees

·     Supplies

·     Equipment (if required for enrollment or attendance)

·     Room and board (if enrolled at least half-time)

There is no dollar-based limitation placed on the amount of money that can be invested in a 529 or QTP. The only limit is that the amount invested cannot be greater than the amount that is necessary for the beneficiary’s qualified tuition expenses. There are also no limits placed on who can contribute to a plan—no matter what an individual’s Adjusted Gross Income (AGI), he or she may contribute to a 529 or QTP.

You may have only one beneficiary per 529 account, so, each child will need to have his or her own. However, if the beneficiary of the account does not use the funds because he or she chooses not to go to school, earns a scholarship, or whatever the reason, the beneficiary can be changed to another family member without triggering the tax.

You must decide who the owner will be, as well as the successor owner in the event that the owner dies. The choice of successor is important because he or she will have the ability to change the beneficiary; choose one who will have the child’s interests first.

Contributing funds to a QTP or 529 is considered a gift for gift-tax purposes. The annual gift-tax exclusion is available for these contributions. That means that in 2014 an individual may contribute up to $14,000 to a QTP or 529 per individual beneficiary. A married couple may elect to treat their contributions separately, each giving $14,000 to an individual, for a total possible gift of $28,000 per beneficiary per year.

images   Tip   If an individual or couple would like to contribute more than the annual-exclusion amount in one year, they may do so by electing to spread that gift over five years for tax purposes. A gift-tax return must be filed to make this election, and care must be taken to not make gifts in the following five years to the same beneficiary in an amount that would exceed the extended exclusion. In this way a couple could contribute as much as $140,000 ($14,000 exclusion × 2 individuals × 5 years = $140,000) in one year to a single beneficiary’s 529 or QTP. Also note that the gift-tax limitation is per contributor, not per recipient. In theory, many people could contribute substantial amounts to an individual’s 529 or QTP and there would be no limit on the total contributions, other than the total qualified educational expenses that the beneficiary will need.

Discuss with your financial advisor the important investment limitations placed on 529 plans, such as what investments can be chosen and how often they can be changed. In addition, most state-sponsored plans are run by a mutual fund company and, as such, have only the funds of that company available to choose from.

Should you decide to pull money from a 529 account for nonqualified reasons, the growth of the investment will be taxed at the beneficiary’s applicable income tax rates plus an additional 10% penalty tax (plus any taxes and penalties imposed by the state). Because of this penalty you should use caution to not invest more money into the plan than will be used for education.

Coverdell Educational Savings Accounts

Coverdell Educational Savings Accounts (ESAs), formerly known as Education IRAs, are a more limited vehicle for tax-benefited college savings, other than the 529 plans and QTPs. However, two features of these accounts make them intriguing in certain circumstances.

First, the funds in these accounts are not limited to higher education, but can also be used for qualified elementary and secondary education expenses (such as for private school) and many other school-related costs. This opens up additional possibilities for parents and grandparents who are seeking tax-preferred ways to enhance their children’s or grandchildren’s education. The list of qualified educational expenses includes:

·     Tuition for all levels of education from elementary school through graduate level

·     Books

·     Fees

·     Supplies

·     Equipment (if required for enrollment or attendance)

·     Room and board (if enrolled at least half-time)

·     Tutoring (for K-12)

·     Transportation (for K–12)

·     Uniforms (for K–12)

·     Extended Day programs

Second, funds can be contributed to 529/QTP plans and Coverdells in the same year, which opens up additional planning opportunities.

A maximum of $2,000 per beneficiary may be contributed to a Coverdell account (or combination of accounts) per year. It does not matter how many people contribute, or how many accounts there are; the grand total of contributions per beneficiary cannot exceed $2,000. In today’s world this is not very much money, even for a private elementary school—much less for higher education. However, the amount allowable is not indexed for inflation, so has remained the same since it was last changed in 2002 (prior to that it was $500).

The contributions are not deductible. However, the growth in the account is tax-deferred, and if used for qualified purposes when withdrawn it is tax-free. A person’s ability to make contributions is limited by his or her AGI. The allowable contribution is phased out for married couples in the $190,000 to $220,000 range of Modified AGI (MAGI). The phase-out is between $95,000 and $110,000 for single filers These contributions are considered gifts, so the amount given must be included in the annual gift-tax exclusion with any other gifts given to the same individual.

If funds are withdrawn from an ESA for nonqualified reasons the growth portion of the investment will be taxed at the beneficiary’s applicable income tax rates plus an additional 10% penalty tax (plus any taxes and penalties imposed by the state). However, the 10% penalty does not apply if the distribution is less than the amount of a scholarship received by the beneficiary. It also does not apply in the event of the death or disability of the beneficiary. In these cases, though, regular income tax on the growth will be due—only the penalty is waived.

The ESA must be established before the beneficiary’s 18th birthday. In addition, all funds must be withdrawn from the account by the time that the beneficiary reaches the age of 30. However, the beneficiary can be changed to a family member in the same (or previous) generation if that new beneficiary meets the age requirements.

Education Savings Bonds

The federal government issues Education Savings Bonds as “zero-coupon” bonds, meaning they are sold at a discounted rate, pay no interest during the holding period, and then pay a higher principal amount than the original selling price when they mature. For example, you might purchase a savings bond for $800 that will pay you $1,000 when it matures in 5 years (and no interest). The higher amount paid at maturity is the implicit interest on the bond, which in this case would be 5% simple interest ($800 × 5% = $40, $40 × 5 years = $200 increased price at maturity).

As you learned in Chapter 11, the implicit interest in this type of bond is usually taxed each year on a pro-rata basis. However, with Series EE and Series I federal savings bonds you can elect to not recognize the interest until you sell the bond or until it matures. Further, if you use the proceeds of the bond for qualified higher-educational expenses you don’t ever need to recognize the interest—it is tax-free.

To qualify, the purchaser of the bond must have been at least 24 years old before the bond was originally issued (not when it was purchased). The proceeds of the bond must be used for the educational expenses of the bond owner or the owner’s spouse or dependents. Qualified expenses include only tuition and fees that are required for enrollment or attendance at an eligible educational institution.

The exclusion of interest income is subjected to a MAGI-based phase-out as well. For 2014, a married couple’s ability to exclude the interest income is phased out when MAGI is between $113,950 and $143,950. For all other taxpayers the phase-out is between $76,000 and $91,000 MAGI. MAGI is calculated using the following formula:


+ Non-taxable Social Security

+ IRA deductions

+ Qualified adoption expenses

+ Student loan interest deduction

+ Tuition deduction

+ Foreign income exclusion


IRAs and Roth IRAs

Saving for an education using an IRA or Roth IRA is not an ideal method. However, if the situation arises such that the only funds available for necessary educational expenses are in one of these accounts, it is good to know that the normal 10% penalty on early withdrawals will not apply. If you withdraw funds from these accounts regular income taxes will be due, but no additional penalty.

For this exception to apply the money must be used for the higher education expenses of the IRA owner, or the owner’s spouse, child, or grandchild. Qualified expenses include tuition, fees, books, supplies, and equipment necessary for post-secondary education. Note that room and board are not included in the list.

A Word of Caution (and Coordination)

It is important to understand that there is no double-dipping allowed with the qualified expenses used for any of the four savings strategies listed above. If you count certain expenses toward the qualified withdrawal of funds from one type of account you may not use them toward the exclusion of funds from another account. In other words, you cannot spend $1,000 on tuition and use that as the sole reason that you withdrew $1,000 from a 529, $1,000 from an IRA, and $1,000 from an ESA. Only one of those withdrawals will receive the tax benefits and the others will not.

Because each type of savings strategy has a different list of qualified expenses, coordinating those expenses with withdrawals from the proper accounts will allow you to maximize the amount of withdrawals that can be taken without negative tax consequences. In addition, all of these expenses used against the withdrawals must also be coordinated with any tax credits that are claimed, as discussed later in Chapter 30.

Gifting Appreciated Items

One additional method for reducing taxes on educational savings is to give the student a gift of an appreciated item (such as shares of stock). When an individual receives a gift, the tax basis that she has in that gift is the same as that of the giver. When the student sells the item the gain will be calculated from that basis. However, the tax rate paid on that gain will be at the recipient’s tax rate. In this way the net-of-tax amount realized from the gift could be much greater.

image   Example   Many years ago, Grandpa Joe purchased 100 shares of XYZ stock for $1,000, or $10 per share. Today the market price of XYZ shares is $60, making the total value of the 100 shares $6,000.

Grandpa Joe would like to help his granddaughter, Cindy, pay her college tuition, and needs to liquidate some of his investments to do so. If he were to sell the XYZ shares he would pay 15% capital-gains tax on the $5,000 gain, or $750, based on his current tax bracket. However, because Cindy has no significant income he could save on taxes by giving the shares to Cindy and then having her sell them. Cindy would still need to recognize the $5,000 capital gain, but her income places her in the 0% tax bracket for those gains, so the $750 in tax that Joe would have paid can be avoided, making more net-of-tax income available to her as a gift.