Great News on Gifting and Two Ways to Save for Education Expenses
{{#rendered}} {{/rendered}}Attention Readers,
MAJOR ANNOUNCEMENT FROM THE I.R.S.!
What I told you weeks ago is now officially confirmed: Beginning in 2002, the annual "gift exclusion" — the amount you can give to someone in a year — increases to $11,000. (It's been stuck at $10,000 for decades.) As you can read below, this will increase the amount you can gift to a 529 college savings plan.
Gail
{{#rendered}} {{/rendered}}Gail,
On what date next year can I sign for a tax-deferred private elementary school account? Is it dependent on whether my employer has such a plan?
Thank you. Jim.
{{#rendered}} {{/rendered}}Dear Jim,
I assume you are referring to an Education IRA, now more appropriately named the "Coverdell Education Savings Account." The biggest benefit these accounts offer is that you pay no federal tax on their earnings, provided all withdrawals are used for "qualified education expenses."
Through this year, the maximum contribution per child is $500. However, the 2001 Tax Act increases the annual contribution to $2,000 per child starting in 2002.
{{#rendered}} {{/rendered}}Equally significant, the Act broadens the use of this account. As always, withdrawals used to pay for college-related expenses are federally tax-free. However, as you have obviously heard, starting in January you can also get this federal tax break on educational expenses incurred from kindergarten through high school.
For this reason, if you are saving for a child's college expenses, the first $2,000 you put into an account each year ought to go into an Education Savings account. Thanks to the new flexibility of these accounts, if you choose, you could use withdrawals to pay for parochial school, uniforms, after-school day-care, even summer programs you deem "educational" well before the child is 18. Of course, when the child goes to college, withdrawals can be used for these expenses.
Even better, starting next year, it will be possible to contribute to both an Education Savings Account and a 529 college savings plan for the same child. So after you (or grandma :>) have put $2,000 into a Coverdell account, you can set aside even more money into a state-sponsored 529 plan, which also offers federally tax-free withdrawals for qualified college expenses starting next year.
{{#rendered}} {{/rendered}}Contributing to either a Coverdell Education Savings Account or a 529 plan has nothing to do with your employer. Both are available today. I suggest you talk with a financial advisor in your area to decide on the best approach for your situation.
Hope this helps, dad!
Gail
{{#rendered}} {{/rendered}}Does a 529 plan allow me to put money in as a tax deduction and then allow me to take out as a tax-free distribution? Where can I get more info on how to set up this plan?
Paul
Dear Paul,
{{#rendered}} {{/rendered}}Contributions to a 529 college savings plan must — by federal law — be made in cash and always consist of after-tax money. The tax break comes on the withdrawal end (assuming, of course, that the money is used for qualified college expenses). The more time you've got until your child needs the money for college, the more significant this tax-free compounding becomes.
A great website with both general information as well as links to all of the plans currently offered by each state is: www.savingforcollege.com.
But a word of caution: 529 plans are state-sponsored programs. You are actually investing in a municipality run by a state, which invests in underlying mutual funds. An investment in a 529 plan is not an investment in a mutual fund. However, like mutual funds, the plans invest in financial instruments — stocks and bonds — and consequently, they are subject to market risk. But every plan offers a variety of investment options, including more conservative choices that can help reduce the risk of market volatility.
{{#rendered}} {{/rendered}}In addition to the special tax breaks 529's offer, they also give you something you cannot get with a "Uniform Gift to Minor" account: control. With an UGMA/UTMA (the name depends on the state in which you live), the money becomes the child's property once he or she reaches the age of majority — usually 18 or 21. If the account has done well, that means an 18-year old could be looking at tens of thousands of dollars. Pretty tempting.
With a 529 college savings plan, the child never gets control of the money — he or she is the beneficiary but the control stays in the hands of the adult responsible for the account. Often, this is the same as the person who contributed the money, but it doesn't have to be. Grandpa, for instance, could make the donation but name mom as the controller. No money ever comes out of the account without permission from the controller.
Furthermore, if Little Johnny decides to blow off college or gets a scholarship, you can name another person as the beneficiary of the account — his sister, perhaps.
{{#rendered}} {{/rendered}}Each state's 529 plan has its own features and benefits. You do not have to use the plan offered by your state, but you should check to see if you get any benefits if you do. For instance, some plans state residents a tax deduction. While this seems like a great deal, keep in mind that the value of this short-term benefit can be over-shadowed by lousy long-term investment performance. So check into the reputation of the investment manager hired to do the investing.
Some 529 plans are more restrictive than others; it really pays to compare what your state offers against the terms of other plans. A few will penalize you, for instance, if you want to move your money to a plan offered by another state.
The way you invest in a 529 plan depends upon the state sponsoring it. With some, you're completely on your own. You simply call their toll-free number, order the materials and send your check. Others give you a choice of doing it yourself or using the services of a financial advisor.
{{#rendered}} {{/rendered}}You should especially consider using the help of a professional advisor if you want to take advantage of the estate planning benefits 529s offer. For instance, this year you can put as much as $50,000 into a 529 and not owe any gift tax, even though this is five times more than the annual federal gifting amount. (Next year, when the federal gifting amount increases to $11,000, the limit on a 529 plan gift rises to $55,000.)
For such a contribution to benefit from the gift tax exemption, you cannot give the beneficiary of the 529 anything else of value for 5 years. Here's the benefit to the donor: at the end of the 5-year period, the money is completely removed from your estate for estate tax purposes — even though you can still control it. (Note, though, that should you die within the 5-year period, any amount over the $11,000 gift tax exemption would revert back to your estate.)
I love 529 plans. They're the answer to every parent's prayer for a tax-advantaged method of saving significant money to educate a child. Don't get too hung up on comparisons among the plans. It's more important to just get started!
{{#rendered}} {{/rendered}}Gail
If you have a question for Gail Buckner and the Your $ Matters column, send them to moneymatters@foxnews.com along with your name and phone number.
The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.